2022 has been a tough time for investors, with major market benchmarks having entered bear markets after prolonged declines. Many shareholders have seen the stocks they hold lose 50% or more of their value just this year alone, in some cases giving back massive gains from previous years.
Given how choppy the stock market has been so far this year, investors have paid a lot more attention to defensive investments designed to hold up better than the overall market during tough times. In particular, low-volatility ETFs allow investors to stay invested in stocks but with an eye toward reducing the violence of the ups and downs in their portfolios. Despite a mixed history, low-volatility ETFs have gotten the job done in 2022, although that might not mean exactly what some of those who bought these wealth-protecting investments think it does.
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What low-volatility ETFs try to do
The idea behind low-volatility ETFs is simple. Their goal is to allow investors to get stock market exposure but avoid the full brunt of bear market downturns.
Different ETFs take different tacks toward achieving this goal. The Invesco S&P 500 Low Volatility (SPLV -0.22%) ETF focuses solely on stocks that are part of the S&P 500 index. Meanwhile, iShares Edge MSCI Minimum Volatility USA (USMV -0.16%) has a slightly larger universe of stocks to select from, incorporating both large-cap and mid-cap companies in the U.S. market.
Both of these ETFs hope to provide U.S. stock exposure with less risk. In particular, investors hope that in a bear market environment, these low-volatility ETFs will manage to preserve wealth more effectively than a simple index-tracking fund.
How low-volatility ETFs have fared in 2022
Indeed, when you look at their performance so far this year, low-volatility ETFs have done what they were supposed to do. As you can see below, the two ETFs mentioned above have suffered losses year to date, but they're much smaller than the corresponding losses in the broader S&P 500.
SPLV Total Return Price data by YCharts.
The source of outperformance for low-volatility ETFs has largely been the companies in traditionally defensive areas of the market, such as healthcare and consumer staples. Among top performers among the fund's holdings, you'll find biotech giants Gilead Sciences and Amgen, as well as consumer brand leaders Hershey and PepsiCo. In addition, some other stalwart stocks have performed well, including defensive contractor General Dynamics and healthcare conglomerate Johnson & Johnson.
Accepting smaller gains
The problem with low-volatility ETFs, however, is that they don't tend to outperform the market when it's going up. And because the market goes up more often than it goes down, this can cause dramatic underperformance.
For instance, take a look at what happens when you widen the time horizon for performance out to three years:
SPLV Total Return Price data by YCharts.
That period had two bear markets, but it also included a long period of sharp advances from mid-2020 to late 2021. As you can see, the S&P 500 built up a huge lead during the bull market phase, and even now that minimum-volatility ETFs are faring better, there's still a wide performance gap between the two.
Watch your risk level
In the end, investors might be happier owning the stocks in which they have the greatest conviction but tempering their risk level by making allocations to other types of assets, including fixed-income securities and cash. That strategy can be just as effective in managing risk while offering the advantage of letting you invest in companies you truly believe in.
