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.”
XSLV Details
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.
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.
“Each quarter, it ranks the stocks in the S&P SmallCap 600 Index by their volatility during the past 12 months and targets the least-volatile 120. It then weights these holdings by the inverse of their volatility, so that the least volatile stocks get the largest weightings in the portfolio. The fund has been successful at reducing volatility and downside risk, but it does take big sector bets from time to time, which may not always pay off,” according to Morningstar.
Morningstar has a Bronze rating on XSLV.
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