How volatile is your ETF?

Research shows that certain traits ("factors") can lead stocks to outperform the market over the long run. "Smart beta" (see below) exchange-traded funds (ETFs) aim to exploit this. They've proved popular with investors, who see them as a logical advance on index trackers (why track the benchmark when you can build a better index)? Yet recent turbulence in ETFs tracking one factor "low volatility" (also known as low vol or minimum volatility) highlights just how important it is to keep an eye on what's actually going in your funds.

The idea behind low-vol investing is to buy stocks that suffer from fewer ups and downs than the wider market. The benefit is that when markets are going up, you miss out a little bit, but when they fall, you avoid a lot of the worst of the slide. In other words, you make "superior risk-adjusted returns". Sounds good. There's just one problem: they may not always do what you expect.

What's your idea of a "low-vol" stock? It's probably something like a consumer-staple giant a large company with big brands and a relatively dull business. The last thing you might see as low vol is hot tech stocks. Yet, as Goldman Sachs noted last month, if Facebook, Amazon, Apple, Microsoft and Google comprised one sector, it would (until very recently) have been the least volatile in the market this year. That, in turn, reports Bloomberg, saw two of the most popular US low-vol ETFs load up on tech a few weeks ago.

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That was bad timing. Over the course of the past week, fears over rising interest rates and political interference have hit big tech stocks hard. As a result, the low-vol ETFs have fallen by more than the wider market in recent sessions. As another rebalancing isn't due for at least a quarter, low-vol investors may suffer a lot more "high vol" than they expected over the coming months.

What's the lesson? Firstly, no strategy works all the time. Low vol might work out in the long run, but after a strong run over the last few years, we may be at a turning point for the strategy. Secondly, always keep an eye on what your ETFs are investing in, particularly once you move beyond "plain vanilla".

I suspect that many holders of the MSCI Min Vol USA ETF, for example, would be surprised to hear that nearly 20% of their money is in tech stocks. Finally, be aware of the risk to the wider market. As Goldman notes, "if fundamental events cause volatility to rise", the low-vol ETFs "will sell [tech stocks] and exacerbate downside volatility". We like ETFs but the more that investors buy into strategies that they don't really understand, the greater the risk that something blows up unexpectedly.

I wish I knew what smart beta was, but I'm too embarrassed to ask

In theory, you shouldn't be able to beat the market. In its strongest form, the still-influential efficient-market hypothesis (EMH) argues that all available information is priced into markets instantly. As a result, prices are always "right", so there's no point in trying to outperform your fellow investors. That's a strong argument for passive investing if you can't beat the market, you might as well just track it.

Yet it's more complicated than that. Intuitively, most people understand that the EMH is an oversimplification that fails to take human behaviour into account. Moreover, plenty of academic studies show that companies with certain traits ("factors") have consistently beaten the wider market over time. Mainstream stock benchmarks (such as the S&P 500, for example) tend to be weighted by market capitalisation. In other words, the more valuable the company is, the bigger its weighting in the index. One objection to this is that it means a passive tracker is always putting more money into companies that are becoming more expensive, and selling those that lose value buying high and selling low, effectively.

These objections have fuelled the rise of "smart-beta" exchange-traded funds (ETFs). These tend to be more expensive than standard trackers, but they are still passive they use rules, rather than human discretion, to identify companies that meet specific characteristics and then invest in them. Examples of factors that seem persistently to outperform over time include value (cheap stocks tend to beat expensive ones in the long run); momentum (buying stocks that have gone up recently, and selling ones that have fallen); and low volatility (see above).