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While the stock market was busy heaving up and down in recent months, some funds were offering a steadier, slightly less-nauseating ride.

“Low-volatility” funds cater to skittish investors who have less tolerance for turbulent markets. These funds generally restrict themselves to stocks with the mildest swings historically, and several have lived up to expectations by dropping less than broad index funds since the market turned choppy in early February.

“They have delivered what you would expect them to provide,” said Alex Bryan, director of passive strategies at Morningstar. “These are most appropriate for more risk-averse investors” who might be tempted to sell during a down market — a no-no for long-term investing.

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No investment is perfect, of course. Low-volatility funds lagged S&P 500 index funds in 2017, when big swings were rare and the market rode a powerful surge higher. Another risk lies in the areas of the market that low-volatility funds tend to favour. Many have loaded up on the kinds of stocks that may be hurt most if interest rates keep rising, as many on Wall Street expect.

For now, though, investors can appreciate the slightly smoother ride. Since S&P 500 index funds set a record high on Jan. 26, they’ve lost about 8 per cent due to a combination of fears about a possible trade war and a more aggressive Federal Reserve. At one point, S&P 500 funds were down more than 10 per cent from their peak, something that investors haven’t had to deal with in about two years.

Over the same time, though, the iShares Edge MSCI Min Vol USA ETF is down a more modest 6.1 per cent. The PowerShares S&P 500 Low Volatility Portfolio ETF, another one of the largest funds in the category by assets, is down only 5.3 per cent.

In general, experts says, investors in low volatility funds can expect more muted losses in down markets but also more modest gains during up markets, leading to roughly comparable returns over the long term.

Low-volatility funds take different approaches, but they generally focus on stocks that have a record of milder swings than the rest of the market.

The PowerShares S&P 500 Low Volatility Portfolio ETF, for example, tracks an index that holds only the 100 steadiest stocks in the S&P 500, as measured by their volatility over the past 12 months. It rejiggers its portfolio every three months, and its biggest investments currently include giants in the consumer staples sector, such as Coca-Cola and PepsiCo, along with big utilities like Duke Energy of Charlotte, North Carolina.

This kind of approach homes in on the steadiest stocks, but it can also mean concentrations in certain swaths of the market. Nearly a quarter of the ETF is in utility stocks, for example. Utilities make up less than 3 per cent of S&P 500 index funds.

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The iShares Edge MSCI Min Vol USA ETF tries to mitigate that by following an index that can limit how big sectors get in the portfolio. Utility stocks make up 7 per cent of its investments, for example. Its biggest investments include Visa, McDonald’s and Johnson & Johnson.

Utilities and stocks in the consumer staples sector generally have histories of steadier price movements, and they also tend to pay higher dividends than the rest of the market. Those stocks have been particularly attractive in recent years, when interest rates were close to record lows and bonds were paying scant amounts of interest.

But interest rates have been on the rise. The Federal Reserve is gradually raising short-term interest rates and paring back its bond investments. A 10-year Treasury note has a yield of nearly 2.80 per cent, up from 2.36 per cent a year ago.

Higher rates make bonds more attractive and undercut demand for utilities and high-dividend stocks. That’s part of the reason low-volatility funds have had days during the recent volatility where they’ve fallen more than the rest of the market.

On Feb. 21, for example, when bond yields jumped following the release of minutes from a Fed meeting, the PowerShares S&P 500 Low Volatility Portfolio ETF lost 0.8 per cent. S&P 500 index funds lost 0.5 per cent the same day.

Because their prices can be so sensitive to interest rates, strategists at BlackRock generally prefer stocks outside what they call the “RUST” belt of real estate, utilities, staples and telecoms — where low-volatility funds tend to have bigger concentrations than S&P 500 index funds. Instead of stocks where dividends are simply high, the BlackRock strategists prefer areas where dividends are growing, such as in the technology and banking industries.

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Regardless of any underperformance low-volatility funds may have in the short term, investors need to be willing to hold onto them for years, said Morningstar’s Bryan.

“We think these are good ideas for long-term investment,” he said. “But if you get frustrated easily by underperforming the market, these aren’t for you because they’re going to go through multi-year dry spells.”

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