CHICAGO During the financial market turbulence of recent years, fund marketers have launched a number of stock funds that boasted exceptionally low volatility. They were the equivalent of sea-sickness pills for those who still wanted to go on stock-market cruises.
Yet these exchange-traded funds (ETFs) make less sense when the stock market is bullish. You may sacrifice returns and could dampen volatility more effectively with other strategies. In a sustained bull market - if you want to be invested in stocks at all - you would be much better off in a broad-based, all-in index fund than a low-volatility ETF.
To be sure, as risk-reduction vehicles, low-volatility ETFs play it safer by investing in mature companies with steady cash flows and solid dividends. They are less likely to be sold off in a market rout such as the one experienced last year.
For example, ETFs such as the PowerShares S&P 500 Low-Volatility Portfolio focus on long-established dividend payers in consumer products and utilities. Their overall approach is to lower the risk in stock market investing by lowering the volatility.
LAGGING THIS YEAR
This strategy may have softened the swells from the stormy markets of last year, but it's coming up a laggard this year as a recovering economy is propelling the general market.
According to the Leuthold Group, "during periods of buoyant equity returns, the strategy fails to perform as intended."
How much does the low-volatility approach fall behind during up markets? About 4.0 percent on average, Leuthold reported.
Indeed, despite a strong showing overall for stocks in the first quarter - the Standard & Poor's 500 index was up almost 12 percent in total return year-to-date through April 5 - even one of the best-performing low-volatility ETFs - the EGShares Low Volatility Emerging Markets Dividend fund - rose only 10.4 percent.
That return trailed the broad-based Vanguard Total Stock Market Index ETF by almost three percentage points year-to-date through March 31, according to an analysis prepared by Lipper, which is owned by Thomson Reuters.
That's not to say you should throw the baby out with the bathwater. Leuthold also found that "during periods of increased market uncertainty" as defined by the CBOE Volatility Index (VIX) being up at least two points, low-volatility stocks outperform an average 6.48 percent from 1990 through 2011. The funds in the Lipper sample also had volatility measures as much as a point lower than the whole market.
Dividends have always been a bulwark when the market commences a selling frenzy of high-flyers in technology and non-essential businesses. The low-volatility companies will protect you somewhat against "deteriorating equity market sentiment and normal to negative equity market returns," according to Leuthold.
If you want a low-volatility portfolio in general, concentrate on companies that have long track records of dividend growth in boring businesses such as consumer staples and electrical power generation. Think corn flakes and power plants.
Worthy considerations in the low-volatility camp include the Russell 2000 Low Volatility fund, which focuses on smaller companies and the iShares MSCI Emerging Markets Minimum Volatility Index fund, which holds companies from developing countries.
If you want to remain in U.S. stocks for the long haul, consider a low-cost, total market index fund such as the Fidelity Spartan Total Market Index Fund. At an annual expense ratio of 0.10 percent, managers give you a sampling of most of the U.S. stock market.
Still, a much more comprehensive approach to market risk should be on your radar screen. If you want a buffer against U.S. stocks, consider real estate investment trusts, bonds and commodities. And if you own single companies - such as your employer's - hedge that risk by either reducing your stake or buying put options on those shares, which will pay you when they decline in value.
No matter what you or pundits think stocks will do this year, the market will always be volatile and you will be at risk for losing money if you're invested in it. You'll need to regularly ask yourself how much money you can afford to lose - and adjust your portfolio accordingly. There's no sin if you don't want or need to be in stocks now, so it may make more sense to shift more assets into bonds or cash.
Disclosure: I don't own any of these funds.
(The author is a Reuters columnist. The opinions expressed are his own.)
(John Wasik; Editing by Chelsea Emery and Linda Stern)