Among smart beta exchange traded funds dedicated to individual investment factors, low volatility products have been popular with conservative investors based on the premise that emphasizing a low volatility strategy can help reduce a portfolio’s downside potential.
The trade-off with ETFs such as the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) is that these funds are designed more to be less bad in bear markets than they are to capture to all of the upside during a bull market.
Low-volatility factor investments work on the idea that they help cushion against market turns, limiting drawdowns that investors experience while providing upside potential. Consequently, the low- or min-vol strategies may produce better risk-adjusted returns over the long haul, which has been backed by extensive academic research.
“But low volatility ETFs aren’t sold on their returns. They’re sold on their risk reduction capabilities. These funds should be expected to underperform in bull markets, when their more traditional value investing style falls out of favor. It’s in down markets when low volatility funds earn their keep,” according to ETF Daily News.
Different issuers and index providers arrive at a basket of low volatility stocks in varying fashions. For example, SPLV holds the 100 S&P 500 members with the lowest trailing 12-month volatility. That means, in a surprise to some investors, the fund is sector agnostic. Currently, financial services and industrials, not utilities and consumer staples, are SPLV’s largest sector weights.
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.
“It’s been about one year since the 2016 election, when equities really started rallying. During that time, the Low Volatility ETF has returned a total of 18% compared to a 23% return for the S&P 500. Again, that’s not surprising given that the growth style has significantly outperformed value. What is surprising is the risk profile of both the fund and the S&P 500 over that time,” reports ETF Daily News.
With investors favoring the growth and momentum factors and related cyclical sectors this year, SPLV has seen year-to-date outflows of $28.5 million.
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