Don't Write Off Low-Volatility ETFs

The low-volatility investment style has grown out of favor as more traders turned to high-octane growth stocks in the ongoing bull market rally. Nevertheless, exchange traded funds investors should not completely write off the low-volatility factor as it has proven to produce long-term outperformance.

Low beta investments, or securities that exhibit low volatility traits, have been shown to deliver higher returns with less volatility compared to the broader market over eight and ten year periods.

“The Russell 1000 Low Beta Equal Weight Index has had a higher return than the market capitalization-weighted Russell 1000 Index since the beginning of the current US bull market in early 2009 with lower relative volatility,” according to FTSE Russell. “The same comparison holds true for the ten year period ended February 28, 2017.”

Specifically, the Russell 1000 Low Beta Equal Weight Index has returned an average 19.0% in the past eight years, whereas the Russell 1000 Index showed an 18.2% return. Additionally, over the past 10 years, the low beta index returned 8.8%, compared to the benchmark Russell 1000’s 7.7% return.

The alternative, smart-beta indexing methodology helped screen for an academically proven factor that has outperformed over the long haul.

“Smart beta indexes are effective tools in that they allow us to screen a universe of stocks for certain characteristics which index users believe may benefit them over time. In the case of the Russell 1000 Low Beta Equal Weight Index, the methodology screens out unprofitable companies and includes higher quality US large cap stocks which are skewed more toward mid-cap and exhibit low volatility relative to the broad universe of US large-cap stocks,” Tom Goodwin, senior index research director, FTSE Russell, said in a note.

While something like the iShares Russell 1000 ETF (NYSEArca: IWB), which tracks the benchmark Russell 1000, has been a stable in many investment portfolios, investors may consider a low-volatility alternative to produce improved long-term risk-adjusted returns.

For example, the PowerShares Russell 1000 Low Beta Equal Weight Portfolio (NYSEArca: USLB) tries to reflect the performance of the Russell 1000 Low Beta Equal Weight Index, which tracks Russell 1000 components that exhibit low beta characteristics or smaller swings and equally weights its components.

“Using indexes as the basis for investable products may be useful for investors constructing the core of their portfolio to fit a unique risk profile and overall investment objective. For example, we’ve worked closely with FTSE Russell to package an equal-weighted index into ETF technology for investors to gain broad exposure to profitable companies that have also shown to be less volatile than the broader market,” John Feyerer, vice president, director of equity ETF product strategy, PowerShares, said in an FTSE Russell note.

Due to its underlying indexing methodology, USLB may focus more on smaller, mid-sized U.S. companies. The low beta ETF’s market-cap weights include 12.4% small-cap, 55.7% mid-caps, 24.1% large-caps and 7.7% mega-caps. In contrast, IWB holds 45.5% mega-caps, 33.0% large-caps and 19.6% mid-caps.

The smaller market-cap tilt may also help the low beta index and corresponding USLB outperform traditional market-cap weighted indices in the environment ahead as the Donald Trump administration focuses on the America first mantra and supports domestic growth.

“With corporate tax reform and new trade policies likely to put pressure on large US multinationals and benefit smaller, more domestically-oriented US companies, many market participants are considering diversifying their core US equity position away from cap-weighted exposure, the performance of which relies disproportionately on just a few companies,” Todd Millay, managing director, Choate Investment Advisors, said.

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