Minimum Volatility: A Versatile ETF

Includes: EUSA, USMV
by: Noel Archard, CFA

Tourists who come to San Francisco often rent convertible sports cars so they can zoom along California’s iconic Pacific Coast Highway. But many Bay Area residents opt for four-wheel drives. Not only can a four-wheel drive handle a trip along the coast, but it can also be trusted to make a trek up to Tahoe when the Sierras get a fresh batch of snow. Yes, the trade-off means giving up some speed, but it also means gaining some reliability and the flexibility to respond to changing weather conditions.

Now, why am I talking about cars on a blog about ETFs? I think they’re a good analogy to use to explain minimum volatility ETFs and low beta stocks.

Last year, we introduced four minimum volatility ETFs. They launched in October as investors were asking us for ETFs that could help insulate their portfolios from wild market swings. But these funds were not designed for use only in volatile markets. Instead, they can be used as core, long-term holdings that over time seek to deliver close to market returns with less risk. Rather than thinking of a minimum volatility ETF as a sports car that’s designed for an undulating market, think of it as a versatile four-wheel drive vehicle that helps you to tackle both calm and chaotic conditions.

To achieve the objective of lower risk, minimum volatility ETFs hold low-beta stocks, or stocks that typically don’t exhibit excessive amounts of volatility versus the broader market. Now, it’s important to remember that there’s usually a trade-off between risk and return. With minimum volatility, you’re taking on less risk and may experience lower returns when the market is rising. But you also tend to experience less of a decline when the market is dropping.

That is the potential benefit of minimum volatility ETFs - you can fine-tune the risk in your portfolio by smoothing out its performance, especially on the downside. Remember, if you have $10,000 invested a stock that falls 10% that stock needs to rise 11% for you to get back to $10,000. But if you lose 20% in a stock, your stock needs to jump 25% for you to break even. If you have an aversion to choppy markets, minimum volatility funds could be worth examining.

Let’s look at the iShares MSCI USA Minimum Volatility Index Fund (NYSEARCA:USMV) and the iShares MSCI USA Index Fund (NYSEARCA:EUSA). Both ETFs offer broad equities market exposure and hold mainly large-cap U.S. stocks. But of that universe of stocks, USMV is designed to hold low beta stocks - stocks whose price tends to move less than the broader market. A stock with a beta below 1 is considered low beta.

Now, how does USMV’s minimum volatility screen change its holdings compared with EUSA? Let’s look at Wal-Mart (NYSE:WMT), which is held by USMV and EUSA. It accounts for 1.45% of USMV, but only 0.87% of EUSA as of March 23. Why? According to data from Factset as of March 23, Wal-Mart’s beta compared with the S&P 500 is 0.39, qualifying it as a low beta stock and giving it a higher weighting in USMV. But a large-cap stock like JPMorgan (NYSE:JPM), which is held by EUSA, is excluded from USMV entirely because of its high beta of 1.39 - which means its price tends to fluctuate more than the overall market.

Low beta stocks like Wal-Mart aren’t the flashy, sexy stocks that tend to grab investors’ attention and zoom higher, especially during market rallies. Instead, they’re more like the steady 4-wheel drive. They may easily be passed by the sports car on the trip up the mountains, but they tend not to loose their grip and slide off the road as much on the descent. In the same regard, while minimum volatility portfolios grow slower in rising markets, they tend to decline less when the market is moving south.

The Minimum Volatility Funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

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