Investing in equities these days should come with a warning for those who suffer from motion sickness.
In response to the roller-coasterlike swings that investors have suffered since 2008 and the expectation of more to come,
BlackRock Inc.'s iShares unit, Invesco PowerShares Capital Management LLC and Russell Investments have launched low-volatility exchange-traded funds that are designed to offer a smoother ride.
Such ETFs hold the least-volatile stocks, or those with the lowest standard deviation over the previous year in their respective indexes. PowerShares' ETF is based on the S&P 500, Russell's on the Russell 1000 and iShares' on the MSCI USA Index.
The stocks with the lowest volatility are less likely to have big swings.
“It's going to give you a much calmer bag of securities,” said Abraham Bailin, an ETF analyst at Morningstar Inc.
Low-volatility strategies have paid off in the long run. Back-tested data for the PowerShares S&P 500 Low Volatility ETF shows that it would have trumped the S&P 500's annualized returns over the five-, 10- and 15-year periods ended June 30.
Since it was launched in early March, the S&P 500 ETF has outperformed the index by almost 7%. The Russell 1000 Low Volatility ETF has outperformed the Russell 1000 by 3% and the iShares MSCI USA Minimum Volatility ETF was launched in mid-October.
Even though the strategies historically have done well, they do trail when the market is in an upswing. For example, PowerShares' low-volatility strategy would have trailed the S&P 500 in 2009 and last year.
“You could certainly be limiting your upside,” said Taylor Ames, a senior equity product strategist at PowerShares. “But for a lot of advisers, wealth preservation is more important now than capital appreciation.”
Financial advisers have been turning to ETFs increasingly to deal with increased volatility, according to a recent study by Cogent Research LLC. It found that advisers plan to boost the use of ETFs in portfolios designed to lower risk to 30% of assets by 2014, from 22%.
“With ETFs, you've got an easy way to pull the plug and avoid riding the market down,” said David Shucavage, president of Carolina Estate Planners LLC.
Volatility has resurfaced since Standard & Poor's cut the U.S. credit rating in early August. Since then, the Chicago Board Options Exchange Market Volatility Index, or VIX, has closed at an average of 34.49 points, up from about 18 over the first seven months of the year.
The volatility hasn't reached the levels seen during the financial crisis. From September 2008, to the market bottom on March 5, 2009, the VIX closed at an average of 51.88 points.
That is a far cry from the relative calm that preceded 2008. From 2004 to the end of 2007, it closed at an average of 14.8 points.
CHANGED MINDSET
“No doubt, what happened in 2008 really changed the mindset of advisers,” Mr. Ames said. “Advisers realized they need to be able to protect against the downside, not just look for overall performance.”
The resurgence of volatility has underscored that, Mr. Ames said.
But not all advisers are convinced that low-volatility ETFs are the best way to manage volatility.
“It seems somewhat gimmicky,” said Chip Addis, co-founder of Addis & Hill Financial Advisors.
He sees a well-diversified portfolio using low-cost broad-based ETFs, such as the SPDR S&P 500, as the best way to combat volatility.
The low-volatility ETFs have expense ratios that range from 15 basis points to 25, while broad-based large-cap ETFs typically charge less than 10 basis points.
