Those crazy financial engineers seem to be creating new exchange-traded funds (ETFs) on a daily basis. Just about every index, country, sector and idea have a related ETF. Some of these ETFs become popular trading tools, others fail to gain traction, quickly fading into obscurity.
Recently, despite record-low volatility levels, a new type of ETF has surged in popularity among investors. Known as low-volatility ETFs, these investing instruments are built upon stocks with low volatility, so they serve as a diversified hedge against risk within a portfolio.
But before I tell you about a great low-volatility ETF, let's take a closer look at underlying concept of volatility and why it matters...
Market volatility is measured by the Volatility Index (VIX). Even this measurement is relatively new in the history of the stock market. The index measures the implied volatility of the S&P 500 during the next 30 days. Specifically, it is a weighted blend of prices for a range of options contracts on the S&P 500. These options are priced based on the expected volatility or price changes for the next 30 days. In other words, it's the expected percentage move of the S&P 500 during the next 30 days on an annualized basis.
This figure has been as low as 9% and as high as 89% since the VIX was first put into practice in 1993. When the market drops, the VIX usually climbs, indicating fear, represented by option prices. In fact, extremely high VIX readings like the ones we witnessed in October 2008, correspond with sharp sell-offs. Similarly, a climbing market generally results in a lowering VIX, as fear leaves the market and greed starts to take over.
Today, the VIX is near historic lows around 14 or 15. So why, then, are low-volatility ETFs are so popular right now?
A combination of reasons
The recent flash-crash scenarios in the stock market, the European debt crisis, overall economic uncertainty of the presidential election, and the fact that many people are still overly cautious with their investments have led investors to believe the stock market volatility will increase soon.
Looking at the weekly VIX chart, there has been a clear technical support in the 14-15 range during the past 2 years. In other words, it appears the VIX has nowhere else to go but higher from here. The inconsistency is that since the latest selloff in May, stocks have been pushing higher, with the S&P 500 touching a 4-year high even as this article is being written.
Well, remember, stocks are driven by perception, not reality. As long as traders believe there is going to be a major increase in volatility, low-volatility ETFs will remain popular. Not to mention, they serve the purpose as a de facto value-investing tool in many circumstances.
The spectrum of low-volatility ETFs ranges from iShares MSCI All Country World Minimum Volatility Index Fund (NYSE: ACWV) to the most popular low-volatility ETF, the PowerShares S&P 500 Low Volatility ETF (NYSE: SPLV).
This ETF chooses the 100 least volatile companies in the S&P 500 for investment. These 100 stocks are then weighted, with the least volatile of the group having the most representation.
It is by far the most popular of the low-volatility ETFs, with about $1.7 billion of assets in its first year of trading. It's currently trading close to 19% higher from last year, compared to a 20% increase in the S&P 500.
Remember, this ETF is not designed to beat the S&P 500, but in the current choppy-wall-of-worry climbing uptrend, it has been. If the uptrend had been smooth and continuous, then it is unlikely that SPLV would have beaten the benchmark. This high performance is probably because investors have been embracing riskier, higher-potential assets during an improved period market confidence, which induces a long-term bull market rally.
Risks to Consider: Outside of the normal daily risks of the stock market, the risk factor with low-volatility ETFs is one of lack of performance rather than outsized risk of loss. Should markets continue their upward momentum, low-volatility stocks may languish, giving back their present gains on the year.
Action to Take -- > Long-term investors would be wise to consider one or more low-volatility ETFs as a buffer against potential volatility spikes in their portfolio.
As an individual investment instrument, whether or not to purchase depends on your own feelings about the future of the market. Remember, no one knows for certain what the future holds. Always position size properly based on your risk tolerance and account size. If you believe volatility will be ramping up or if you just want a counter point in your stock portfolio, then low-volatility ETFs are the way to go.