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In an earlier blog post, I explained how minimum volatility ETFs are like four-wheel drive vehicles - they might not be the flashiest cars on the road, but over the long haul they have the potential to get you where you need to go in all kinds of weather.

Now - no pun intended - I’m going to go under the hood and talk about why it’s important for investors to understand the methodology a minimum volatility ETF uses to determine which stocks to hold.

Minimum volatility ETFs attempt to smooth the market’s peaks and valleys by holding low beta stocks. These low beta stocks tend to be less volatile than the broader market. While they may not rise as much in a rallying market, they tend to decline less when the market is headed south.

But the low beta stocks that minimum volatility ETFs hold can vary greatly and some of that variation can be linked to the indexes that the funds seek to track. As I’ve mentioned before, for investors trying to determine what an ETF might hold, it is important to understand that different index providers use different methodologies to build and maintain an index.

At iShares, our minimum volatility ETFs seek to track the MSCI family of minimum volatility indexes, like the MSCI USA Minimum Volatility Index (the benchmark for USMV). We chose MSCI because they take a dynamic approach to selecting and weighting the stocks in each index. To do this, MSCI assesses an individual stock’s volatility compared with the broader market, and it also looks at that stock’s correlation to other stocks in the index. Screening for correlation helps to increase diversification by ensuring the stocks selected for the index don’t move in lock step with one another.

Other fund providers use the S&P 500 Low Volatility Index as a benchmark and this index follows a different methodology. To determine its holdings, the S&P Low Volatility index selects the 100 stocks in the S&P 500 with the lowest 12-month standard deviation.

As I mentioned above, the reason we chose to use the MSCI USA Minimum Volatility Index is because its index methodology allows for more diversification across sectors, as you can see illustrated in the chart below. Clients were asking for a minimum volatility ETF that offered diversification across sectors rather than an ETF with high sector concentration.

The S&P 500 Low Volatility Index can have a greater overweight toward a particular sector if that sector tends to be comprised of low beta stocks. In this case, the S&P Low Volatility Index has a large concentration in utilities and consumer staples.

Here is a breakdown of the sector exposure of each index:

Click to enlarge

(click to enlarge)

As I’ve said before, investors who are interested in ETFs should look at a wide range of factors, including provider, structure, liquidity and costs, before making any investment decisions. For those investors who are considering minimum volatility ETFs it might also make sense to consider how much sector exposure is important when it comes to constructing an overall portfolio strategy.

The Minimum Volatility Funds may experience more than minimum volatility as there is no guarantee that the underlying indices’ strategy of seeking to lower volatility will be successful. Diversification may not protect against market risk.

Original post

Source: Under The Hood: Choosing A Minimum Volatility ETF