Low Volatility U.S. ETFs: How do they work?

What is volatility?

When it comes to individual equity-like securities (stocks, ETFs), volatility is primarily measured by two concepts: standard deviation and beta. 

• Standard deviation: The square root of an investment's variance measures the percentage of how much investment has historically fluctuated on average from its expected return. A stock with an average compound annual growth rate (CAGR) of 7% with a standard deviation of 15% is much more volatile than one with a CAGR of 7% but a standard deviation of 10%. 
• Beta: measures how sensitive investment is relative to a market index, such as the S&P 500. A beta of greater than 1 means an investment is more volatile than the market and moves in line with it, a beta of between 0 and 1 means the investment is less volatile and moves in line with it, albeit more muted, and a negative beta means the investment moves inversely to the market. 

Low volatility investments are, therefore, stocks or ETFs with a lower-than-average standard deviation and beta compared to a benchmark. Investors can therefore screen for stocks with historically low amounts of either. While this approach is past-looking, it actually serves as a fairly predictable indicator of future volatility compared to using past returns to extrapolate future returns. 

Explanations for low-volatility investing

Explaining the low volatility phenomenon is a herculean research endeavour in and of itself, with numerous studies finding evidence for different reasons. To save you time, I've summarized some of the more notable ones below:

• Low-volatility stocks tend to be mature, stable companies with excellent balance sheets, strong revenues, consistent earnings, and good cash flows. Thus, they provide excellent exposure to the profitability and investment risk factors, which explains their out-performance. 
• Low-volatility stocks minimize the negative effects of large compounding losses. For example, losing 33% in a year requires a 50% return in the following year to break even due to how the geometric mean works. For that reason, avoiding large losses should be more important than chasing high returns, and low-volatility stocks do that better. 
• Low-volatility stocks are often overlooked by investors in favour of high-beta growth stocks (think about all the tech sector bubbles that occurred). Thus, they tend to be underpriced relative to their fundamentals and, according to the value risk factor, can provide a higher return. 

The real answer is still unknown and not agreed upon, but if I had to guess, I would wager it's a mixture of the three mentioned above. Whatever the case is, low volatility investing has worked historically. 

Low-volatility investing using ETFs

Investors can use a stock screener to pick a portfolio of low-volatility companies, but this approach is time-consuming, difficult to rebalance, and may incur substantial trading commissions and bid-ask slippage. A better way is via ETFs, and the following funds might work:

1. iShares MSCI USA Min Vol Factor ETF (USMV): 0.15% expense ratio. 
2. Invesco S&P 500 Low Volatility ETF (SPLV): 0.25% expense ratio. 

Let's see how both funds have historically performed versus the S&P 500:

Both ETFs underperformed the S&P 500 in terms of CAGR, but USMV outperformed in terms of risk-adjusted returns, with a higher Sharpe ratio and lower max drawdown. The period of the backtest was constrained by the inception date of the funds in 2011 and covered an unusually long low-interest rate bull market that helped high-beta technology stocks in the S&P 500 outperform. It's worth noting that in 2022, both low volatility ETFs fell significantly less than the S&P 500.