Low-Volatility ETFs May Help Clients Meet Retirement Goals

These transparent, lower-fee vehicles offer a potential way to capture equity appreciation without boosting risk.

By Jerilyn Klein

Editor’s Note: Many pre-retirees and retirees seeking to achieve their retirement goals are still struggling to find the answers in fixed income and are scared to dive into equities. Low-volatility strategies could be a good, less stressful way to invest in equities and an ETF wrapper can also make them attractive, Christopher Huemmer, senior investment strategist for FlexShares Exchange Traded Funds at Northern Trust Asset Management, recently explained to Rethinking65.  

Klein: How can low-volatility strategies help advisors address their client’s retirement goals?
Chris Huemmer
Chris Huemmer

Huemmer: Generally speaking, a focus on low volatility within a client’s asset allocation can have several benefits. Chief among them: the potential to mitigate downside risk while still participating in equity markets when stocks rise. This can allow an advisor to lower a client’s overall portfolio risk while still maintaining their exposure to risk assets.

When it comes to retirement planning, demographics show us that people are living longer, which means that they still need to grow their nest egg even in the decumulation phase of their lives. A low- volatility approach to equities can offer potential capital appreciation that is not available to fixed-income securities.

In addition, inflation can erode the nest egg clients have worked so diligently to save. In times like this, the potential for capital appreciation from equities can be handy in battling inflationary pressures on a client’s portfolio. Even in periods of low inflation, it is crucial to find ways to protect a client’s purchasing power throughout their entire retirement.

Klein: Can you explain the difference between low volatility, minimum volatility and buffering strategies?

Huemmer: Low volatility, minimum volatility or minimum variance are similar in approach. These strategies own equity securities and look to reduce the volatility comparable to a market-weighted index. This can be done in one of two ways: at the security level or at the portfolio level.

I advocate for executing a low-volatility approach at the portfolio level for a couple reasons. First, by minimizing volatility at the portfolio level, you can consider the correlations of the underlying securities and how those correlations affect the portfolio as a whole. This should allow the end result to take advantage of the diversification between the securities within the universe at the portfolio level. The relationships between securities do not come into account when implementing low volatility on the security level, where the approach simply concentrates on selecting the least volatile names from the starting universe.

Second, it is easier to control for sector, country and regional exposures when applying low volatility at the portfolio level than at the security level. This can be helpful in reducing sector concentrations or regional concentrations that can exist when these are not controlled for in the methodology while still delivering on the low-volatility objective.

A buffering strategy is very different than a low-volatility or minimum-variance approach in that it utilizes derivatives to provide a downside buffer at the expense of capping upside capital appreciation. Buffering strategies typically contain a specified percentage of losses that are nullified with upside capped at an explicit percentage. Any losses beyond the specified downside buffer are suffered by the investor, while any gains beyond the upside cap are also lost. Additionally, buffering strategies have a specified time period, such as one month or one year, so these strategies need to be rolled over or re-purchased. This can lead to more realized tax events than a buy-and-hold equity-based low-volatility approach.

Klein: I’ve read that some low-volatility ETFs capture more downside risk than one would expect. Why might that be true?

Huemmer: It is crucial for advisors to realize that the selection of a low-volatility strategy is just as important as deciding to use low volatility in a client’s portfolio. Many poorly designed approaches trade volatility risk for sector risk or concentration risk. For example, a low-volatility approach that does not manage sector exposures in its design may end up with a quarter to a third of the entire portfolio in the utilities sector, a sector that is only 3% of the S&P 500 Index. As utilities are particularly sensitive to changes in interest rates, such a large relative exposure can open a client’s portfolio up to additional interest rate risk, or term risk, that the advisor did not intend to introduce into their asset allocation. I believe a well-designed low-volatility strategy can be thoughtful with regards to uncompensated risks, such as sector concentrations, while still delivering a comparable reduction in volatility.

A second way to improve a low-volatility strategy is by introducing a factor such as quality into the investment approach. Quality is a measure of the financial health of the company and pairs very well with low volatility. We find that the poorest quality companies tend to be among the most volatile. So by removing those poor quality companies from the starting universe, we can better position the low volatility approach to deliver on its objective and provide meaningful returns for investors.

Klein: Bond investors have been abandoning mutual funds for ETFs at a record pace. Why is this and do you expect it’ll continue?

