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How Have Low-Volatility Funds Performed in 2022?

And are there any Morningstar Medalists in the group?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. As their name suggests, low-volatility funds are designed to offer better downside protection, a smoother ride, and better risk-adjusted performance than the market long term. Joining me today to discuss how these funds have held up so far in rocky 2022 is Ben Johnson. Ben is Morningstar's director of global ETF research.

Hi, Ben, nice to see you.

Ben Johnson: Hi, Susan. Great to see you, too.

Dziubinski: Let's start out with a brief introduction for what low-volatility funds are and what role they might play in a portfolio.

Johnson: Susan, I think you said it well, the expectation with low-volatility funds is that over a sufficiently long period of time, investors will get exposure to a particular corner of the equity market, be it U.S. large and mid-caps, emerging-markets stocks, developed international stocks, with a lower degree of volatility. It'll be a bit smoother ride. Now, that's not necessarily always going to be the case. These funds aren't going to bat 1,000, taking a little bit of the sting out of each and every downdraft in the market. But if you give them long enough, if you can stick with them long enough, the expectation is that you'll get marketlike returns over a long period of time with less risk, which, at least in theory, might make it somewhat easier to stick with that portfolio.

In all of the various implements that investors have at their disposal, all the different levers that they can pull to reduce the overall level of risk within their diversified portfolios, this is really a fine-tuner. So for those out in our audience that are old enough to remember good old-fashioned stereo receivers that had a crude tuner that would get you from 88.3 to 107.9 with a quick flick of the wrist--this is not what you're looking for. That has more to do with your decisions around your allocation between cash and stocks and bonds. This is a precision instrument. It's that fine-tuner that gets you from 93.1 to 93.9 with precision. It dials down the risks specifically within your equity sleeve and just a little bit more often than not.

Dziubinski: These funds can pursue different types of strategies to achieve these more-muted risk results. Now, are there a few approaches that are more common among low-volatility funds?

Johnson: Generally speaking, Susan, there are two most-common approaches, and they're very nuanced in how they differ. One common approach, an approach applied by certain ETFs that are underpinned by S&P low-volatility indexes, looks to build the portfolio that comprises the least volatile stocks in a given selection universe. Say, for example, the S&P 500--that portfolio will pick the least volatile members of the S&P 500 index based on the standard deviations of their returns over the preceding 12 months. So the least volatile stocks is one approach to constructing a low-volatility portfolio. The other approach that is quite common is to produce the least volatile portfolio of stocks possible from a given selection universe. Now least volatile stocks, one approach, least volatile portfolio, the other most common approach.

Now what the least volatile portfolio approach might entail is actually owning some stocks that might be quite volatile, among the most volatile in the market. But in doing so, what that does is it balances out other stocks that might be held in that same portfolio. And what you see is that there are trade-offs between these two approaches. And the most significant of those, I would argue, is that in the case of picking the least volatile stocks, without anchoring to the characteristics of that selection universe, you can take certain unintended risks, you can see very significant sector concentrations, for example, crop up in those portfolios from time to time, which might not necessarily always be rewarded, which might not necessarily always align with the portfolio's low-volatility objective. So these very fine nuanced differences between these approaches to portfolio construction can lead to very different outcomes over a long period of time. So it's important that investors understand all of the various devils that reside within these fine details.

Dziubinski: Ben, given that, what is a fair expectation for an investor to have for a low-volatility fund over time? What really is realistic?

Johnson: Well, I think first and foremost, investors should be focused, as always, on the very long term. As we've seen, in each and every market episode that we might experience, these funds aren't necessarily going to perform as investors might expect. We saw this in the case of the drawdown in early 2020. That was induced by the COVID crisis. And what we saw is that, in many cases, low-volatility ETFs underperformed their more common vanilla counterparts, drawing down even further on the bottom, and what was worse still, though, what should have been expected is that when markets bounced off that bottom and roared higher, these funds lagged quite badly to the upside and gave up, in many cases, most of their outperformance that they had experienced from their inception. What we've seen more recently for the year to date in 2022 is that depending on the day, depending indeed on the week, low-volatility funds have either done better or worse than their common vanilla market-cap counterparts. Indeed, at one point as recently as a week ago, high-beta stocks were outperforming low-volatility stocks for the year to date, reflecting the fact that energy stocks have really been on a tear as a result of the spike we've seen in energy prices.

