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The words “risk” and “return” are often used glibly in investment stories. Too many investors focus on the latter and how much money they can make. They do not consider risk in a disciplined way – or account for it in portfolio construction – until it’s too late. 
When they do focus on risk, it is often through simplistic comparisons around company size and quality. A “large-cap” stock is supposedly less risky than a small-cap. Yet many of the worst-performing Australian stocks this decade have been so-called “blue chips”.
Even fewer investors consider risk-adjusted returns: what sort of return an investment can generate for the risk involved in producing that return. Risk in equity markets is typically measured by a security’s standard deviation – a measure of volatility – over several periods. 
Simply, long-term investors should look for securities that can produce consistent returns with volatility. That is, quality stocks that do not behave like rollercoasters during volatile markets and scare the life out of shareholders who hang on grimly.
I have thought about ways to reduce portfolio volatility in recent weeks. As this column’s readers know, I have been bullish on the global equities market for the past few years. I still think markets will trend higher this year, but am concerned about the outlook beyond 12 months.
The US equities bull market is maturing. It’s troubling that the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google, via parent company Alphabet) are responsible for so much of the US bull run. Investment guru Marc Faber noted recently that the FAANG stocks represent almost 11 per cent of global stockmarket value. 
It’s terrifying to think that trillions of dollars of sharemarket value rests in the hands of five companies. I cannot recall a time when concentration risk in global equities was as high. When fewer and fewer stocks drive a bull market, and that trade becomes unbearably crowded, it is usually time to exit. Concentration risk can be a sign of an impending bear market. 
To be clear, I’m not suggesting Australian investors slash their sharemarket exposure or dump their global equities allocation. But the case to reduce equities exposure in portfolios, and increase cash holdings, is strengthening. 
Nor do I suggest investors start positioning in short instruments, such as inverse exchange-traded funds that rise in price when their underlying benchmark index falls. Leave that to active investors and traders who latch on to short instruments when markets tumble.
Rather, portfolio investors should consider ways to reduce volatility in their equities portfolio, in addition to increasing the cash weighting. The goal: to preserve more capital if global equity markets slump next year and to have cash available to pounce on fallen stocks.
As I have written before, there are two key rules in investing. One, preserve capital. Two, don’t forget rule one. Keeping capital intact during bear markets separates great investors from the rest. Knowing when to move to cash and reduce portfolio volatility is an art. 
Index exposure and volatility 
ETFs that focus on minimising volatility are a useful tool to achieve better risk-adjusted returns. Most ETFs mirror an underlying benchmark index that is constructed by market weight. Minimum volatility ETFs use custom-made indices designed to include securities that exhibit lower volatility. 
Essentially, minimum volatility ETFs aim to lose less than the market during downturns, allowing investors to remain invested during different market cycles. Such ETFs can return less during market uptrends. 
The Vanguard Global Minimum Volatility Active ETF is an interesting newcomer. The fund invests in offshore and local shares, and aims to provide lower volatility than the global market.
The fund considers the risk and diversification characteristics of securities in the benchmark and hedges most of the currency exposure from its offshore securities holdings – eliminating much of the currency risk for Australian investors. 
About half of the fund is allocated to US shares and a quarter of it is invested in the financial services sector. The fund has a low annual fee of 28 basis points, but a limited performance record given it was launched in April 2018.
The iShares Edge MSCI World Minimum Volatility ETF has almost two years of performance history. The ETF holds several large global utility and consumer staples stocks that tend to be more defensive during market downturns. 
iShares’ backtesting shows the ETF’s benchmark has produced similar returns to the MSCI World Index with significantly less risk. If that trend continues, the ETF will offer the type of risk-adjusted return that investors should favour at this stage of the equities cycle.
The iShares ETF returned almost 12 per cent over a year. The annual fee is 30 basis points.
Chart 1: iShares Edge MSCI World Minimum Volatility ETFSource: The Bull

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• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article you should consider the appropriateness and accuracy of the information, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at July 19, 2018.