While the low-volatility exchange traded funds may underperform in isolated periods, the strategy can provide a more conservative long-term play with a more attractive risk-adjusted return profile.
Based on the recent 30-day volatility readings, volatility in the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV), which tracks the 100 least volatile stocks on the S&P 500, has been higher each day since February 27, peaking on March 18, reports David Wilson for Bloomberg.
“There’s no guarantee that the name of an ETF, the label, means it’s going to perform the way it’s advertised,” Michael Rawson, an ETF analyst at Morningstar Inc., told Bloomberg. “Investors need to know there’s no magic formula.”
Consequently, investors should dive deeper into the ETFs to get a better handle of what they are investing into. For instance, SPLV does not include energy stocks, which have been rebounding lately.
Additionally, SPLV includes large positions in financials, utilities and consumer staples, which make up 68% of the fund’s portfolio, whereas the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) only includes a 38% tilt toward the three sectors. [Surprises in Low Volatility ETFs]
Due to the ETF’s sector weights, performance and volatility may vary over the short-term, especially with utilities currently underperforming the overall market. Nevertheless, the low-volatility strategy has provided investors exposure to smaller swings and better risk-adjusted returns over the longer term.
Specifically, SPLV shows a 3-year trailing standard deviation of 8.79 and a Sharpe Ratio of 1.67, while the S&P 500 has a 9.59 standard deviation and 1.61 Sharpe Ratio, according to Morningstar data. Additionally, USMV shows a 8.24 standard deviation and a 1.83 Sharpe Ratio. Standard deviation is a measure of dispersion from its mean, so a greater deviation reflects greater volatility. Additionally, the Sharpe Ratio is a measure of calculating the risk-adjusted return and a greater value typically reflects a more attractive risk-adjusted return.
However, due to their conservative tilt, the strategies would underperform in periods of bullish market rallies. Additionally, looking ahead, the low-volatility strategy could underperform in a rising rate environment.
“Their absolute returns may be less attractive going forward,” according to Morningstar analyst Michael Rawson. “Stocks with low volatility tend to be less sensitive than average to the business cycle and experience slower cash flow growth as the economy expands. Expansionary economic environments often lead to an increase in interest rates. Because stocks in this fund may be growing more slowly, they may have less earnings growth to offset the negative impact of rising interest rates than the broad market.”
For more information on the low-vol strategy, 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.