Investors need to understand that, at any given moment, these portfolios might not necessarily perform as expected. They need to take a deep breath, take a step back, take the long view, and know that fairly reliably over a sufficiently long period of time, they've offered less volatility than owning the market outright. And they've offered depending on the time frame, marketlike returns. Though that promise has been somewhat hindered recently by virtue of the fact that they lagged on the upside as markets rebounded from the depths of the 2020 sell-off.

Dziubinski: Then let's probe a little bit more on 2022 so far, and how these funds have done as a group in this market. And you know, which strategies have maybe outperformed a little bit more than others. And have there been any surprises here from your perspective?

Johnson: Yeah, so what was really surprising was, as I alluded to earlier, as recently as just a week ago, for the year to date, what we saw was that the S&P High Beta ETF (SPHB) had outperformed for the year to date the standard S&P 500 ETF--so I'll use the iShares Core S&P 500 ETF (IVV) as a proxy here--which in turn had outperformed the Invesco S&P 500 Low Volatility ETF (SPLV). So as the markets were getting rocky, what we saw is that the riskiest stocks were outperforming the market at large, which in turn was outperforming the least risky stocks, which at face value would seem to make absolutely no sense, which, as I mentioned before, really reflects more so than anything the fact that energy stocks have outperformed the broad market by a very wide margin up through that point.

Now, fast-forward to today, one week, hence. And what we see is that the reranking among those same three funds has gotten back to what an investor might expect. Now, SPHB has still outperformed both IVV and SPLV on a year-to-date basis. But one week later, the low-volatility portfolio, SPLV, is now outperforming IVV, the standard S&P 500 ETF on a year-to-date basis. So really, I think what this emphasizes more so than anything is the lack of utility that investors will get by peeking in on these portfolios each and every day, each and every week, and even sometimes on a monthly basis. And what we see again over a sufficiently long horizon is that these relationships that we would expect tend to hold and you see that shine through in the long-term risk-adjusted returns of the low-volatility portfolios relative to standard market-capitalization-weighted ETFs, relative to the ETFs that invest in the market's riskiest stocks.

Dziubinski: Ben, let's talk a little bit now about the long term. Give us a couple of low-volatility ETFs that you think are good long-term holdings for a portfolio.

Johnson: Well, if you look at the entire menu of low-volatility ETFs, which invest in everything from U.S. large caps to mid-caps to small caps, emerging-markets stocks, developed international. There's just one Morningstar Medalist among their ranks. And that's the iShares Minimum Volatility ETF. (USMV) is the ticker. USMV retains a Morningstar Analyst Rating of Silver. And what we like about it is it takes that ladder approach that I described earlier to portfolio construction, looking at all of the stocks in the MSCI USA Index and looking to build out of those raw materials the least volatile portfolio possible. And in doing so, what it does is it avoids some of the risks that that second approach, looking just for the least volatile stocks, might take in the course of building its own portfolio, specifically, certain sector risks, steep sector concentration that may or may not always pan out as an investor might expect.

We like that it maintains a level of diversification. We like that it looks at stock's characteristics more holistically. And what we see is that, since its inception, what it has done has delivered an outcome that an investor would expect--a meaningful increment lower in terms of its volatility; it participates less on the downside; as a trade-off, it participates less on the upside. And what we've seen is that it has delivered risk-adjusted returns that have ultimately been comparable to the market's returns. USMV is the one and only Morningstar Medalist among the whole lot of low-volatility strategies available in ETF wrapper to investors today.

Dziubinski: Ben, thank you for your time and for helping unpack these particular funds. It's very timely conversation. We appreciate it.

Johnson: Thank you for having me.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.



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