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Low-Vol ETF Attracts More Attention in Riskier Market Conditions

This article was originally published on ETFTrends.com.

As market volatility spiked, investors who continued to view U.S. stock markets in a favorable light looked to a low-volatility exchange traded fund strategy to diminish further risks ahead and still keep a foot in the game.

The iShares MSCI Min Vol USA ETF (Cboe: USMV) , the largest US-listed low volatility exchange traded fund, was among the most popular ETF plays over the past month, attracting $1.1 billion in net inflows, according to XTF data.

"This fund doesn't directly target stocks with low volatility, though it still heavily favors them. It considers both expected individual stock volatility and correlations across stocks, under a set of constraints, like limiting sector tilts. This holistic approach causes the fund to own some more-volatile stocks than it would if it simply targeted the least-volatile stocks in the market. However, it should lead to a better-diversified portfolio that can translate into lower risk at the portfolio level," Morningstar's Alex Bryan said in a research note.

USMV select stocks based on variances and correlations, along with other risk factors. The low or minimum volatility strategy targets stocks that have lower expected risk or less idiosyncratic risks. Specifically, the strategy targets equities that exhibit lower beta, a measure of volatility or systematic risk of a security to that of the overall market. Consequently, minimum volatility portfolios are constructed with stocks that exhibit lower market risk or beta.

The low-volatility factor investments work on the idea that they help cushion against market turns, limiting drawdowns that investors experience while providing upside potential. Consequently, the low- or min-vol strategies may produce better risk-adjusted returns over the long haul, which has been backed by extensive academic research.

Low-volatility stocks historically offered more favorable risk/reward trade-off than the market due to investor behavior, which has induced mispricing. Riskier stocks typically exhibit greater upside potential than defensive stocks, which makes them more attractive to investors whom care about chasing after high returns. Consequently, these collective bets on risky stocks can cause these riskier bets to be overvalued and offer less attractive compensation for their risk than their more defensive counterparts, especially after an extended bull run.

Looking at the fund's underlying holdings, USMV has greater tilt toward defensive sectors, including utilities, healthcare and consumer defensive, compared to the benchmark MSCI USA Index. The ETF also has greater exposure to real estate stocks and a smaller weight to more volatile sectors like energy, tech and financials.

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