Low Volatility ETF: How It Works, What It Holds, and When It Falls Anyway

A low volatility ETF holds the calmest stocks in an index and stays fully invested in them. It seeks a smoother ride than the market, not an exit from it.

That second point is the one buyers miss. In a slow, rate-driven decline, a low volatility ETF can cushion a lot. In a fast crash it can fall as far as the market. Sometimes further.

What is a low volatility ETF?

It's an equity fund that tracks a rules-based index of lower-risk stocks. The index ranks a universe, like the S&P 500, by how much each stock has moved. Then it keeps the quietest names.

Two index families dominate. The S&P 500 Low Volatility Index holds the 100 least volatile stocks in the S&P 500. The MSCI USA Minimum Volatility Index runs an optimizer for the lowest-variance portfolio it can build, within caps.

Both rebalance on a calendar, not on market conditions. Both are 100% stocks every single day.

How do low volatility ETFs work?

1. Measure. The index calculates each stock's volatility over a trailing window. The S&P version looks back 252 trading days, about one year.
2. Select. It keeps the lowest-volatility names. The minimum volatility version also counts how stocks move together.
3. Weight. The S&P version weights each stock by the inverse of its volatility. The calmest stock gets the biggest weight.
4. Rebalance. The S&P version resets quarterly. MSCI resets twice a year. Between those dates, nothing reacts to the market.

What comes out is a sector tilt. Calm stocks cluster in utilities, consumer staples, health care and real estate. So a low volatility ETF is partly a bet on those four sectors. And on the interest rates that move two of them.

Low volatility vs minimum volatility ETF: what's the difference?

Low volatility ranks stocks one at a time. Minimum volatility looks at the whole portfolio, correlations included. Its optimizer will hold a jumpy stock if it tends to move against the rest.

Minimum volatility also keeps sector weights within five points of the parent index. The S&P low volatility screen has no sector cap. That makes it more concentrated and more sensitive to rates. We compare the two designs in detail in equal-weight low volatility vs minimum volatility.

Did low volatility ETFs hold up in the 2020 crash?

No. The S&P 500 fell 33.9% from its close on 19 February 2020 to its close on 23 March.

Over the same dates, a fund tracking the S&P 500 Low Volatility Index fell about 35.8%, with dividends. A fund tracking the MSCI USA Minimum Volatility Index fell about 33.0%.

So the low volatility screen fell further than the index it was drawn from. The minimum volatility version saved less than a point.

The sector tilt explains it. The trailing window held a calm 2019, so the index went in heavy on utilities and real estate. Then the sector funds for those two fell about 35% and 38% over those 23 trading days. Staples and health care held up better, but not by enough.

Correlation did the rest. In a forced-selling panic, investors sell what they can, not what's risky. A stock's calm history doesn't matter when the whole market is being liquidated.

Did low volatility ETFs work in the 2022 bear market?

Yes, and by a wide margin. In calendar 2022 the S&P 500 returned -18.1% with dividends. The low volatility tracker returned about -4.9%. The minimum volatility tracker returned about -9.4%.

2022 was a different kind of decline. Slow, and driven by rates and valuations. The S&P 500 took from 3 January to 12 October to reach its low. Technology fell about 28% for the year. Utilities finished slightly up. Staples and health care lost about 1% and 2%.

That's the environment a low volatility ETF is built for. Expensive growth stocks got repriced, and the calm defensive names were already the portfolio.

Real estate is the warning inside that good year. Its sector fund lost about 26% in 2022. Rate-sensitive stocks look calm right up until rates move.

What does a low volatility ETF cost in a bull market?

Quite a lot, in the wrong kind of bull market. In 2023 the S&P 500 returned 26.3%. The low volatility tracker returned about 0.5%. The minimum volatility tracker returned about 10.3%.

Look at the four years together, start of 2020 to end of 2023, with dividends. The S&P 500 gained about 57%. The minimum volatility tracker gained about 28%. The low volatility tracker gained about 17%.

Those four years held a crash, a V-shaped rebound, a bear market and a narrow rally. The low volatility screen lost more in the crash, trailed the rebound, won 2022, then missed 2023. One good year in four.

When do low volatility ETFs fail?

• Fast crashes. Correlations jump toward one and the calm-stock filter stops mattering. 2020 is the clean example.
• Rate shocks. Utilities and real estate trade partly like long bonds. When yields spike, the "defensive" sleeve takes the hit.
• Narrow rallies. When a few large growth stocks drive the index, a fund that owns none of them falls far behind.
• Regime changes. The trailing window describes last year. A stock that was calm in a quiet year can be the first to break.

None of these is a flaw in the index rules. They're the rules working as written. A low volatility ETF changes what you own. It never changes how much you own.

How should advisors evaluate a low volatility ETF?

• Does total equity exposure ever change, or is it always 100%?
• How long is the lookback window, and how often does the index rebalance?
• Is there a sector cap? What were the utility and real estate weights at the last reset?
• What did the index do from 19 February to 23 March 2020? And in calendar 2022?
• Can the client live with trailing a strong market by 20 points or more in a year like 2023?

For retirees taking withdrawals, the 2020 answer matters most. A deep, fast loss early in retirement does lasting damage. Our guide to sequence of returns risk works through why.

Is there a low volatility approach that can hold cash?

Yes. The design question is whether the index is allowed to own less.

The THOR Equal Weight Low Volatility Index holds ten S&P 500 sectors at equal weight. Each sector carries its own on or off signal. When sectors turn off, their weight moves to the sectors still on, up to a 20% cap. Past that cap, the remainder goes to cash alternatives. With every sector off, the index holds no equity at all.

So it seeks to reduce drawdowns by changing how much it owns, not only what. It has limits too. Signals lag, so the first part of any decline gets through. And a sharp V-shaped rebound can leave it in cash while the market recovers. The index explainer walks through a dated example from 2024 and 2025. For a wider look at the category, see our low volatility ETF comparison.

Definitions

• Low volatility ETF. An equity ETF tracking an index of the least volatile stocks in a universe. Always fully invested.
• Minimum volatility ETF. An equity ETF tracking an optimized portfolio built to have the lowest expected variance, within sector caps.
• Volatility. The standard deviation of returns, usually measured on daily prices over a trailing window.
• Inverse volatility weighting. Each holding's weight is set in proportion to one divided by its volatility.
• Beta. How much a stock or fund has moved relative to the market. A beta of 0.7 means about 70% of the market's moves.
• Correlation. How closely two assets move together. It tends to rise toward one in a crash.

Past performance is not indicative of future results. Index and fund figures cited above are public market data, total return where stated, for illustration only. They do not represent the performance of any THOR fund or strategy, and this material is not investment advice.