What is Driving the Performance of Low-Volatility ETFs?

September 18th at 12:41pm by Jason Stoneberg - Invesco PowerShares

Low-volatility ETFs debuted in 2011 with the launch of the PowerShares S&P 500® Low Volatility ETF (SPLV). Many other ETFs have launched with variations on the low volatility strategy but SPLV has attracted the vast majority of assets with over $2.3 billion in AUM.1 In this article, we focus on the performance of low-volatility ETFs and dissect their returns to understand how these products work.

The PowerShares suite of low-volatility ETFs seek to deliver exposure to a certain market segment as measured by volatility, which is the annualized standard deviation of index returns, rather than traditional cap-weighted benchmarks. Standard deviation measures a fund’s range of total returns and identifies the spread of a fund’s short-term fluctuations. The methodology is relatively simple. In the case of US equities, SPLV takes the 100 companies from the S&P 500® Index that have exhibited the lowest volatility within their returns over the last 12 months. The PowerShares S&P International Developed Low Volatility Portfolio (IDLV) and the PowerShares S&P Emerging Markets Low Volatility Portfolio (EELV) take the 200 least volatile companies from their respective S&P international equity indexes.2 The weight of the constituents is determined by using the inverse of volatility which ensures that the least volatile companies receive the highest weight.

Each of the three low-volatility funds has been successful in delivering returns with lower volatility than their cap-weighted counterparts. Since its inception on May 5, 2011, SPLV has exhibited 69% of the volatility seen in the S&P 500 Index; EELV has exhibited 71% of the volatility seen in the MSCI Emerging Markets Index, since its inception on January 13, 2012; and IDLV has exhibited only 55% of the volatility seen in the MSCI EAFE Index, since its inception on January 13, 2012.3

In addition to providing lower volatility, each fund has outperformed its cap-weighted benchmark in terms of absolute returns as well. Since its inception, SPLV has delivered an excess return of 11.7% relative to the S&P 500 Index. Since their inception, IDLV and EELV have outperformed the MSCI EAFE Index, an unmanaged index considered representative of value stocks of Europe, Australia and the Far East, and the MSCI Emerging markets index, an unmanaged index considered representative of European growth stocks, by 6.6% and 7.1%, respectively.4

Below, we provide attribution analysis on SPLV, IDLV and EELV versus their respective S&P or MSCI cap weighted benchmark to determine the main drivers of their excess return.

Source: FactSet, as of July 31, 2012
Performance data quoted represents past performance. As stated in the Fund’s prospectus, the expense ratio of 0.25% is expressed as a unitary fee to cover expenses incurred in connection with managing the portfolio. Past performance is not a guarantee of future results; current performance may be higher or lower than performance quoted. Investment returns and principal value will fluctuate and Shares, when redeemed, may be worth more or less than their original cost. See invescopowershares.com to find the most recent month-end performance numbers. After Tax Held represents total return after taxes on distributions and assumes Shares have not been sold. After Tax Sold represents total return after taxes on distributions and the sale of Fund Shares. After-tax returns reflect the highest federal income tax rate but exclude state and local taxes. Market returns are based on the midpoint of the bid/ask spread at 4 p.m. ET and do not represent the returns an investor would receive if shares were traded at other times.

SPLV’s excess return relative to the S&P 500 Index was caused by two main factors: an overweight of defensive sectors and the avoidance of the worst performing companies. Since inception, nearly half of SPLV’s 11.7% excess return was caused by the sector allocation of the fund. Specifically, the fund benefited from an overweight position to utilities (avg. weight 29.2% versus a 3.4% weight) and consumer staples (avg. weight 27.4% versus an 11.1% weight) which were the second and third best performing sectors after telecom.

An investor cannot invest in an index. Performance data quoted represents past performance. Past performance is not a guarantee of future results; current performance may be higher or lower than performance quoted. Investment returns and principal value will fluctuate and Shares, when redeemed, may be worth more or less than their original cost. See invescopowershares.com to find the most recent month-end performance numbers. A load or fee will reduce performance shown.

While sector allocation was an important driver behind SPLV’s performance, we think stock selection was a more important factor. Stock selection was responsible for just over half of SPLV’s excess return. Further, we feel that SPLV benefited significantly by which stocks it avoided. Four of the top five stocks that benefited SPLV’s relative performance were hard hit banking and technology stocks that the fund avoided. SPLV did not hold Bank of America, Citigroup, Hewlett-Packard or JPMorgan which were down between 17 to 55%. While these four companies were significant contributors to relative performance, the fund benefited from stock selection across the entire portfolio. In fact, SPLV had better performance than the S&P 500® Index within each sector except for technology and telecom.5

EELV has outperformed the MSCI Emerging Market Index by 7.1% since its inception while exhibiting about 70% of the volatility. We believe this excess return relative to the MSCI Emerging Market Index was caused primarily by security selection followed by country allocation and then sector allocation. When conducting the analysis based on sector allocation, roughly two-thirds of the outperformance was a result of security selection. The remaining portion of excess return was derived from the sector allocation. When the analysis is conducted based on country allocation, the mix is split roughly 50-50 between security selection and country allocation.6

