Low-volatility exchange traded funds have gained popularity as a way to curb swings in an investment portfolio. However, investors should still understand how they work and the best way to implement the strategies.
Like our own Todd Shriber has said before: slapping a label on something isn’t really delivering on the promise. In essence, people shouldn’t invest in a security just because it sounds nice. Instead, you should look under the hood.
So far, low-volatility ETFs, like the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) and the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV), the two largest low volatility ETFs, have muted downside, along with upside, swings. The ETFs have even outperformed the S&P 500 year-to-date after the large sell-off earlier in the year. [Low-Volatility ETFs: Slow and Steady Winning the Race]
The low-volatility approach may be attributed to the ETFs’ overweight conservative sector plays, like health care, consumer staples and utilities – utility stocks make up 23.4% of SPLV and health care is 18.3% of USMV’s portfolio. [Get Defensive with Low Volatility ETFs]
Investors have warmed up to low-vol ETFs as a way to generate better risk-adjusted returns. Dan Draper, managing director of PowerShares, points out that academic research has found a type of “low-volatility anomaly” where the strategy has produced diminished risk and generated health returns over long periods, reports Elizabeth MacBride for CNBC.
Nevertheless, there are some considerations. For instance, Ed Gjertsen II, vice president of Mack Investment Securities, reminds investors that low-volatility stock funds are still based on riskier equity securities. Stocks, even those that exhibit low-volatility traits, are no substitute for conservative plays like fixed-income assets.
Looking at the ETFs, investors have to be aware of the subtle differences between varying products. USMV factors in how stocks interact with one another, weights each sector within 5 percentage points of the parent index and leans toward stocks that generate relatively stable earnings and are less sensitive to the business cycle than the broader market. SPVL, on the other hand, picks out the 100 least volatile stocks from the S&P 500.
While low-volatility stocks can help cushion a position in a prolonged market downturn, the strategy can miss out on short-term moves. For instance, SPLV has only gained 1.5% over the past month, whereas the S&P 500 has increased 3.7% – this is party due to the recent underperformance in the utilities sector, which has dipped 0.3% over the past month.
Furthermore, the conservative tilt hinders low-volatility ETF gains in a cyclical, bullish rally. In 2013, the S&P 500 returned over 32.4% while SPLV rose 23.3% and USMV gained 25%.
“Because the fund’s holdings have relatively stable earnings and are less sensitive to the business cycle than the average stock in the S&P 500 Index, they should hold up better than their peers during market downturns,” according to Morningstar analyst Michael Rawson. “However, they will also likely underperform during bull markets.”
For more information on low-volatility strategies, visit our low-volatility category.