While low-volatility exchange traded funds may not outperform in a strong bull rally over the short-term, the strategy’s ability to hedge downside risk may be worth it over the long run.
“If you have a client who when the market is up 30% one year and you’re only up 20% and that client’s going to be mad at you and fire you, don’t do this because that’s what low vol is designed to do,” S&P Dow Jones Indices’ Craig Lazzara said in a Morningstar article. “The reason it produces excess returns over time–or one of the reasons–is it truncates the downside. The price for truncating the downside is truncating the upside.”
For instance, over the past year as the equity markets rallied to new heights, the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) has increased 12.9%, whereas the S&P 500 gained 19.0%.
However, the low-volatility option has outperformed the broader market earlier this year as stocks sold off. Over the first seven months, SPLV was up 8.8% while the S&P 500 was up 7.7%.
The reason SPLV acts this way is all in its underlying holdings. The fund is part of the growing group of factor-based or strategic-beta index-based ETF offerings on the market. Specifically, the low-volatility ETF targets 100 of the least volatile stocks from the S&P 500 index and weights the positions inverse to volatility – the least volatile stocks has a greater weight in in the portfolio. [Focused Use of Low Volatility ETFs]
The low-vol ETF includes a significantly greater position in defensive sector stocks from consumer staples 14.6% and utilities 19.4%. In comparison, the S&P 500 allocates 9.5% to consumer staples and 3.0% to utilities. Additionally, SPLV includes a small 2.9% weight toward the sensitive tech sector, compared to the S&P 500’s 18.0% position in technology firms.