What Are Volatility Insulated Funds?

Perhaps the recent stomach-churning action in the stock market has you reaching for antacids. As a result, you have begun to wonder if you should be heading for the hills, we think you should reconsider. After all, the stock market is still one of the best places to invest your money in the long run. And getting out at the wrong time can lead to serious losses from which you may never recover.  Worse yet, you may be left watching from the sidelines as the markets quickly reverse its course.  

Uncertain Times Ahead

However, we can’t deny that it can be difficult to stay the course during extreme selloffs in the market.  Looking ahead, there are still significant headwinds to come.  The coronavirus pandemic has pushed the global economy into a recession. Although there are signs of recovery, fears of a second wave are weighing on the market.  As well, political uncertainties, like the US-China trade war and the upcoming U.S. presidential election, contribute to an uncertain outlook.  While the fiscal policy has helped to stabilize the market, it may be that the easy wins have already occurred.

But before we scare you out of the market (again), we think you might want to consider another approach.  Instead of getting out of the market completely, why not take a more diversified approach?  Having a diversified portfolio is one key to limiting your risks in the stock market.  One way you can do this is to add something like a volatility insulated fund to your portfolio.  After all, volatility insulated funds were created exactly for uncertain times like these.   

Volatility Insulated Funds Explained

You might hear volatility insulated funds also referred to as low volatility funds. As their name implies, these funds are specifically designed to give market exposure but with less volatility than the overall market. Generally, this involves investing in stocks with the lowest price volatilities. The volatility of a stock is usually measured by the standard deviations of a stock’s price.  Another measure is its beta which measures its volatility relative to the overall market.  

For risk-averse investors, these funds will offer better downside protection when the markets fall.  The trade-off, however, is that you will also sacrifice some returns when the markets are good.  Overall though you will experience fewer wildly unpredictable price swings – both up and down.  Over the long term, this may translate into a better risk-adjusted return, as well as a more comfortable ride.

Low volatility funds became popular after the 2008-2009 financial crisis.  They saw another surge in popularity in early 2016 when the S&P 500 got off to its worst start ever.  Because of their short history, though, their effectiveness over the long run, especially during a prolonged bear market, is still unproven.

Should You Invest in Volatility Insulated Funds?

For those starting out in the investment world, volatility insulated funds may serve as a good entry point. This is because you will be less subject to the wild swings in the market.  Additionally, they may help you to stay invested for the long term. This is because they will help you to ride out the downturns with more confidence.  As a result, you will be less likely to panic and jump ship at the worst possible times.  

Low volatility funds may be the way to go for those investors nearing retirement. This is because these investors may not have the time to wait out an extended market downturn. They will allow you to keep your exposure to the markets while providing some insulation from market fluctuations.  And when the market does go down, these funds are more likely to recover faster.

Really, for any investor looking to manage risk, low-volatility funds can offer a higher risk-adjusted return.  Besides lowering risk, many will offer income as well since they tend to have greater exposure to companies and sectors offering above-average dividend yields (eg. consumer staples and utilities).  As such, they can serve as a good alternative to low-yielding bonds.

While these funds do have benefits, it is important to remember that they are not designed to outperform the market.  Their main objective is just to perform less poorly during a market downturn.  When times are good, these funds will tend to lag the market.

Same Objective, Different Approaches

While all low volatility funds have the same objective of insulating investors against wild market swings, they are not all created equal. You can choose from many different strategies.  When selecting your strategy, you must consider how these funds are constructed. The strategy you chose will affect both overall performance and odds of success.

Basic Approach

The most straightforward approach that a fund can take is to select individual stocks based on those showing the least volatility on a daily basis.  An example of such a fund is the PowerShares S&P 500 Low Volatility ETF which is based on the S&P 500 Low Volatility Index.  

This fund holds the 100 lowest daily volatility stocks, based on price action from the preceding 252 trading days.  The weighting of the stocks is based on the inverse of their volatility, meaning that those with the lowest volatility are given the highest weighting. There are no sector constraints and the portfolio is rebalanced quarterly.

The risk with this approach is that, without taking the sector into account, you may be vulnerable to sector concentration risk.  For example, because utilities and REITS have historically low volatility, they may end up making up a high proportion of the portfolio’s allocation.  This may increase your risk in the event of a sector downturn or changes in market conditions such as rising interest rates. 

Correlation Approach

Another approach takes into consideration how stocks correlate with each other.  Rather than just including two stocks because they have low volatility, one would also take into account their correlation, i.e. whether they tend to move together.  Stocks that are less correlated balance each other out and decrease the overall volatility of the portfolio.  

Taking a more holistic approach increases diversification, but may result in less exposure to the least volatile stocks.  In some cases, this can be offset by the reduced volatility in the overall portfolio.

Stock selection would be based on a quantitative process that measures the stock’s impact on the overall volatility of the portfolio.  A potential drawback is that the selection process used may be more complex, and not readily transparent to the investor.  An example of a fund using this approach is the iShares MSCI Canada Minimum Volatility ETF (XMV-TSX).

More Complex Approaches

In more actively managed portfolios, you might decide to use a more sophisticated approach.  Besides basing stock selection on low volatility, other factors would be taken into consideration.  Such factors may include excessively high valuations or unsustainable price momentums.  In taking into account these risk factors, we would assume the portfolio’s volatility will be even more reduced.

Other strategies may incorporate the use of derivatives or some other hedging strategy to boost returns and limit volatility.  For instance, a manager may overlay a portfolio of low volatility stocks with put and call options on the stocks to limit risks and increase returns.  

By including other risk factors, portfolio managers hope to be more adaptive to changing market conditions and manage risk more effectively.

Other Factors To Consider

Other factors that may affect a portfolio’s performance are the volatility measurement period and the frequency of portfolio rebalance. A stock’s volatility is based on past historical data. A shorter lookback period (eg. one year vs. five years) and a more frequent rebalancing of the portfolio will mean that a fund can react faster to changes in market conditions.  However, this may be offset by the higher transaction costs that result from a more frequent turnover. 

In selecting a fund, you might also want to consider whether the fund has any portfolio constraints.  Constraints may include limits on countries, sectors, and stock weightings, as well as non-targeted exposures.  These may also have an effect on a fund’s overall style and performance. 

Before You Jump In

It is important to keep in mind that low volatility is not the same as “risk-free”.  This style of investing may expose you to other undesirable risks. It is a backward-looking approach that relies on historical data to find low volatility stocks.  However, there is no guarantee that a low volatility stock in the past will continue to be one in the future.  Also, historical data do not reflect current market conditions or recent developments in a company that may pertain to future risk.  

Reliance on historical data may also lead to an over-concentration in certain sectors such as consumer staples or utilities, or over-exposure to certain risk factors such as interest rate sensitivity.  It may also leave you under-represented in the more volatile but potentially more rewarding sectors such as technology or resources.

As with any strategy, it may become ineffective as it increases in popularity. When demand for low volatility stocks increases, their valuations may become too high, limiting their upside potential.  It is good to keep in mind that this style of investing can overlap other similar styles such as value-investing or dividend-payers.

While low volatility funds will offer downside protection when markets are retreating, you must also be willing to expect below-average returns when markets are advancing.  That said, with continued uncertainty in the markets, adding a low volatility component to your portfolio may be just what you need to ride out these turbulent times. 

As always, please keep in mind that this information is for educational purposes only and does not constitute financial advice.  If you are looking for an alternative way to invest outside of the stock market, why not check out our Hedgetrade platform.