Among smart beta exchange traded funds dedicated to individual investment factors, low volatility products have been popular with conservative investors based on the premise that emphasizing a low volatility strategy can help reduce a portfolio’s downside potential.
The trade-off with ETFs such as the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) is that these funds are designed more to be less bad in bear markets than they are to capture to all of the upside during a bull market.
The $7.98 billion SPLV, one of the largest low volatility ETFs on the market, holds the 100 S&P 500 stocks with the lowest trailing 12-month volatility.
“This fund basically just starts out with the stocks in the S&P 500. It ranks them on their volatility over the last year, and then it targets the 100 that have exhibited the lowest volatility and weights them by inverse of their volatility, so that the least volatile stocks get the biggest weightings in the portfolio,” said Morningstar in a recent note.
Sector Bets
An important element with low volatility ETFs is just how defensive these funds get at the sector level. SPLV does not have sector constraints, meaning it can feature large weights to traditionally defensive groups.
“It does this without any limits on how big the sector weightings can be or how much turnover there can be in the portfolio,” according to Morningstar. “That can lead to some pretty concentrated bets on things like utilities and healthcare stocks, for example. Overall, this offers very potent exposure to stocks with low volatility, which have historically offered better downside protection than the market and have tended to offer better risk adjusted performance than the market over long periods of time.”