Investors have poured about $10 billion into the 10 largest
low-volatility funds since the start of 2010, according to Chicago-based
investment researcher Morningstar. But there are other ways to accomplish the
same goal at a lower cost without getting exposed to unexpected risks the funds
can pose.
Low-volatility funds assemble a portfolio of stocks that
have been less vulnerable to big price moves. Often, they are in large, stable
companies that pay hefty dividends and that may not be growing as quickly as
smaller rivals. For investors worried about a market swoon, the simplest
alternatives are to increase the share of their portfolio that is allocated to
bonds or to take some money out of stocks and keep it as a cash reserve.
By reducing stockholdings and holding cash instead, investors
can get similar protection in a market downturn and have money set aside to
plow back into stocks when conditions are more favorable.
Low-volatility strategies have been used by institutional
investors since the 1970s, but low-volatility ETFs aimed at individual
investors have appeared only in recent years. Since the funds hold out the
potential for steady returns and lower risk, they often underperform the
broader market during rallies.
The payoff from the strategy can come when markets sour. In
theory, low-volatility funds won't tumble as far, because investors are less
likely to jettison shares in established companies that pay steady dividends.
An S&P low-volatility index that tracks such companies fell 21% in 2008,
compared with a 37% loss in the S&P 500.
Still, low-volatility ETFs made their debut after that 2008
market plunge and therefore haven't been through a real-world test under such
tough conditions. The funds tend to be slightly more expensive to buy than
plain-vanilla index funds, which also could result in a modest drag on returns.
There can be other potential pitfalls with low-volatility
funds. Their stock portfolios often are tilted toward a particular sector or
type of company, and therefore the returns on the funds could be driven by
factors that have little to do with volatility in the broader market.
Cash has its own drawbacks, of course, including the risk of
losing value to inflation. But for investors who find short-term volatility in
their portfolio tough on the nerves, it might be an even better way to try to
ensure a better night's sleep.
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