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.
Low-volatility factor investments work on the idea that they help cushion against market turns, limiting drawdowns that investors experience while providing upside potential. Consequently, the low- or min-vol strategies may produce better risk-adjusted returns over the long haul, which has been backed by extensive academic research.
“But low volatility ETFs aren’t sold on their returns. They’re sold on their risk reduction capabilities. These funds should be expected to underperform in bull markets, when their more traditional value investing style falls out of favor. It’s in down markets when low volatility funds earn their keep,” according to ETF Daily News.
Different issuers and index providers arrive at a basket of low volatility stocks in varying fashions. For example, SPLV holds the 100 S&P 500 members with the lowest trailing 12-month volatility. That means, in a surprise to some investors, the fund is sector agnostic. Currently, financial services and industrials, not utilities and consumer staples, are SPLV’s largest sector weights.