How Volatility Weighted ETFs Work

VictoryShares is innovating in smart beta with a different way of approaching markets.

Reviewed by: Cinthia Murphy
Edited by: Cinthia Murphy

VictoryShares has 12 ETFs on the market today, with all but one using a volatility-weighting scheme that attempts to offer better diversification and risk management than competing strategies. Together, they command about $1.4 billion in assets.

The firm, still relatively new to the ETF space, last month launched its first nonvol-weighted ETF using an index co-developed with Nasdaq to capture dividend growers.

Mannik Dhillon, president of VictoryShares, walks us through the philosophy and methodologies behind these ETFs, and the firm’s commitment to pushing boundaries in the smart-beta ETF segment. Almost all of VictoryShares’ ETFs are volatility-weighted, the largest being the VictoryShares US EQ Income Enhanced Volatility Wtd Index ETF (CDC), with $435 million in assets. Why this approach?

Mannik Dhillon: Volatility weighting, very specifically, is not targeting low volatility as a selection mechanism. It’s a weighting mechanism to better diversify an index—to address the concentration that occurs in cap-weighted indices where a few stocks dominate the performance and the risk profile of the index.

If you think back to index design, the first answer the industry came up with to tackle that issue was equal weighting. That was a pretty good solution in diversification from cap weighting, but it introduces some other biases. For example, you weight more to the smaller companies in the index, which could be riskier.

The idea here is that if you use the volatility of a company’s stock price over the last 180 trading days, and basically inversely weight securities based on that metric—that the least volatile weights more—the most volatile stocks will still be in the portfolio. That's what makes it different from some of the very popular low-vol strategies. Do you compare these vol-weighted ETFs to other low-vol and minimum-vol strategies in the market, like the PowerShares S&P 500 Low Volatility Portfolio (SPLV) and the iShares Edge MSCI Min Vol USA ETF (USMV)?

Dhillon: No. I consider SPLV and USMV to be in a similar bucket, trying to drive a similar outcome. The question here is, what's the outcome you're trying to drive? In both those cases, you're trying to get a less volatile portfolio.

Our strategies don’t have a target or end objective of adjusting volatility at all. We’re simply saying that if you use volatility of a company as your weighting mechanism, you get better diversification across that list of securities. Would you say that smaller-cap stocks tend to be more volatile, so you’d you end up with some sort of size bias in this approach as well?

Dhillon: You would think, but no. If you think about how people are using risk parity to allocate their assets—say, I’ll increase my fixed-income allocation because it has less risk—the idea is that you can use a similar concept across your stocks.

You can say, “I want all the stocks to have the same risk contribution to the portfolio.” With volatility weighting, you’re doing just that. Even the most volatile stock will still be there at, say, 0.10% weight, and the least volatile could be in there at a 0.40%. From a risk contribution perspective, they're equal.

The other thing at work here is that only companies that have been profitable in the previous year are considered for inclusion in the index. The reason for that is that the genesis of this approach was to improve upon the S&P 500. And the S&P 500 has earnings criteria in it. It's just applied very loosely.

For us, if profitability of a company is a good measure for its inclusion, it should also be for its retention, so we require four quarters of profitability. As an investor, should I look at these ETFs as an investment in quality companies that are stable in terms of market performance?

Dhillon: You're getting profitable companies. And earnings is one characteristic of quality.

You're also emphasizing those that are less volatile. Who decides on stock price volatility? The market decides that. And the market is fairly efficient; it has taken a lot of information about a company into consideration to treat its stock price a certain way.

So, a company that's less volatile means the market has said, “Based on your financials, your earnings profile, the business you're in, the industry, you're less risky than something over here that might be more sporadic.” It's an interesting factor in and of itself.

But the portfolios are still broad. They’re well-diversified across sectors. You have to maintain purity to the exposure you’re trying to provide. So in the case of your equity ETFs, they are direct competitors to market-cap-weighted ETFs accessing the same pockets of the market?

Dhillon: They’re a substitute for the S&P 500 or Russell 2000, etc. You want to be true to that cap profile, and then just volatility-weight them instead.

