By Adam Laird | 03 December, 2013

Innovation is one of my favourite things about the ETF industry. When I research passive investments I want to find new strategies, assets or exposures that will work in clients’ portfolios. The creativity that has gone into alternatively weighted ETFs, often called “Smart Beta”, has been laudable.

However, there is one product whose popularity has been growing in recent years that I always tell investors to avoid. That is low volatility ETFs.

Low volatility is a simple concept. Take the stocks in the index and arrange them in a way that reduces the price volatility. The result: an ETF which rises less than the market, but falls less in a correction. Some studies have found that these products actually outperform on a risk adjusted basis. Whether or not this premium persists in the future, it is a worthy aim.

Despite there being fewer than a dozen low volatility ETFs on the London Stock Exchange, the strategy has received a lot of attention. Some products have done exceptionally well in absolute performance terms, even beating the standard market cap weighted index. Take for example the only low volatility ETF on the UK stock market- Ossiam’s FTSE 100 Minimum Variance ETF (UKMV). In the 2012 calendar year, the ETF grew by 14.4 percent versus 10.0 percent for the FTSE 100 total return index. This has narrowed in 2013, but on the whole investors have still been rewarded.

Despite such strong performance, I do not feel these products are right for individual investors. The person on the street does not calculate their Sharpe Ratio, they simply wants low risk.

In finance, we often use volatility and risk interchangeably. These concepts are linked but are not equivalent. Volatility is the way that the price of an investment fluctuates over time and takes into account both gains and losses in value- variance is a measure of volatility, as is standard deviation. Risk, loosely speaking, is the chance that you will lose money and is difficult to condense to a number as there are many sources of risk. The distinction is critical for low volatility ETFs- these investments can never be low risk. Funds that hold shares can always lose money.

In some ways, we are all the same. We care about downside risk but when markets are rising we would bet the ranch. So when they fall, how much protection would we get from a low volatility product? We need to remember that prices have been hit across the board when the market has crashed in the past. When there is a market correction, correlation increases between stock prices, all companies fall and even defensive investors have suffered.

Concentration is another risk- some products are highly skewed towards certain stocks and sectors. Investors may only be buying only 20 percent- 40 percent of the shares in the index, thereby losing an important element of diversification.

Would I scrap these funds? No. I don’t think that Low-Vol is flawed as a concept, indeed some products do a very good job. They have been used successfully by many discretionary managers, private banks and institutional funds. But it takes a professional manager to understand and monitor the risks on an on-going basis.

For retail investors, my advice is unchanged. If you want low risk, hold cash or government backed securities. Leave low volatility to the professionals.

Adam Laird is the Passive Investment Manager at Hargreaves Lansdown- a leading stockbroker, investment platform and financial advisor in the UK.