Subscribers to this blog know that I subscribe to Charles Ellis’ philosophy that properly practiced, wealth management is not about the management of returns, but rather the informed management of investment risk. That’s not to say that investors should ignore return, but rather that by properly managing risk, an investor can hopefully avoid significant losses. That way, when the market does recover, it will take less time for an investor to recover any losses and benefit from the market recovery quicker than those who need more time to recover from their losses. As I often say, “you’ll never get ahead if you have to spend all your time catching up.”

During the fourth quarter of 2015, I had a number of people ask me what, if any options are available to better address market volatility and reduce market risk.  These questions became more regular during the increased volatility in the stock market during January.

Our approach to investing is what is referred to as a core-satellite strategy. We begin by establishing a equity-based core using traditional assets such as a broad, low-cost diversified U.S. stock market index fund, such as the Vanguard Total Stock Market Index Fund, and a broad, low-cost diversified international equity index fund, such as the Vanguard Total International Stock Market Index Fund. We then establish a fixed-income core using a broad, low-cost diversified bond fund, such the Vanguard Total Bond market. Bonds have historically had a low correlation of return to equities, so the bond exposure will hopefully reduce the overall volatility of an investor’s total portfolio.

We generally favor a traditional 60% equity/40% fixed income core in favorable market conditions. However, we also believe in adjusting allocation within the core based on conditions in the stock market, the economy, and in geopolitical factors, most notably the ongoing concern over terrorism. That is why our current core is less than the traditional 60/40 split, as the current concerns over the economy and the oil crisis have definitely had an impact of the markets. Despite these concerns, we still think it is important to always maintain some equity exposure since no one can predict, or control, the movements of the market.

Our satellite positions are an attempt to help investors capture “alpha,” or extra return, based on market fundamentals, and current and historical performance trends. Even though we recommend satellite positions, there is nothing wrong with just allocating one’s assets  in accordance with our core recommendations.

But back to the issue regarding volatility. One obvious way to reduce the volatility of one portfolio is to reduce the level of one’s investment and simply hold more cash. But the people who have questioned me have generally said that they want to stay invested, but want to reduce their portfolio’s overall volatility.

The investment industry has heard this same request. Within the last few years the industry has seen the creation of a number of low- volatility equity-based mutual funds and exchange traded funds (ETFs), both for domestic and international market. While the track records of such funds is relatively short, most with only a three-year track record, they generally have performed as expected, slightly less returns than indices such as the S&P 500 during up trends in the market, slightly less losses than said indices during market downturns.

While we all know the mantra, “past performance is no guarantee of future returns/results,” it is reasonable to assume that the performance of low volatility equity-based funds will continue their current trend. The reason for this optimism is simply that low-volatility funds generally allocate their resources among the same equity categories as contained in the index they track, For instance the S&P 500 or DJIA. In order to reduce volatility, they just allocate more resources to the asset categories which have been less volatile historically, sectors such as consumer staples, utilities, industrials and to some extent health care. These are sectors that produce goods and services which everyone needs, thus making them less susceptible to changes in economic conditions.

At the same time, the low-volatility funds invest less in more traditionally more volatile sectors such as technology, discretionary consumer products and services, information technology, and energy. Unless otherwise indicated they will generally avoid mid-cap and small-cap stocks since these are generally more volatile than large-cap stocks. However, these are the same sectors that often drive bull markets. Therefore, by reducing exposure to these higher volatility sectors, investors must accept the fact that the low-volatility funds will generally underperform the “market” as measured by popular stock market indices. Again, the history of low-volatility funds thus far has slightly less returns, but also with less risk.

ETFs have clearly embraced the low-volatility concept. Some the leading low-cost, low volatility ETFS are:

iShares (www.ishares.com): Domestic: USMV (iShares MSCI USA Minimum Volatility ETF); International: EFAV (iShares MSCI EAFE Minimum Volatility ETF); ACWX (iShares MSCI ACWI excluding U.S. ETF)

PowerShares (invescopwoershares.com): Domestic: SPLV (S&P 500/Large Cap Low Volatility ETF); XMLV (Mid-Cap Low Volatility ETF); XSLV (Small Cap Low Volatility ETF): International: IDLV (International Developed Low Volatility ETF)

There is one other low-volatility fund that investors might want consider. The PowerShares S&P 500 Low Volatility High Dividend Fund (SPHD) does attempt to provide a high dividend yield, which can help reduce any losses due to the performance of the stock market. The fund does have a higher annual expense ratio (0.33%) than most of the other low volatility funds (generally 0.15-0.20% annually), and everyone knows I prefer low expense ratios. But the performance of the fund to date, plus the potential benefit of a nice dividend yield, makes it worth considering since the other funds do not include high dividend yield as a stated objective.

Low volatility investments are still relatively new.  For anyone potentially interested in low volatility funds, I would recommend the article, “The Beauty of Simplicity: The S&P 500 Low Volatility High Dividend Index,” which provides a detailed overview of both the overall concept of low volatility investments. The article is available online at https://us.spindices.com/documents/research/research-the-beauty-of-simplicity-the-sp-500-low-volatility-high-dividend-index.pdf%3Fforce_download%3D true+&cd=1&hl=en&ct=clnk&gl=us

As always, I recommend that investors visit a fund’s web site, as well as Morningstar’s site (morningstar.com), to learn more and properly evaluate a fund. I often use iShares’ web site for investment professional and their excellent analytical tools. Just out of curiosity, I ran a model portfolio equally allocating one-third of my money to SPHD, EFAV and iShares Core Total U.S. Bond Market ETF (AGG) (not a low volatility ETF) and compared it to another model equally allocating one-third of my money to the more well known regular volatility market indices, the SPDR S&P 500 ETF Trust (SPY), the iShares EAFE ETF (EFA) (International fund covering Europe, Asia and the Far East) and AGG.

The results were interesting. The low volatility portfolio had a three-year annualized return of 8.79% and a standard deviation (risk measure) of 6.97%. The portfolio of regular stock market indices had a three-year annualized return of 7.41% and a standard deviation of 7.93%. The three-year period did include a year when the market was down, possibly reinforcing the value of a lower volatility and dividends strategy.  .

NOTE: THIS WAS ONLY A THREE-YEAR ANALYSIS SINCE MOST LOW VOLATILTY FUNDS LACK A LONGER PERFORMANCE RECORD, AND ONLY INVOLVED TWO POSSIBLE SCENARIOS/MODELS. THE REFERENCE TO THESE SIX ETFS AND THEIR USE IN THE TWO MODELS IS/WAS FOR ILLUSTRATIVE PURPOSES ONLY AND IS NOT, AND SHOULD NOT BE CONSIDERED, A RECOMMENDATION FOR OR AN ENDORSEMENT OF ANY OF NAMED FUNDS. INVESTORS SHOULD ALWAYS REVIEW A FUND’S PROSPECTUS BEFORE INVESTING.

AGAIN, PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.

Bottom line, for those looking for investments that provide some level of market returns with less risk due to volatility, low-cost, low volatility funds might be worth a look. However it is worth remembering that even low volatility funds have exposure to market volatility. Therefore, even when investing in low volatility funds, allocation decisions should be tempered by considering the prevailing trend of the overall stock market and economy. The popular saying “the trend is your friend” is a reminder that historically, three out of four stocks follow the prevailing trend of the overall stock market.