One thing to keep in mind is that people like to say that in strategic beta, “You're just getting small-cap exposure.” The moment you don't cap weight, you're going to look smaller. There's no ifs/ands about that.

But then you have to go back and look at the underlying companies. The size of the companies that are underneath are pretty much the same as the S&P 500; they're just weighted differently.

That's our core methodology. From there, if volatility weighting is a good way to diversify an index, you can then apply it to other outcomes like income, dividends. We take the 500-stock index, pick the 100 highest dividend yielders, and volatility-weight them. That's very different from what our competitors are doing, which either market-cap-weights or yield-weights a dividend index. Are you looking for the stability of dividend?

Dhillon: First and foremost, it’s the diversification you can achieve through volatility weighting and putting them all on that equal-risk contribution stance in the portfolio.

But secondly, it’s exactly what you're saying. If you can invest in a set of high yielders, but emphasize the ones that are less volatile as deemed by the market, you're hoping that you get a little better risk-adjusted return out of it.


By comparison, yield-weighting a high-dividend yield index is a tricky proposition, because yield, at the end of the day, is an equation; it's dividends over price. Something that has a very high-yield percentage could be just a function of its price having declined, which could be a sign of a deteriorating company. To further weight an index based on yield, you could then be increasing the impact that company with a falling price has on your portfolio.

That's why even the earnings criteria helps toward saying the only dividend payers that we have in our dividend index are those that are profitable. First of all, they're profitable; then they can keep paying dividends. Your latest ETF, the VictoryShares Dividend Accelerator ETF (VSDA), is the first in your lineup not built around volatility weighting. Why the departure?

Dhillon: We want to offer a diverse set of outcomes on the passive side of our business, our ETF side of the business, like we do on the active side.

The ETF tracks an index of dividend growers. With an ETF like the VictoryShares US Large Cap High Div Volatility Wtd Index ETF (CDL), we're offering exposure to high-dividend yielders, but we didn't have anything that offered exposure to dividend growers.

We know rates are probably going up. Dividend-yielding stocks can sometimes underperform dividend growers in that situation. If an advisor has clients that are in significant demand of income, and they want to get that income from equities, they have long been relying on these equations of yield and saying, “I want the one with the biggest percentage yield.” Dividend growers are a way to access dividends that diversify away from dividend yielders. It’s about offering a variety of solutions.

What’s unique to our approach is that a lot of the dividend-growth indices use simple rules that look at whether a company has grown their dividends for X-number of years in a row, like 20, 25 years. That means you've waited 25 years to put this company in your index. It must be a pretty good company that’s likely to grow their dividends because they've done so for 25 years.

But what happened to all the appreciation you missed to that company for all the years that it increased dividends from years five to 25? Those companies that are able to grow their dividends do well. They help clients protect on the downside. And if you're able to grow your dividends every year, you’re financially a pretty good company. We include companies at the five-year mark. We then look at other financial criteria that are indicative of companies' ability to grow their dividend.

Finally, we realize we have a dividend-yield product. We know a lot of people focus on that yield percentage. Even though your percentage yield might be going up, the actual dollars you get might be going down. We focus on stocks that emphasize growth of the actual dividends, the dollars. People can't take a yield number to the store and buy groceries in retirement. What are the main risks in a volatility-weighting scheme, or in this dividend-grower approach?

Dhillon: Volatility weighting won't do well in periods where there is leadership in a concentrated number of securities. Like FANG [Facebook, Amazon, Netflix, Google], and the mega-cap stocks—when the market return is not broad-based. This year, for example, about half the return in the S&P 500 was driven by 10 stocks. Even in that case, we were only a few basis points behind, but we were behind nonetheless.

In a year where 10 stocks are positive, 490 actually have negative returns, but the index returned 1%, that's not the right environment for volatility-weighting.

Contact Cinthia Murphy at [email protected]


Cinthia Murphy is head of digital experience, advocating for the user in all that does. She previously served as managing editor and writer for, specializing in ETF content and multimedia. Cinthia’s experience includes time at Dow Jones and former BridgeNews, covering commodity futures markets in Chicago and Brazil equities in Sao Paulo. She has a bachelor’s degree in journalism from the University of Missouri-Columbia.