by Daniel Putnam | February 26, 2013 6:15 am
How would you like to own an investment that can participate in the stock market’s upside, while at the same time limiting the downside risk?
That’s the key selling point for low-volatility ETFs, which have become a rapidly growing area within the universe of exchange-traded funds. The largest — PowerShares S&P 500 Low Volatility Portfolio (NYSE:SPLV) — has grown to $3.4 billion in assets and daily trading volume of more than 1 million shares, and this month brought the introduction of four new low-volatility funds targeting various segments of the U.S. stock market.
It’s undoubtedly a hot area — but it’s also one that investors need to take a closer look at before diving in.
SPLV helps illustrate the potential surprises that can lurk under the hood of low-volatility funds. Three aspects of this fund should give investors reason for pause:
PowerShares also offers S&P MidCap Low Volatility Portfolio (NYSE:XMLV) and S&P SmallCap Low Volatility Portfolio (NYSE:XSLV), as well as S&P Emerging Markets Low Volatility Portfolio (NYSE:EELV) and S&P International Developed Low Volatility Portfolio (NYSE:IDLV). While the asset classes are different, the funds use the same methodology as SPLV, meaning they have similar issues. XMLV and XSLV are extremely concentrated, with 51% and 50% in financials, respectively. IDLV has 26% in financials and 21% in consumer staples, while EELV has 28% of its portfolio invested in financial stocks.
This should lead investors to question what happens to these funds if the source of the next market downturn is an issue that hits financial stocks disproportionately hard. In that scenario, can the funds truly be counted on to deliver on their objective of below-market volatility? There’s a good chance they won’t, but investors have no way to tell as yet since the funds have little to no track record.
SPLV has put up some good numbers since its 2011 inception, and it has been one of the most successful ETF launches of the past two years. The fund — and its four counterparts — are certainly worth keeping an eye on.
For now, however, investors might be better served by letting these funds develop a track record before taking the risk of large sector bets and the potential for longer-term underperformance.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
Source URL: http://investorplace.com/2013/02/the-hidden-dangers-of-low-volatility-etfs/
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