Three Ways To Invest In A Volatile Environment

The economy has slowed down and many economists predict continued sluggish growth for a considerable amount of time. There has also been mention of a double dip recession and how the European crisis may push the entire global economy into a dire situation. This has caused quite a bit of volatility as news has caused rapid spikes and drops in the market.

As an investor looking at a long time horizon, you may wonder when the right time to invest in the stock market is (if you haven't invested already) or whether to get out of the market until the economic environment has more clarity. The problem with this strategy is that it is very difficult to accurately time the market and many studies have shown that if an investor misses the beginning of a bull market, their long-term returns will be sub-par. So the key is to stay in the market and manage risk by adjusting your exposures. But how?

Well, there are several mutual funds and ETFs that have much lower volatility than other funds within the same asset class. The majority of these mutual funds are in the alternative space. But in the ETF world, there are several ETFs that can be great ways for investors to participate in the stock market and still be able to sleep at night.

The Easily RepeatableThe PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV) is based on the S&P 500 Low Volatility Index. It is probably the easiest low volatility index to explain and if an investor really wanted to, they could also duplicate it. Basically, the S&P Low Vol index measures the standard deviation of the 500 companies in the Standard & Poor's 500 Index for the preceding 12 months. It then ranks all 500 companies from lowest standard deviation (lowest volatility) to highest standard deviation (highest volatility). It then assigns a pro-rated share to each stock, based on its standard deviation versus the standard deviation of other stocks; the highest weighted stock is the one with the lowest standard deviation.

The result is that the index typically has only 70% of the volatility of the S&P 500. That means, for every 1% drop in the S&P 500, the S&P Low Volatility index will tend to decline by 0.7%. However, the same may hold true for bull markets. In fact, in a very strong bull market, the S&P Low Vol Index will underperform. In addition to the lower volatility, however, the stocks in the index tend to have attractive yields, which as of June 29, 2012, was 2.87%.

By looking at the underlying sectors, we also notice that there tends to be concentrations in the consumer staples, utilities and healthcare sectors. This makes sense, since these sectors tend to be more defensive in nature and, hence, less volatile.

The Sophisticated MethodologyInvestors can also choose to invest in the iShares MSCI Minimum Volatility Index Fund (USMV), which is based on the MSCI Minimum Volatility Index. This index is constructed using a much more sophisticated optimization process designed to minimize the absolute risk of the index, within a certain set of constraints. These constraints may include replicability, investability, turnover, and minimums and maximums for each stock, sector and country. In many cases, it will not include those stocks with the least volatility, but rather, it strives to create the combination of stocks that together will have the least amount of absolute risk. Needless to say, it would be very hard to explain this to grandma, much less replicate it yourself.

The Dynamic ApproachIn addition to these two funds, Direxion offers a fund that is called the Direxion S&P 500 DRRC Index Volatility Response Shares (VSPY). Unlike the other ETFs, this fund has a set target volatility of 15% and is dynamically adjusted to try to achieve that level of risk. It adjusts its exposure to equities based on the volatility of the S&P 500, increasing exposure to equities when the volatility on the S&P is low and decreasing it when the volatility on the S&P is high.

Source: Investopedia