ETF: Volatility ETFs explained

In ETF Blog, Latestby Kristia van Heerden

This year, Absa introduced three new ETFs that aim to capitalise on the relationship between risk and return. (If that sentence scared you to death, hang in there. It will make more sense later in this article.) The products aim to minimise the amount of money investors can lose when markets are scary. They do this by limiting the amount of risk a single company is allowed to contribute to the ETF and by selling shares and holding cash when the market is a circus. 

Here, we attempt to understand these strange new beasts by looking at how ETFs are normally put together. Once we understand that, we’ll delve into what exactly Absa mean by “risk”. Lastly we’re going to explain how these products turn those concepts upside down. 

Tip: To learn more about these products, Simon Brown interviewed Absa’s Len Jordaan. Listen to the interview here.

ETFs: The old guard

Back in the day, ETFs were only put together using market capitalisation. This is when you multiply the share price by the amount of shares available. The bigger that number, the bigger slice of the ETF pie is allocated to the company. This means most of your money is invested in bigger companies, with sometimes only a few cents set aside for the little guys. The most famous example of this method is the Satrix 40. ETFs weighted this way are sometimes called “vanilla” ETFs. 

As the ETF market became more sophisticated, ETF issuers started toying with how much space each company can take up in an ETF. After that they looked at which companies should be included at all. It started out fairly simply, giving equal exposure to all companies in the ETF. In recent times, these methodologies have become increasingly complicated. These days companies are included based on certain criteria, such as how much their share price moved recently or how many assets they have compared to their share price. These fancy ETFs are sometimes called “smart beta” ETFs. 

Until now, limiting your single-stock exposure (a fancy way of saying “how much money is invested in a single share”) was the only type of risk management ETFs offered. Absa’s new volatility managed ETFs represent new way of thinking about things.

How to understand “risk”

As you intuitively know, there are many risks to your financial life. Most of us think of financial risk as the chance that we might lose all our money, like when it gets stolen.

In the world of share investments, risk takes on an additional meaning. Of course, your first priority is to protect yourself from losing all your money. This first type of risk management strategy is called diversification. Diversification is when we ensure that all of our money isn’t in the same place. For example, you’ll have some of your money in an emergency fund, some of your money will go towards insurance and some of your money will go to share investments. 

ETFs have diversification built in, because you don’t invest all your money in a single company. In fact, some ETFs don’t even invest in a single country, but rather in thousands of companies around the world. 

The “risk” we refer to when we talk about share investments means something different from the types of risks we discussed above. In this context, “risk” refers to how much a share price goes up and down over time. The risk is not in losing all your money, but rather that you won’t be able to sell the share at a profit when you’re ready to sell. This type of risk is called “volatility”.

Volatility is normal in the stock market. In fact, it is the reason why share investors do better than people who save their money in the bank. The market rewards us for taking a chance on a company by making us more money

How Volatility Managed ETFs work

The amount of risk a company contributes to a portfolio is measured in the volatility of the share price. In this case volatility refers to how often and by how much the share price moves away from the share’s average price over time. 

Just like other ETFs use size to determine how much space a company can take up, these ETFs use a volatility to determine a company’s weighting in the ETF. Depending on which of the Volatility Managed ETFs you choose, companies with higher volatility take up less space. The hope is to smooth out the ride for investors by not allowing volatile shares to run amok. These ETFs are therefore risk-weighted.

The other unique feature is how these ETFs behave during volatile market conditions. When the situation in the market gets too hairy, the ETFs sell equities and hold onto cash. Once things calm down again, the ETFs buy back into equities. That means during market crashes, the ETFs will lose less money by going into cash. When market volatility calms down again, you buy back into equities, but because you didn’t lose so much ground to begin with, you start from a higher base. This strategy will ensure peace of mind during market crashes.

These ETFs are worth consideration if you are approaching your financial independence date. The equity exposure will keep your investments growing, while cashing out during volatile times will protect your assets. 

It is, however, important to know that companies whose share prices never move could sneak into the more conservative of these ETFs due to its low volatility filter. Remember, investments need to keep up with inflation for you to get ahead. If this is a concern to you, the higher volatility option is better. If holding on to your money for dear life matters more, take it nice and breezy with the low risk option. 

Click on the below link to download more technical information about these products in PDF format.

Absa Volatility Managed SA Equity Indices Methodology

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