We feel that in both cases, security selection and weighting is a large factor behind the fund’s performance. However, no single stock was a major driver of the fund’s outperformance.  We think the bigger impact came from stock selection across the board with EELV providing better returns in every sector except telecom. While stock selection was the biggest driver of performance, the fund also benefited from an underweight position to energy (avg. weight 3.7% versus 13.7%) which was the worst performing sector.7

Source: FactSet, as of July 31, 2012
An investor cannot invest in an index. Performance data quoted represents past performance. Past performance is not a guarantee of future results; current performance may be higher or lower than performance quoted. Investment returns and principal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. See invescopowershares.com to find the most recent month-end performance numbers. A load or fee will reduce performance shown.

From a country perspective, the stock selection was mixed. EELV outperformed the benchmark in half of the countries; however, the outperformance came in the most heavily weighted countries. EELV had superior stock selection in the top five weighted countries (Malaysia, South Africa, Taiwan, Brazil and China ) which constitute roughly 75% of the fund’s weight. The most significant country allocation contributions came from an underweight position to Brazil (avg. weight 8.7% versus 14.3%) and an overweight position to South Africa (avg. weight 20.6% versus 7.8%).8

Performance data quoted represents past performance. As stated in the Fund’s prospectus, the expense ratio of 0.25% is expressed as a unitary fee to cover expenses incurred in connection with managing the portfolio. Past performance is not a guarantee of future results; current performance may be higher or lower than performance quoted. Investment returns and principal value will fluctuate and Shares, when redeemed, may be worth more or less than their original cost. See invescopowershares.com to find the most recent month-end performance numbers. After Tax Held represents total return after taxes on distributions and assumes Shares have not been sold. After Tax Sold represents total return after taxes on distributions and the sale of Fund Shares. After-tax returns reflect the highest federal income tax rate but exclude state and local taxes. Market returns are based on the midpoint of the bid/ask spread at 4 p.m. ET and do not represent the returns an investor would receive if shares were traded at other times.

Source: FactSet, as of July 31, 2012

IDLV has outperformed the MSCI EAFE Index by 6.6% since its inception while exhibiting only 55% of the volatility. Similar to EELV, we think IDLV’s performance was driven primarily by security selection followed by country allocation and then sector allocation. While we believe stock selection was the most important factor to the fund’s performance, no single stock position contributed significantly to the overall outperformance. The impact came from a large number of positions that collectively benefited the fund and resulted in the significant outperformance.

IDLV’s stock selection was consistent across sectors and countries. The fund outperformed the MSCI EAFE index in every sector except consumer staples. The fund also outperformed across 20 of 26 countries with the underperforming countries only making up 18% of the fund’s overall weight.

Source: FactSet, as of July 31, 2012
An investor cannot invest in an index. Performance data quoted represents past performance. Past performance is not a guarantee of future results; current performance may be higher or lower than performance quoted. Investment returns and principal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. See invescopowershares.com to find the most recent month-end performance numbers. A load or fee will reduce performance shown.

Inception Date: Jan 13, 2012

Performance data quoted represents past performance. As stated in the Fund’s prospectus, the expense ratio of 0.25% is expressed as a unitary fee to cover expenses incurred in connection with managing the portfolio. Past performance is not a guarantee of future results; current performance may be higher or lower than performance quoted. Investment returns and principal value will fluctuate and Shares, when redeemed, may be worth more or less than their original cost. See invescopowershares. com to find the most recent month-end performance numbers. After Tax Held represents total return after taxes on distributions and assumes Shares have not been sold. After Tax Sold represents total return after taxes on distributions and the sale of Fund Shares. After-tax returns reflect the highest federal income tax rate but exclude state and local taxes. Market returns are based on the midpoint of the bid/ask spread at 4 p.m. ET and do not represent the returns an investor would receive if shares were traded at other times.

The fund’s heaviest overweight was in Canada (average weight 20.7%) which is held by the fund but not the MSCI EAFE Index. We feel this position contributed positively to the fund’s performance. Furthermore, we believe overweight positions in New Zealand and Singapore also contributed to the fund’s outperformance and that an underweight position to materials was the single largest contributor from a sector allocation perspective.

Across each of the low volatility funds, we found the main driver to outperformance and lower volatility was security selection. The stock selection wasn’t concentrated into single positions but rather was found across the entire portfolio. We feel that stock selection across numerous sectors and countries in most cases impacted performance as much as, if not more than the allocations across sectors and countries.

1,3,4 Source: S&P/LCD, as of May 31, 2012
2 The beginning universe of EELV’s underlying index is the S&P Emerging BMI Plus LargeMid Cap Index and the beginning universe of IDLV underlying index is the S&P Developed ex. US and South Korea LargeMid Cap BMI Index.
5 Source: FactSet, as of July 31, 2012
6,7,8 Source: FactSet, as of July 31, 2012

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Unforeseen market conditions may prevent the funds from achieving their goal of providing low volatility.

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