Exchange traded funds have boosted the accessibility of the low volatility factor. Fortunately, that phenomenon is not reserved for large-cap stocks. Some small-cap funds focus on volatility-reduction techniques as well, including the popular PowerShares S&P SmallCap Low Volatility Portfolio (NYSEArca: XSLV).
XSLV takes the securities that exhibit the lowest volatility from the benchmark S&P SmallCap 600 Index. To be precise, XSLV is home to the 120 stocks from the S&P SmallCap 600 that have the lowest trailing 12-month volatility.
Looking ahead, the U.S. economy is still slowly expanding and the Federal Reserve is embarking on a tighter monetary policy outlook. Small-caps, though, can still navigate through a slowly rising rate environment. Smaller companies, which focus on U.S. markets, are less exposed to a stronger U.S. dollar as rates rise, which would more negatively affect larger corporations with a global footprint. Additionally, periods of rising rates also coincide with expanding economies, which often benefit smaller companies.
“So far, the fund’s approach has worked well. From its inception in February 2013 through January 2017, the fund exhibited about 13% less volatility and about 20% less market sensitivity than its parent index,” said Morningstar. “It also beat the benchmark by 124 basis points annualized during that time, largely because of more-favorable stock exposure in the financial-services industry.”
At the sector level, XSLV is not excessively weighted to utilities and consumer staples stocks, two sectors often believed to be the cornerstones of low volatility ETFs. Actually, those groups are two of the ETF’s smallest sector allocations. Rather, financial services, industrial and real estate stocks combine for nearly two-thirds of XSLV’s weight. That said, the fund’s methodology is sector agnostic.
“As an added benefit, low-volatility investment strategies effectively filter out the riskiest and least profitable stocks in the market, which have historically offered terrible returns,” said Morningstar. “Outside of this speculative segment of the market, the relationship between volatility and returns has been weak. Although it isn’t a strong predictor of returns for most stocks, past volatility is a good predictor of future volatility and downside performance, at least in the short term. This risk reduction is the principal source of low-volatility stocks’ attractive risk-adjusted performance.”
XSLV is up 13% over the past 12 months.
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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.