At first glance the price, liquidity and diversity of ETFs appear to be a panacea for building ideal portfolios.
Yet there is one important metric that advisors need to take into account: volatility, which has a significant effect on returns.
Research suggests ETFs don’t cause more market volatility, but certain strategies such as high-frequency trading that use ETFs, may increase it. And some ETFs, even within the same category, are inherently more volatile than others.
A well-diversified ETF portfolio that declines significantly more than the portfolio’s benchmark during a market downturn can completely erase the benefits of using low-cost ETFs. In the past, it has been typical for a portfolio of equities with smaller price fluctuations to outperform one with larger fluctuations over the long term.
As an example we can compare two iShares ETFs, MSCI All Country World Minimum Volatility (ACWV) and its market-capitalization-weighted parent index, ACWI.
ACWV “employs full replication to track the MSCI ACWI Minimum Volatility Index, which attempts to create a minimum-variance [or lowest-volatility] portfolio of 350 holdings selected from ACWI,” according to Morningstar.
I used performance numbers from Morningstar and Portfolio Monkey (portfoliomonkey.com) to perform the volatility comparison.
For individual securities, volatility is calculated as the standard deviation of the security’s historical returns within a specific time horizon, expressed in annualized terms.
For this discussion, the calculated volatility numbers themselves aren’t as important as the differential exhibited between the two ETFs’ numbers. (For methodology details go to the Portfolio Monkey’s FAQs.)
ACWI has a 5.9% expected long-term return and a volatility quotient of 12.7, according to Portfolio Monkey.
ACWV, on the other hand, has an 11% expected return and volatility quotient of just 8.2.
Morningstar calculates that lower-volatility ACWV outperformed ACWI over the three-year period ended March 30 (8.50% versus 5.89%).
When building long-term ETF portfolios, model the potential overall effect on a portfolio’s return by using a minimum-volatility ETF for each asset class, when available. Appropriate weightings of each asset class should also be considered to potentially further lower the portfolio’s volatility.
A tool such as Portfolio Monkey can make this type of analysis relatively easy. Advisors can compare individual ETFs and also various weightings of a mix of ETFs within a portfolio.
Building lower-volatility portfolios may not only outperform their benchmarks but also help clients more easily stay invested during the inevitable scary stock market declines.
Deborah Fox is chief executive and founder of Fox Financial Planning Network.
This story is part of a 30-30 series on smart ETF strategies.
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