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Low Volatility Strategies Are All About Design

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As the pandemic roiled markets, low volatility stocks were top of mind for many investors in 2020. But did low volatility strategies perform true to design in 2020?

In our first Funds in Focus podcast episode of 2021, we spoke with Senior Investment Strategist Christopher Huemmer about how low volatility strategies fared in 2020—and how to avoid some potential pitfalls when constructing low volatility portfolios.

In this episode, you'll learn

  • The low volatility factor and why some investors find it as an attractive way to invest
  • Why low volatility exists and its trend
  • What investors need know about low volatility investing
  • Using quality in addition to the low volatility investment approach

A TREND OF HIGHER MARKET VOLATILITY

The prevalence of market volatility spikes has been on the rise over the past decade. If we look at data prior to the Great Financial Crisis (GFC), the S&P 500 Index1 generally experienced volatility spikes higher than 5% less than once a year. But since the GFC, this figure has increased six-fold—pointing to a significant trend of rising volatility.

In a higher volatility market environment, it’s important to keep in mind that downside and upside volatility don’t have an equal impact on returns. For example, if a portfolio returns -20% in one month and rises 20% the following month, the result isn’t a breakeven. Rather, due to compounding returns, the portfolio nets a 4% loss. It’s for this reason that more investors are turning to low volatility strategies for downside risk mitigation in the face of rising volatility.

DID LOW VOLATILITY STRATEGIES DISAPPOINT IN 2020?

The objective of low volatility investing is to minimize the fluctuation of the value of an investment over a period of time, which is why it’s often considered a defensive strategy that’s best suited for volatile markets. As such, many investors saw the market turbulence in February and March 2020 as an opportunity to put low volatility strategies to the test.

When looking back on the 2020 market turmoil, many investors didn’t believe their low volatility strategies passed this test, finding they didn’t provide adequate downside risk mitigation. However, this outcome wasn’t necessarily an indication of a “broken” low volatility factor, but rather largely a result of how their strategies were designed.

Our research suggests that low volatility strategies have historically resulted in portfolios with significant sector biases, such as utilities and consumer staples. During the February and March market downturn, these two sectors were hit particularly hard relative to others. As a result, low volatility strategies constructed from a security level with no sector constraints underperformed, while strategies designed to avoid these sector biases fared better.

INTEGRATING THE QUALITY FACTOR

We believe that a company’s financial health is important when constructing low volatility strategies. Metrics such as profitability and cash flow are key to assessing the quality of a company, and our research shows that the poorest quality companies also tended to be the most volatile. As such, incorporating the quality factor into volatility strategies to eliminate low quality companies can result in a more targeted low volatility experience.

The FlexShares Quality Low Volatility ETFs are designed to provide exposure to companies that possess lower overall absolute volatility characteristics, while also exhibiting financial strength and stability, or what we believe are quality characteristics. They’re also constructed with sector constraints to avoid the sector biases that can be inherent in low volatility strategies.

For more information, please see our Quality Low Volatility Suite of FlexShares ETFs.


IMPORTANT INFORMATION

Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus and a summary prospectus, copies of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest.

Foreside Fund Services, LLC, distributor.

An investment in FlexShares is subject to numerous risks, including possible loss of principal. Fund returns may not match the return of the respective indexes. A full description of risks is in the prospectus.

The FlexShares US Quality Low Volatility Index Fund (QLV) is passively managed and uses a representative sampling strategy to track its underlying index. Use of a representative sampling strategy creates tracking risk where the Fund’s performance could vary substantially from the performance of the underlying index along with the risk of higher portfolio turnover. Although the fund seeks lower volatility than the broader U.S. equity market, there is no guarantee it will be successful as securities or other assets in the Fund’s portfolio may be subject to greater price volatility than the market as a whole The Fund may also invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Fund could lose more than the principal amount invested. The Fund is also is at increased risk of Industry Concentration, where it may be more than 25% invested in the assets of a single industry.

1 The S&P 500, or simply the S&P, is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States.

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