Huemmer: Several factors played into fixed-income flows over the past year. If you look at where ETF inflows have been the largest, U.S. Treasuries and aggregate bond indices have seen the strongest flows. Both of those categories are dominated by passive index managers. Such a shift in asset classes within fixed income can lead to a shift from active management to passive index strategies, which would also be mimicked by a shift in flows from mutual funds moving to ETFs.

Additionally, it is important to consider the macroenvironment and the rapid change in monetary policy we have all experienced over the past year. As investor expectations changed quickly, the liquidity provided by many large fixed-income ETFs allowed investors to gain beta exposure and for advisors to shift their clients’ portfolios swiftly.

One other thing to consider when looking at recent trends is end-of-year tax management. With many bond funds having negative year-to-date total returns, advisors may have been looking to harvest losses for their clients and using liquid ETFs to maintain fixed-income exposure while benefiting their clients’ tax situations.

Klein: What’s your outlook for inflation and recession? What impact might they have on low-volatility ETFs?

Huemmer: This continues to be a compelling environment for low-volatility ETFs. Low volatility as a factor tends to do well during periods of economic slowdown and contraction. Quality is another factor that tends to do well in these economic regimes. Additionally, our research at FlexShares shows that volatility spikes are more common today than they were 20 years ago. We feel that a strategy focused on quality and low volatility is well positioned in the current environment.

Recession fears and slowing global growth are the big topics clients want to discuss with their advisors today. Inflation plays a big part in those conversations. The expectation is that we have moved off of “peak inflation,” but how far and how quickly inflation will fall is unknown. In the U.S., we have seen inflation on goods come down; and though shelter costs remain high, there is data that suggests the sharp increase in mortgage rates is starting to rein in housing prices. Inflation on services is still an issue, as are labor costs. We feel that the U.S. is in a better position to handle a slowdown than Europe where energy costs will complicate the inflation picture.

Klein: What ETF strategies do you recommend advisors consider for older clients given the current level of interest rates and expectations?

Huemmer: As I discussed earlier, with clients living longer, low-volatility strategies can be a good way to add potential capital appreciation — with the assumption that advisors who do so are mindful of a longer drawdown period on a client’s asset pool. Sources of reliable income will be particularly important for older clients, as a combination of fixed-income and dividend-paying equities can provide advisors with a large number of options. Finally, protecting the purchasing power of your clients against the long-term effects of inflation is key. A strategic combination of TIPS, real assets and equities can be used to mitigate the impact of both expected and unexpected inflation on a client’s portfolio.

Klein: Older investors often are invested more heavily in fixed income. I’ve seen some low-volatility ETFs that also offer high dividend income. Does that combination make sense to you? Why or why not?

Huemmer: I would caution advisors to tread lightly when trying to accomplish too many objectives within a single strategy. In my opinion, the best way to gain access to low volatility is by minimizing volatility or variance at the portfolio level. Any time you inject another objective into that process, like targeting a high-dividend yield, you have to be very deliberate in your approach or you will not be delivering on your low-volatility objective.

For example, look at how I described how we bring quality into our low-volatility process; in this instance, it is more about adjusting the starting universe and then minimizing volatility at the portfolio level. And unlike quality, where the poorest rated companies tend to be highly volatile, I have not seen similar findings between dividend yield and low volatility.

Klein: Are there any types of ETFs that advisors should avoid, particularly for individuals nearing and in retirement? Why?

Huemmer: Generally speaking, the usability of a specific type of ETF is dependent on the advisor’s client and their goals, assets, expected drawdown rate, risk tolerance, investment knowledge and the tax environment. Depending on the situation, the ETF product vehicle may be advantageous in helping to achieve those goals efficiently and transparently, but in some cases, a different investment vehicle could be a better fit.

One type of ETF that I would generally caution advisors to fully understand before using with those close to or in retirement are inverse and leveraged ETFs. These types of ETFs typically use derivatives to deliver on their investment objectives and are often designed for short-term, tactical use. They are also likely to be less tax efficient than ETFs that own conventional equity or fixed income securities. As such, the design of these strategies may not align with the goals of many individuals close to or currently in retirement.

Klein: Thanks, Chris.

Jerilyn Klein is editorial director of Rethinking65.

 

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