So far, 2020 has been one of the most volatile years for stocks on record, featuring both huge one-day spikes and sell-offs in the broad stock market.
If you're looking to reduce volatility in your portfolio, there's no substitute for adjusting your investment mix to align with your tolerance for risk. But by substantially adding to your investments in conservative fare such as bonds or cash, you'll likely earn less than you would sticking with stocks, which provide higher returns over time.
"Volatility is the price of admission when I comes to investing in the stock market," says Ben Johnson, director of global exchange-traded fund research at Morningstar. "Over the long term you'll be compensated for that short-term risk — all the gut-rot we've had with all the volatility this year."
If you're in for stocks' superior long-term returns but would prefer less stomach-churning bumpiness, consider adding an exchange-traded fund that holds stocks and yet can produce less turbulent returns than the broad market. It won't reduce your portfolio's volatility as much as adding bonds or cash would, but it could provide a smoother ride for your portfolio through short-term bouts of market jumpiness without meaningfully diminishing your returns over the long term.
Companies deemed high-quality, such as those that have little debt, offer robust competitive advantages, and generate prodigious amounts of cash generally hold up better than the broad market during sell-offs. Funds that invest in such firms "tend to give you a less volatile ride while maintaining equity exposure," says Johnson.
The Invesco S&P 500 Quality ETF (SPHQ), which invests in high-quality firms in the S&P 500, for instance, has been 10% less volatile than the broad stock market over the past decade.
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A similar theory applies to funds that focus on firms with a long track record of paying and raising their dividends. Such firms tend to have staying power in their industries and prodigious cash flows, says Johnson, and their dividend payouts can support investor returns when stock prices are falling.
The Vanguard Dividend Appreciation ETF (VIG), which holds firms that have hiked their payout for at least 10 years, surrendered a little more than 17% during the market drawdown that began in February, compared with a 34% slide in the S&P 500.
Using an ETF designed to limit volatility beats trusting an active mutual fund manager to do the same job, says Todd Rosenbluth, director of ETF and mutual fund research at investment research firm CFRA. "The great thing about index-based ETFs is that the company tells you what they're going to do and then adheres to that rulebook," he says. "A manager may change their strategy depending on the market environment."
The Invesco S&P 500 Low Volatility ETF (SPLV), for instance, follows a simple and rigid set of rules, investing in the 100 least volatile stocks in the S&P 500 over the past 12 months and rebalancing on a quarterly basis. The most placid stocks occupy the top positions in the portfolio, which is low on stocks that are sensitive to economic cycles (such as financial stocks) and heavily invested in traditionally defensive sectors such as health care and consumer staples.
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The iShares MSCI USA Min Vol Factor ETF (USMV) invests in low-volatility stocks as well, but adheres closer to the sector breakdown of the broad stock market, holding the largest chunk of its portfolio — 22% — in tech stocks, which are generally thought of as stocks with exposure to swings in economic cycles.
Neither fund will typically keep up with the market when stocks are soaring, but they should provide a smooth ride and hold up during downdrafts. Over the past three years, both funds have done their job, with returns that were about 20% less volatile than the broad stock market over that period.
Whenever you buy an investment, you can never be sure how it will perform. But for investors nervous about wild swings in the stock market, so-called "buffer" ETFs can give you a predefined range of outcomes over the 12 months following the fund's release date.
Returns on these funds are capped, meaning investors can only earn a certain maximum return from the fund, even if the underlying index it tracks does better. But these ETFs also come with "buffers" — set percentages the ETF will lose before passing a loss on to investors.
For example, investors who bought shares in the Innovator S&P 500 Power Buffer ETF Nov (PNOV) on its November 1, 2020, release date could earn a maximum return of 12.7% through October 2021, with a buffer of 15%. If the S&P goes up 20% over that time, the shareholder would earn 12.7%; if it goes down 20%, the shareholder loses 5%.
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These kind of funds provide "a bumper-bowling approach to investing in the stock market," Johnson says. "You know you're staying out of the gutters. But the number of pins you can knock down is capped. So you know you're not going to get a strike."
Depending on the company, these funds are released on a quarterly or monthly basis. If you're considering investing in one, try to do so as close as possible to the start date, says Corey Walther, president of Allianz Life Financial Services. "If you purchase at the beginning, you know exactly what your upside cap and downside buffer is," he says. "Once it's day two or month three or month seven, those are going to fluctuate depending on how much of the time period is left and how the index is doing."
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