This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.

Between Dec. 31, 2013, and Nov. 19, 2014, large-cap stocks outpaced small caps by 11.26% (the S&P 500 Index returned 12.87% versus 1.61% for the S&P 600 Index).1 Given this recent underperformance, and given that small-cap valuations are stretched compared with large caps, investors seeking exposure in the small-cap sector may want to consider an allocation that exploits the low volatility anomaly.

What is the low volatility anomaly?

The low volatility anomaly postulates that stocks with lower volatility produce higher risk-adjusted returns than stocks with higher volatility, turning the academic theory of “increased return for increased risk” on its head. One way to seek the potential benefits of this anomaly in the small-cap sector is through the PowerShares S&P 600 Small Cap Low Volatility Portfolio (XSLV).

Since its inception on Feb. 15, 2013, XSLV has generated a 0.80 beta to the S&P 600 Index and standard deviation of return of 12.40% compared to 14.78% for the S&P 600 Index, which indicates lower volatility.2 Moreover, between Feb. 15, 2013, and Oct. 31, 2014, it produced a return of 18.83% — just three basis points less than the S&P 600, highlighting its ability to participate in market rallies.2 The combination of return and risk has allowed XSLV to obtain a Sharpe Ratio of 1.39 compared to 1.16 for the S&P 600 Index.2

Why low volatility may make sense in the small-cap space:

Reason No. 1: Small caps have generated an extended period of outperformance:

The graphic below displays the relative price of the S&P 600 Index (small cap) to S&P 500 Index (large cap). Notice that small caps outpaced large caps between early 1999 and late 2013.  The sharp outperformance may not signal the run is done, but it does suggest investors may want to evaluate the risks in the small-cap sector more closely, and the low volatility anomaly may provide an avenue for upside participation while mitigating the risk that small caps go out of favor compared to large caps.

On a side note, XSLV has a 30-day SEC yield of 2.32% compared to dividend yield of 1.35% for the S&P 600 Index.3 The higher yield could help if small caps go through a period of sluggish performance.

Reason No. 2: Small-cap valuations look expensive compared to large-cap valuations:

The graphic also highlights that the PE ratio spread between the S&P 600 and S&P 500 is elevated, suggesting small caps may be relatively more expensive than large caps based on valuation. As of Oct. 31, the S&P 600 Index had a PE ratio of 21.4 compared to 16.8 for the S&P 500 Index. The premium was 11.8% above average seen since January 1995.2