FDLO: A Low-Volatility ETF With Favorable Risk-Reward (NYSEARCA:FDLO)

What has happened in the market in the last few days is a stark reminder of the potential volatility often neglected by the average investor. In this context, the Fidelity Low Volatility Factor ETF (NYSEARCA:FDLO) is one of the funds that address this question, offering access to a portfolio that seeks to mitigate overall volatility while still delivering competitive returns compared to broader stock indexes.

This fund adopts a slightly different approach from other low-volatility ETFs, keeping a sector allocation similar to its benchmark, the Russell 1000 index, rather than overweighting defensive sectors like utilities. This approach has benefited FDLO, as it has taken advantage of its nearly 30% allocation to the technology sector, which has helped this fund outperform its low-volatility peers over the past years, while maintaining volatility levels on par with this peer group and significantly lower than stock market indexes.

Thus, despite potential risks associated with its exposure to more sensitive sectors, such as technology, I view FDLO as a fund that can add value for investors and is worth considering for a diversified portfolio.

ETF Description & Highlights

FDLO is an exchange-traded fund that offers exposure to large and mid-capitalization companies in the U.S. market with lower volatility compared to the overall market, tracking the Fidelity U.S. Low Volatility Factor Index.

This index seeks to achieve returns generally in line with the U.S. stock market, but with reduced volatility. The index construction process selects stocks that meet a low volatility criteria based on their historical prices, earnings stability, and beta, which measures a stock’s volatility relative to the benchmark.

A quantitative approach also assesses correlations among stocks and applies optimization routines to minimize overall volatility. Stocks are ranked according to a composite score, and those expected to contribute to a low-risk portfolio are selected for inclusion in the index, with rebalancing occurring semi-annually.

As of July 30, 2024, FDLO manages $1.1 billion in assets invested in 124 companies, with an average market cap of $213.9 billion. Of these, nearly 40.2% is allocated to mega caps, 37.2% to large caps, 19.3% to mid-caps, and 3.2% to small caps, in a distribution across market cap categories that is similar to its benchmark, the Russell 1000 index, represented by the iShares Russell 1000 ETF (IWB).

FDLO’s top ten holdings (Apple, Microsoft, Alphabet, Amazon, Eli Lilly, UnitedHealth, Texas Instruments, Oracle, Visa, and Mastercard) include some mega caps that also constituted the Russell 1000 index. Notably absent are semiconductors NVIDIA and Broadcom, as well as Meta Platform, which are relatively higher volatile stocks compared to other top holdings.

Below is a table comparing FDLO with a peer group of ETFs emphasizing lower-volatility stocks. The first two ETFs, USMV and SPLV, are the largest players in the segment. The other four ETFs are much smaller in terms of AUM, and although they all target low-volatility portfolios, their approaches have slight differences. For instance, CFA has a more diversified allocation strategy with nearly 500 holdings, while ONEV includes other measures besides low volatility, such as value and quality. Meanwhile, the last fund on the list, THLV, is a relatively new ETF that invests in sector ETFs rather than common stocks and is rebalanced weekly.

From a sector allocation perspective, FDLO’s largest allocation is to the technology sector, with 30.3% of total equities, followed by financial services with 12.3%, healthcare with 12.4%, consumer cyclical with 10.0%, industrials with 9.6%, communication services with 8.8%, consumer defensive with 6.0%, energy with 3.7%, real estate with 2.5%, basic materials with 2.3%, and utilities with 2.2%.

FDLO has a somewhat similar sector allocation compared to the Russell 1000 index. The main differences are in the industrial sector, where FDLO is overweight by 0.8%, and in financial services, with an underweight exposure of 0.9%.

However, the main divergences are found in individual stock holdings. FDLO has almost no exposure to the semiconductor industry and major software players such as Adobe and Salesforce. Instead, it has heavier allocations to names like Microsoft, Apple, Oracle, and IBM. In the financial sector, the fund has no holdings in banks, with its allocation concentrated on Visa, Mastercard, and insurers.

This selective approach can be seen in other sectors as well. In the industrial sector, Lockheed Martin, Union Pacific, and Honeywell are the main holdings, while in the healthcare there are overweight allocations to the biggest players such as Eli Lilly, UnitedHealth, and J&J, but limited exposure to the medical devices industry.

Compared to the peer group of low-volatility ETFs, FDLO is overweight in technology (+18.0%) and communication services (+5.7%), but underweight in utilities (-7.4%), consumer defensive (-5.2%), and industrials (-4.9%). This highlights a cautious stance among low-volatility funds on the technology sector, favoring more stable sectors such as utilities and consumer defensive. This is underscored by the historical elevated volatility in the technology sector, which shows a high beta of 1.24 over the past three years, as measured by the Technology Select Sector SPDR Fund ETF (XLK), contrasting with lower betas of 1.08 in the industrial sector and 1.02 in the financial sector, two cyclical areas of the market as well.

FDLO’s price/earnings ratio of nearly 21.8x is marginally higher than 21.5x for the Russell 1000 index. This might seem counterintuitive given FDLO’s minimal exposure to high-multiple industries like semiconductors and software. However, this is at least partially offset by FDLO’s overweight allocation to large companies like Microsoft, Apple, and Eli Lilly that trade at a premium relative to the broader market, and also due to FDLO’s no exposure to the bank industry, which typically trades below 15x and certainly lowers the Russell 1000 index valuations.

The peer group of low-volatility ETFs exhibits lower valuation multiples though, driven by its overweight allocation to more value sectors, such as utilities and consumer defensive. That is applicable even for its heavier exposure in industrials, as this sector also trades at much lower multiples than the technology sector.

Delivering On A Lower Volatility Portfolio

Although FDLO’s total return has not been on par with benchmarks like the Russell 1000 or the S&P 500 indexes, there is no doubt it has delivered a fairly good performance, outpacing its peers over time. This is consistent with the FDLO’s sector exposure close to the Russell 1000 index, unlike the peer group, which leans toward value sectors that have underperformed the broader market over the past years.

As expected for a low-volatility fund, FDLO’s volatility measures, such as beta and standard deviation, have remained roughly 20% lower than the broader market. This has been generally in line with the peer group of low-volatility ETFs, with FDLO showing a slightly lower standard deviation and essentially the same beta in the 0.80 – 0.85 range.

In summary, FDLO’s overall performance reflects an optimized portfolio with relatively low volatility compared to the broader stock market index. Meanwhile, total returns have not kept up with stock indexes but have outperformed the peer group.

This outperformance is likely due to FDLO’s sector allocation pretty much in line with the Russell 1000 index, with significant exposure to technology and limited allocation to defensive areas of the market that have lagged the market over the past years.

Meanwhile, FDLO has also avoided more volatile names like Tesla and semiconductor companies, a selective approach that can be seen in its lack of exposure to banks as well.

In my assessment, FDLO is a fund worth considering for the long run, as it balances exposure to higher-growth areas while limiting the risk associated with more volatile names and industries. However, investors should keep in mind that even lower-volatility funds like FDLO are not immune to sharp market moves. As we have experienced in recent days, there is seldom a safe place to hide during a market correction, and all sectors and industries can be affected to a certain extent.

This is perhaps the biggest risk for this fund at this moment, as investors seem to be unwinding bullish bets on market leaders, especially in technology, a sector in which FDLO has significant exposure. This reinforces the importance of defining clear investment goals and keeping a portfolio aligned with investors’ risk tolerance.