Why Low Volatility is Working Now

As has been widely documented, low volatility strategies and exchange traded funds, such as the Invesco S&P 500 Low Volatility ETF (NYSEArca: SPLV), are doing what they are designed amid the recent uptick in equity market volatility.

That objective is to provide investors with less downside capture when stocks tumble. SPLV tracks the aforementioned S&P 500 Low Volatility Index. That index is not constrained at the sector level. Rather, it holds the 100 S&P 500 stocks with the lowest trailing 12-month volatility.

“It’s not uncommon for the S&P 500 Index to experience corrections greater than 5%,” said Invesco in a recent note. “There have been 15 such declines since April 2011, with each year — except last year — experiencing at least one. In all but one of these periods, the S&P 500 Low Volatility index outperformed the S&P 500.”

What Makes SPLV Tick

An important element with low volatility ETFs is just how defensive these funds get at the sector level. SPLV does not have sector constraints, meaning it can feature large weights to traditionally defensive groups. Utilities and real estate are currently SPLV’s top two sector weights combining for about 42% of the fund’s roster.

Market segments will perform differently during various economic cycles, and as the U.S. may be heading toward the late business cycle, exchange traded fund investors should consider which areas could drive returns or increase portfolio risks. While low-volatility exchange traded funds may not outperform in a strong bull rally over the short-term, the strategy’s ability to hedge downside risk may be worth it over the long run.

Historical data confirm that SPLV’s underlying index performs less poorly during big declines for the broader market.

“On average, the S&P 500 Index lost an average of 9.01% during these 15 downturns, while the S&P 500 Low Volatility Index lost only 4.71%,” according to Invesco. “This is important because a lower ‘down capture’ means that the index has fewer stairs to climb in order to recapture its prior peak. Return math helps illustrate this point: If the market declines by 50%, it takes a 100% return to return the point where the sell-off began. Losing less can provide the foundation for generating competitive returns across the market cycle and smoothing out an investment experience.”

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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.