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The big swings for the stock market last week were a chance to shine for funds pitched as a way to lower a portfolio’s volatility, but there are several considerations for investors to know before jumping in. To start, the major funds that are marketed as “low volatility” or “minimum volatility” have been living up to the label. Many have held up better in recent weeks than the SPDR S & P 500 ETF Trust (SPY) , which is down 3.2% in August through Monday’s close, and off 2% in the third quarter. The low vol funds also saw smaller declines than the index during the sharp sell-off on Aug. 5. The largest of the funds is BlackRock’s iShares MSCI USA Min Vol Factor ETF (USMV) , with about $24 billion in assets. The fund is designed to designed to be differentiated from the rest of an investor’s portfolio rather than just a way to gain exposure to defensive sectors, said Robert Hum, U.S. head of factor and co-head of outcome ETFs at BlackRock. “It’s not just about looking for stocks that have low volatility, but it’s also about looking for stocks that have low correlation to other stocks. We might own high-risk stocks that diversify the rest of the portfolio,” Hum said. To do this, the fund caps each individual stock at a 1.5% weighting during a semi-annual rebalance, and also has guardrails in place to keep sectors from drifting too far from broader market levels. USMV has a management fee of 0.15%. Some other funds have a more defensive tilt, with higher exposure to areas including utilities stocks. To be sure, these type of funds do tend to underperform when the market rallies. Hum said the goal of the USMV is to deliver a risk-adjusted return that meets or exceeds the market’s over the long-term. Structured products Another group of ETFs that investors might turn to during volatile periods are income funds — ones that use options such as call writing to generate yield have been especially popular in recent years. JPMorgan Asset Management has been a leader in this area, with Equity Premium Income ETF (JEPI) and Nasdaq Equity Premium Income ETF (JEPQ) now holding more than $48 billion in combined assets, according to FactSet. The funds have also outperformed the S & P 500 and Nasdaq-100 indexes, respectively, over the past month. “We are looking to provide investors with high and consistent levels of income and a good total return, with less volatility and beta vs. the market. During the recent market rotation and uptick in volatility, the ETFs have shown their stripes as more defensive equity strategies and have fared well,” a JPMorgan Asset Management spokesperson said in a statement. JEPI 1D mountain JEPI is outperforming the S & P 500 over the past month. However, the call writing could hurt the long-term performance of the fund versus the broader market, especially when sharp rebounds occur. “The problem is when you’re selling after a market drop with high volatility, yes theoretically on a percentage basis your premium is higher, but you’re also locking in selling upside at a lower level,” said Yang Tang, CEO of Arch Indices. This means that the yields of the funds may not be the best indicator of which one makes most sense for an investor. Many of the funds generate their yield by selling call options, and call options that are closer to the money — meaning lower upside for the fund — result in a higher yield. “In our view, you need to have a responsible yield target. You should be delivering income that is balanced with upside growth potential. Because at the end of the day these are still equity portfolios,” said John Burrello, senior portfolio manager for the Income advantage strategy at Invesco, which launched two of these types of funds in July. Another popular type of structured product ETF are so-called buffer funds , which offer explicit downside protection using options. But investors should be aware that these funds are designed to be held for their entire time period — often 12 months — and that buying in late or selling out early may lead to returns that don’t match what’s on the label. Under-the-radar asset classes Stock and bonds make up the bulk of most investor portfolios, but there are other options out there for investors who want to diversify and potentially lower volatility. Gold is one area that has performed well recently. The SPDR S & P Gold Shares fund (GLD) is ahead 6.2% in the third quarter, and up 2.4% over the past month. GLD 3M mountain Gold has outperformed the S & P 500 since the start of July. Another area is preferred stock funds. The biggest preferred stock ETF, the iShares Preferred & Income Securities ETF (PFF) , has gained 0.5% in the third quarter, though it has dipped 1.4% over the past month. The market for preferred securities has changed a lot in recent years, including more custom offerings that are sold over the counter, said Gary Kessler, a portfolio manager at Goldman Sachs Asset Management, noting that investors should check to see what exactly a fund owns. Goldman’s Access U.S. Preferred Stock and Hybrid Securities ETF (GPRF) , which is less than a month old, owns securities that are traded on and off an exchange, for example. Preferred securities are something of a hybrid between stocks and bonds, and they can help dampen volatility, especially if market moves aren’t hurting the credit-worthiness of issuers, which are often banks. “In a post-Dodd Frank world where banks have been much more highly regulated, we have seen the volatility dampen,” Kessler said, referring to reforms enacted following the Global Financial Crisis of 2008. “And those call features of a growing part of the preferred market has also helped in terms of the rate volatility and the impact.” This group could also benefit as the Federal Reserve dials back interest rate policy. Kessler said that preferred securities typically do well when the Fed is easing, though the market does not have the same long duration profile as it did in the past because many of the over-the-counter securities can be “called away” by their issuers.
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