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.

Alternatively, investors can also take a look at the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) for stocks that exhibit low volatility. USMV evaluates the volatility of each individual stock and the correlations between stocks. The fund applies a number of constraints to ensure the portfolio is sufficiently diversified.

Investors can also take the low-volatility approach to international equity exposure. For instance, the iShares MSCI Emerging Markets Minimum Volatility ETF (NYSEArca: EEMV) and PowerShares S&P Emerging Markets Low Volatility Portfolio (NYSEArca: EELV) can provide a more conservative alternative to market capitalization-weighted emerging market ETFs. [A Defensive ETF Approach to Emerging Markets]

Furthermore, the PowerShares S&P International Developed Low Volatility Portfolio (NYSEArca: IDLV) and iShares MSCI EAFE Minimum Volatility ETF (NYSEArca: EFAV) provide a low-volatile option for developed markets. [Damping Volatility With International ETFs]

For more information on low-vol strategies, visit our low-volatility category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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