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).1Given 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
This may provide another argument for an investment solution that has the potential to lower risk.
Reason No. 3: There is a small-cap story:
The dollar has been strong recently, rallying over 11.0% from its May 2014 low, while overseas economic growth has been sluggish.4 The strong dollar and weak international growth suggest multinational companies face headwinds to their profit outlook. Small caps typically have less international exposure than large caps. As proof of relatively weak international growth, the flash eurozone Purchasing Managers Index (PMI) hit a 16-month low of 51.4 in October, while the Chinese flash manufacturing PMI eased 0.4 to just 50.0 in October.4 These numbers come on the back of the Japan’s third-quarter 2014 gross domestic product contracting 1.6%. In contrast, the US October flash PMI was a more vibrant 54.7.4
Reason No. 4: In its current composition, low volatility may be a play on tighter monetary policy:
Although the timing of a Federal Reserve rate hike is debatable, the US labor market is tightening and higher rates could improve the net interest margin and profitability for some financial stocks. Digging into the jobs opening and labor turnover survey from the US Bureau of Labor Statistics, the ratio of job openings to hiring is at survey highs and points to upward pressure on wage growth. A continuation of the trend could put pressure on the Fed to snug rates, which would benefit the financial sector.
Although weightings can change after quarterly reconstitutions, XSLV currently has over 50% exposure to the financial sector and has had material exposure to the financial sector since its inception Feb. 15, 2013.4
Investors interested in learning more about low volatility products can talk with their advisors and visit this page on our website.
1 Bloomberg LP as of Nov. 19, 2014
2 Bloomberg LP as of Oct. 31, 2014
3 Invesco PowerShares and Bloomberg LP as of Nov. 20, 2014
4 Bloomberg LP as of Nov. 20, 2014
Important Information
Volatility measures the amount of fluctuation in the price of a security or portfolio.
Risk-adjusted return measures the amount of return an investment provided relative to how much risk it took on.
Standard deviation is a measure of an asset’s volatility, signifying how much its return varies from the average or expected return. A higher standard deviation indicates a more volatile, and therefore riskier, security.
A basis point is a unit that is equal to one one-hundredth of a percent.