Looking to Smart Beta ETFs as Rates Rise

With interest rates rising, investors may want to consider strategies designed to survive and thrive as the Federal Reserve tightens. Some smart beta ETFs are designed to do just that, including the PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (NYSEArca: XRLV).

XRLV gives investors the ability to combine the low volatility and hedging rising rates themes. The underling index is composed of the 100 constituents of S&P 500 Index that exhibit both low volatility and low interest-rate risk. XRLV’s underlying index is the S&P 500 Low Volatility Rate Response Index. Historically, that index has outperformed traditional low volatility benchmarks, including the S&P 500 Low Volatility Index, as interest rates climb.

“For all periods, the two strategies had similar hit rates of about 50%, with the rate response index having a slightly higher hit rate (51% to 49%),” according to S&P Dow Jones Indices. “While these two indices underperformed the S&P 500 half of the time, the returns show that the rate response and low volatility indices outperformed the S&P 500 on a cumulative basis over the long-term investment horizon. What could be the cause of this? We investigated by looking at the monthly returns broken down between up markets and down markets.”

XRLV’s Secret Sauce

The low-vol strategy targets stocks that have lower expected risk or less idiosyncratic risks. Specifically, the strategy focuses on equities that exhibit lower beta, a measure of volatility or systematic risk of a security to that of the overall market. Consequently, minimum volatility portfolios are comprised of stocks that exhibit lower market risk or beta. However, XRLV eschews some of the sectors that make conventional low volatility strategies vulnerable to rising rates.

Among XRLV’s 100 holdings, there are no utilities stocks and the rate-sensitive consumer staples and real estate sectors combine for just 12% of the ETF’s weight. XRLV also offers some downside protection on par with that of the S&P 500 Low Volatility Index.

“The rate response strategy performed similarly to the low volatility index—outperforming the S&P 500 in all three periods (down markets), according to S&P Dow Jones. “The largest performance difference came during the tech bust in the early 2000s. While the S&P 500 dropped by over 47%, the rate response and low volatility indices had positive absolute returns. The cumulative outperformance impact relative to the S&P 500 can been understood by calculating the peak-to-recovery period return.”

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