Investment factors, such as growth, low volatility and value, are widely applied in the large-cap universe and with the corresponding exchange traded funds. However, factor-based approaches also merit consideration among small-cap funds.
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.
“The inverse relationship between stocks’ size and the efficacy of the low-volatility effect likely stems from greater mispricing among smaller stocks,” said Morningstar. “For instance, there may be greater lottery-seeking behavior among small-cap stocks, where investors overpay for volatile stocks that offer a small chance for a big payoff, because these stocks tend to offer greater upside potential than their larger counterparts. But that’s not the whole story.”
While some small-cap ETFs limit the impact of the size factor by featuring mid-caps, thereby raising the average market value of the fund’s holdings, the average market capitalization of XSLV’s nearly 120 holdings is $1.76 billion. The ETF allocates just over 8% of its weight to stocks classified as mid-caps.