Tony's ETF Buyer's Guide: Low Volatility and Minimum Volatility ETFs

Low volatility ETFs

SPLV takes a targeted approach to reducing risk by selecting stocks from the S&P 500 that have exhibited the lowest realized volatility over the past 12 months. This strategy results in a portfolio of 100 stocks that have historically been the least volatile.

Realized volatility is calculated using price return data from the last 252 trading days leading up to each index rebalancing date. Those that meet the eligibility criteria are ranked in descending order based on the inverse of their realized volatility. This means that stocks with lower volatility receive higher weights in the ETF.

This selection method tends to favor stocks from defensive sectors such as consumer staples, utilities, and healthcare due to their naturally lower volatility.

Even within more volatile sectors like financials, the ETF gravitates towards sub-sectors perceived as less risky, such as insurers and exchanges. This strategic overweight to defensive stocks is designed to stabilize portfolio performance during market downturns.

Minimum volatility ETFs

In contrast to the straightforward approach of selecting historically low-volatility stocks, USMV follows a more sophisticated method aligned with the MSCI USA Minimum Volatility (USD) Index.

Unlike strategies that focus on individual stock volatility, USMV employs an optimization-based strategy designed to construct a portfolio that exhibits the lowest possible overall volatility.

This means that while the individual stocks within USMV might have higher volatility on their own, the key is their low correlation with each other. By carefully selecting stocks that react differently to various market conditions, USMV aims to achieve a portfolio whose collective components balance each other out, resulting in lower aggregate volatility.

A significant distinction between USMV and SPLV is its sector composition. USMV maintains a sector distribution that closely mirrors that of the broader S&P 500, typically balancing its holdings across technology, financials, and healthcare sectors.

Low volatility versus minimum volatility

When comparing the performance of low volatility versus minimum volatility strategies, the data shows that minimum volatility has the edge.

From October 20, 2011, to October 3, 2024, the iShares Edge MSCI Min Vol USA ETF

achieved a compound annual growth rate (CAGR) of 12.48%, while the Invesco S&P 500 Low Volatility ETF

SPLV

+1.45%

posted a CAGR of 11.07%. In comparison, the SPDR S&P 500 ETF

SPY

-2.58%

outperformed both with a CAGR of 14.72%.

Both strategies effectively reduced overall volatility compared to the broader market. The standard deviation, a measure of market volatility, was 16.68% for SPY, 13.66% for USMV, and 14.56% for SPLV, indicating that both low and minimum volatility strategies managed to smooth out some of the market's rough edges.

However, when it comes to drawdowns, which measure peak-to-trough decline, the benefits were less pronounced. During the 2020 COVID market crash, SPY experienced a maximum drawdown of -33.72%, compared to -33.10% for USMV and -26.26% for SPLV, highlighting that these strategies, while mitigating some risk, do not fully shield against market downturns.

Despite these similarities, USMV's more complex approach resulted in the best risk-adjusted return, with a Sharpe ratio of 0.77, slightly higher than SPY's 0.75 and notably better than SPLV's 0.63. This suggests that while both strategies aim to reduce risk, the minimum volatility approach of USMV

has historically provided better compensation for the risks taken compared to SPLV

SPLV

+1.45%

.

The takeaway here is that low and minimum volatility ETFs are not interchangeable solutions for risk reduction. Each has its merits and can be effective depending on your investment goals and risk tolerance, but historically, minimum volatility has shown a slight advantage.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.