All investments experience their own unique levels of risk and reward, and ETFs are no exception. Fortunately, due to their nature and their added advantage of diversification, ETFs are known for experiencing a happy balance between the two. That said, this doesn’t mean ETFs are never subject to risk or volatility. In this article we will dive into the subject of ETF volatility and whether they increase or reduce the investor’s exposure to volatility.
What do we mean by volatility?
When a market or asset experiences periods of unpredictable – and often dramatic – price swings, it is referred to as volatility.
Volatility measures price movements over a specific time period, and while it is frequently associated with price drops, it equally applies to unexpected price increases. It can be caused by many things, including company performance, economic, political, sector and industry factors.
A price is said to have high volatility when it varies rapidly over a short period of time, hitting new highs and lows. Low volatility, then, describes a price that swings up or down more slowly than usual or remains reasonably stable.
Importantly, volatility is a natural part of long-term investing. Investors who are prepared for periods of volatility from the start of their investing journey are able to react more rationally and are less taken by surprise when volatility does occur.
Investors should prepare themselves and stay focused on their long-term financial goals by adopting a mindset that accepts volatility as a normal part of investing.
Volatility in the context of ETFs
ETFs are considered low-risk investments not only because of their low-cost, but due to the fact that they are made up of baskets of securities like stocks, bonds and other assets across many different companies, sectors, and countries, which allows for greater diversification.
Since diversifying your investments spreads out the potential risk, ETFs are considered an ideal, minimal-risk asset for individual investors who want to reduce volatility when building their investment portfolios.
With every new variant of COVID-19, and the looming possibility of massive global economic disruptions, the stock market is bound to face volatility from time to time. However, if portfolio volatility does occur, investing in ETFs is a great measure to take to control the level of volatility.
When might you experience volatility with ETFs?
It’s crucial to remember that just because an ETF has multiple underlying positions doesn’t imply it’s free of risk and subsequent volatility. The possibility of fluctuations is mostly determined by the fund’s scope.
For example, a broad market index ETF, e.g., one that tracks the S&P 500, is likely to be less volatile than an ETF that tracks a specialized industry or sector, such as an oil, gas or coal services ETF.
Consider ETF volatility in terms of the type of ETF you are investing in, for example:
- Broad market ETFs
The majority of ETFs are actually relatively safe as many of them are index funds. An indexed ETF is a fund that invests in the same assets as a specific index and tries to match the index’s annual returns.
While it’s true that all investments involve risk, and indexed funds are subject to the whole market’s volatility (meaning that if the index drops in value, the fund drops as well), the stock market’s overall trend is optimistic. Over time, indexes are most likely to gain value, so the ETFs that track them are as well.
- Sector ETFs
ETFs have grown increasingly specific to sectors and industries, so keep this in mind if what you’re looking for is diversification and risk-reduction. An ETF that monitors a specific industry, such as the energy sector, will likely be more volatile than one that tracks a wide market index like the S&P 500.
Volatility in an industry or sector might be triggered by certain events. For example, in the oil industry, a significant climatic event in a large oil-producing region might cause oil prices to rise. As a result, oil distribution-related companies’ stock prices may climb, as they are likely to benefit, but those with significant oil costs in their business may see their stock prices decline.
Historically, the risk/reward characteristics of various industry sectors differ. The technology sector, for instance, has the highest volatility over time on average, whereas the utilities sector has the lowest. Individual sectors will, in general, be more volatile than the stock market.
- Minimum volatility ETFs
A minimum volatility ETF is an investment solution worth considering if you want to maintain your long-term exposure to stocks while reducing shorter-term volatility.
A minimum volatility ETF (along with other minimum volatility investment vehicles) aims to reduce volatility exposure by tracking indexes that strive to give lower-risk alternatives to other, higher-risk assets. When opposed to a broadly diversified index like the S&P 500, a low-volatility ETF may demonstrate less risk during time of market instability.
Nevertheless, a low-volatility ETF won’t completely eradicate exposure to volatility. Furthermore, when the overall market is performing well, low-volatility ETFs may underperform non-min volatility funds with similar asset class exposures, and also may face losses during sharp market corrections.
Low-volatility ETF investors recognise that any potential losses experienced during a market dip will be fewer than for other investments that are considered more volatile. As a result, when stocks recover from a dip, a less risky portfolio may rebound faster than the broad market.
- Volatility ETFs, ETNs and Inverse ETFs
There is also such a thing as volatility (VIX) ETFs and exchange-traded notes (ETNs). These will usually move opposite to major stock market indexes. For example, when the Dow Jones Industrial Average is rising, volatility ETFs and ETNs will normally decline, and vice versa.
Volatility ETFs provide exposure to volatility in many forms. These funds, which are commonly referred to as “fear” indicators are largely employed by traders trying to profit from market downturns.
These may provide attractive day trading possibilities at times, but there are times when they should definitely be avoided, especially if you’re a newbie investor.
There are also inverse ETFs to consider. Inverse ETFs try to profit from stock declines by shorting stocks. Shorting is the act of selling a stock and then repurchasing it at a cheaper price, anticipating a price drop. To short a stock, an inverse ETF employs derivatives which are, in essence, wagers on the market’s downfall.
When the market falls, the value of an inverse ETF rises proportionately. Many inverse ETFs are ETNs, not actual ETFs, as investors should be aware.
Inverse VIX ETFs are only really employed by sophisticated traders along with other highly technical trades in a broader portfolio. It’s vital to remember that these are extremely complicated instruments that come with their own set of risks. They’re designed for investors with very short time horizons and shouldn’t be employed as part of a buy-and-hold strategy. Before deciding whether or not to trade such assets, investors should carefully assess their personal risk tolerance and risk capacity.
So, do ETFs increase volatility?
Ultimately, it’s critical to understand an ETF’s focus and the types of assets it holds. When it comes to ETF volatility, it’s all relative. If the ETF is tracking a broad market index, you’re likely to experience less volatility overall, but if you’re investing in a sector-specific ETF, the chances of volatility are higher due to the lack of diversification.
Diversification is a proven asset allocation strategy. While neither diversification nor asset allocation guarantees a profit or protects against a loss, they can both be useful tools for managing long-term market volatility. If your portfolio is well-diversified, you can wait out market volatility and bounce back quickly, which is an ideal strategy for the long-term investor and long-term gains.
If you’re looking for a low-cost, low-risk way to diversify your portfolio and reduce potential volatility, open an arty account today and try it for free. arty offers a selection of well-diversified ETF portfolios that you can copy to your own ETF brokerage account. arty controls volatility by using advanced technology and quants (professional quantitative analysts) and helps you manage risk while copying winning ETF portfolios.