How to Manage Volatility in ETF form
Anyone who has followed the markets since the collapse of Lehman Brothers in 2008 is probably familiar with the concept of volatility.
Markets, of course, always have their ups and downs, but during times of crisis or heightened uncertainty these meandering swings can turn into a roller coaster ride that leaves even experienced investors struggling to hold on.
Lesser spikes in volatility occur all the time: earlier this month, for example, when it looked as though the U.S. Federal Reserve just might hike interest rates, the VIX — the so-called “fear index” that provides a measure of volatility based on options activity on the S&P500 — jumped. The Fed declined to raise rates (surprise, surprise) and the volatility spike subsided.
One big difference since Lehman is that the intervening years have seen an explosion in so-called factor ETFS, which attempt to group stocks according to fundamental factors. And one of those factors is volatility.
Retail investors now have a number of ways to make investments that take volatility into account, either to minimize it or to take advantage of it. Here’s a look at some of the main strategies investors can pursue and their benefits and drawbacks:
These ETFs seek out a group of stocks with the lowest absolute risk versus the market by looking at one simple measure: beta. Beta is the magnitude by which a stock can be expected to move in relation to a given move in the overall market. A beta of 1.2 would indicate a stock that moves more than the market, while a 0.8 beta reflects a stock that would only move 8% versus a 10% move in the market.
A sole focus on beta can and has in the past resulted in sector concentration, which needs to be considered from an overall portfolio management perspective.
Minimum volatility ETFs will select stocks with the lowest standard deviations attainable. With the standard deviation is an absolute measure with respect to a stock’s own volatility, these ETFs taking into account additional measures such as the covariance between selected stocks and deviation from the main index (industry weights) they seek to substitute for.
These products provide direct access to volatility itself, accessed via futures contracts on the CBOE VIX index. There are two key considerations with such ETFs. First, the futures contracts in question primarily trade in a contango market, which increases the cost of ownership over time. Second, yes, there will be spikes in volatility that can be captured via VIX ETFs, but timing them is — you guessed it — easier said than done.
Despite these two hurdles, when markets get stressed, the long positions in VIX ETFs will gain ground, offsetting paper losses in your portfolio.
On the flipside, there exists an inverse VIX, which makes money when volatility declines, or even when it fails to materialize through time.
The Minimum Volatility / Low Vol strategy has attracted broad interest, not just through ETFs, but also through Mutual Funds, to the point where some are questioning the risk posed by the level of valuations of stocks meeting the strategy’s criteria, thereby risking its efficacy going forward.
While this merits closer examination, investors need to remember that the holdings comprising the strategy do not remain static, as the screens used to select holdings are run at a pre-set frequency in order to, at that time, seek the best stocks to move forward with.
That, and the fact that volatility in the markets is transient, should mean there always will be opportunities to produce a lower volatility experience — provided recent volatility in the names is indicative of and predictive of future volatility.