Well-constructed low-volatility stock funds should offer better downside protection, a smoother ride, and better risk-adjusted performance than the market over the long term. But not all low-volatility funds are created equal. Differences in how they are constructed can affect performance and their odds of success. It’s important to have a strong framework to evaluate how these funds are built.

Portfolio Construction Framework

1. What’s the selection universe?

The selection universe is the fund’s starting point, or parent index. It should serve as the benchmark against which you gauge the fund’s risk and risk-adjusted performance. It can also offer insight into the riskiness of the fund itself. For example, large-cap stocks tend to be less volatile than small-cap stocks, so the most risk-averse investors should probably stick to low-volatility strategies that draw exclusively from the largest stocks. That said, the performance improvement from tilting toward low-volatility stocks tends to be the greatest in the small-cap arena.

2. Does the fund consider each stock’s volatility in isolation, or does it account for how stocks interact with each other in the portfolio?

The former approach yields greater exposure to the least-volatile names in the selection universe, more closely capturing the low-volatility effect docu¬mented in the academic literature than the latter, more holistic approach. That said, it can also lead to a less diversified portfolio that loads up on a few sectors or stocks that may have common exposure to other risk factors, like interest rates. This can introduce risks that past volatility alone does not capture.