And while Kraus noted there are potential benefits that come with low-vol exchange-traded funds, he cautioned against potential risks including unintended economic sector concentrations (such as outsized allocations to utilities or consumer staples or telecom companies), unintentional risk factor loading and meaningful tracking error.
“When a fund is put together with good exposure to low volatility without considering any other exposure that may come along with that, sometimes you get pretty substantial tracking error relative to the cap-weighted market,” he said. “This heightened tracking error can persist for significant time periods, and a lot of times tracking error can go against you and look very different from the cap-weighted market.
“Even though over long time periods low volatility should play out in their favor, we know often times investors’ patience don’t line up with the time horizon it takes for low vol to play out,” he continued. “Sometimes the tracking risk is too much for a portfolio allocator to handle, and that can be a problem for those approaching low volatility from a strategic standpoint.”
Kraus said that multifactor ETFs are a way to overcome some of these challenges by offering exposure to both the defensive-oriented low-volatility factor and to offensive-minded factors such as valuation, momentum and quality. (Full disclosure: Hartford Funds offers a suite of multifactor ETFs.)