A Different Way To Deal With Rising Volatility

Low-volatility exchange traded funds are among investors' favorites in the smart beta space and, of course, popular destinations when market volatility is expected to increase.

Other investment factors and the corresponding ETFs can also provide investors with buffers against rising volatility when that scenario arrives. Quality is one such factor.

What Happened

Scores of exchange traded funds focus on single investment factors, notably low volatility, size, growth and value while quality is arguably under-represented in the universe of single factor funds. The iShares Edge MSCI USA Quality Factor ETF QUAL is one of the dominant single-factor quality ETFs.

Historical data indicate quality is efficacious when equity market volatility increases.

“While volatility remains low by historic standards, it is on the rise,” BlackRock said in a recent note. “Last year, volatility was anemic, with the VIX Index averaging just above 11, well below its long-term average of 20. However, during the past six months the VIX has averaged close to 15, a 34-percent increase. Assuming volatility continues to normalize, historically this has been the type of market when quality has been the most valuable.”

Why It's Important

Year-to-date, QUAL is up 10 percent, an advantage of 70 basis points over the MSCI USA Minimum Volatility Index.

QUAL, which targets the MSCI USA Sector Neutral Quality Index, is not excessively allocated to defensive sectors. In fact, technology and consumer discretionary are the ETF's largest and third-largest sector exposures, combining for over 40 percent of the fund's weight. Lage allocations to those groups are usually uncommon in traditional low-volatility strategies.

Still, QUAL's three-year standard deviation is just under 9 percent, making the fund less volatile by that metric than the S&P 500.

What's Next

Data indicate QUAL should work for investors when the VIX spikes.

“Since 1994 quality, measured by the MSCI U.S. Quality Index, has produced higher monthly average returns than the S&P 500. In addition, the relative performance of quality versus the S&P 500 tends to be highest when the VIX is rising,” according to BlackRock.

"In months when the VIX is higher, quality beats the S&P 500 by approximately 40 basis points. This outperformance becomes more pronounced in months when the VIX rises by more than 25 percent. In those months, quality beats the market by approximately 0.90 percent on average.”

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