Volatility is the standard deviation of returns. Put more simply, volatility is basically a measure of the frequency with which the price of a security will change substantially. Higher volatility equals higher risk. Why does higher volatility equal higher risk? Volatility creates a "drag" on returns.
When you lose money the rate of a security's appreciation slows because the base off of which you are compounding is lowered substantially. Losses are linear, but getting back to your original higher base requires an exponential gain. In other words, it takes a much larger percentage gain to get back to even than the original loss you suffered. For example, if you lose 10 percent you would need an 11 percent gain to get back to even, if you lose 20 percent you need a 25 percent gain, and so on. The greater the loss, the disproportionately higher the gain you will need to get back to even.
The SPDR S&P 500 (SPY) and iShares Core S&P 500 ETF (IVV) provide investors with the S&P 500's returns less tracking error. If you simply want to follow the performance of the S&P 500, these funds are your best option. However if you are a more conservative investor that wants lower volatility, you may want to consider low volatility alternatives. The ETFs below follow strategies that dampen volatility which will result in a generally more conservative return stream with lower volatility. Whether or not lower volatility strategies result in a higher or lower return than their relevant benchmark is still the subject of debate among the finance community.
Low- Volatility ETFs
PowerShares S&P 500 Low Volatility Portfolio (SPLV)
The ETF attempts to track the S&P 500 Low Volatility Index which is comprised of the 100 constituent stocks in the S&P 500 with the lowest volatility over the last 12 months. As per the ETF's prospectus, the fund may end up concentrating in particular low volatility industries such as utilities, but it is a byproduct of the fund's main strategy of selecting the 100 least volatile stocks and not a deliberate concentration. The fund has a low fee of .25% and a respectable dividend yield of 2.71%.
One potential downside to the fund is its extremely high exposure to utilities (approximately 30%) and defensive consumer (approximately 20%) companies. Furthermore, the ETF has virtually no exposure to technology.
iShares MSCI USA Minimum Volatility Index ETF (USMV)
USMV is extremely similar To SPLV. The two ETFs have many of the same holdings, and have returns that are approximately 94% correlated. The ETF has a few advantages over SPLV. It has a lower expense ratio of .15% and a more diverse set of holdings that is less concentrated in utilities and defensive consumer. On the other hand, the fund has a lower dividend payout of 1.70% and a higher portfolio turnover of 30% versus 17%.