The Hidden Dangers of Low-Volatility ETFs

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[1]) — 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:

  1. There’s a chance the fund won’t deliver as expected: SPLV is based on the S&P 500 Low Volatility Index, which invests in the 100 stocks within the S&P 500 that have the lowest realized volatility during the prior 12 months. The index is rebalanced quarterly, but the key phrase here is still “the prior 12 months.” While the fund has indeed succeeded in its stated objective of low volatility — its beta is about two-thirds that of the broader market — it’s important to keep in mind that simply because a stock has exhibited a low level of volatility in the past 12 months doesn’t necessarily guarantee that it will do the same in the next 12 months.
  2. Concentration in a handful of sectors: While the SPLV portfolio may be low-volatility, it isn’t necessarily low-risk given than half of the fund is concentrated in two areas: utilities (30.8%) and consumer staples (24.1%). The high weighting in utilities indicates that the fund has an above-average exposure to the possibility of rising interest rates, while the heavy weighting in consumer staples means that nearly a quarter of the portfolio is devoted to a sector that is trading at valuations well above its historical average[2].
  3. The fund is a long-term solution to a short-term problem: The PowerShares Low Volatility Portfolio has succeeded in providing some cushion during market downturns. For example, in the most recent period of market weakness (Oct. 17-Nov. 15), SPLV returned -5.8% and outpaced the -7.2% showing of the broad-based SPDR S&P 500 ETF (NYSE:SPY[3]). On that occasion, the fund did indeed save its investors about 20% of the market’s downside. In the subsequent rally, however, SPLV has trailed SPY, 11.2% to 12.7%. Given that the long-term upward bias of the market, investors need to question whether short-term downside protection is worth the cost of the longer-term upside shortfall.

PowerShares also offers S&P MidCap Low Volatility Portfolio (NYSE:XMLV[4]) and S&P SmallCap Low Volatility Portfolio (NYSE:XSLV[5]), as well as S&P Emerging Markets Low Volatility Portfolio (NYSE:EELV[6]) and S&P International Developed Low Volatility Portfolio (NYSE:IDLV[7]). 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.

Endnotes:
  1. SPLV: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPLV
  2. well above its historical average: http://investorplace.com/2013/02/consumer-staples-no-longer-a-sure-bet/
  3. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  4. XMLV: http://studio-5.financialcontent.com/investplace/quote?Symbol=XMLV
  5. XSLV: http://studio-5.financialcontent.com/investplace/quote?Symbol=XSLV
  6. EELV: http://studio-5.financialcontent.com/investplace/quote?Symbol=EELV
  7. IDLV: http://studio-5.financialcontent.com/investplace/quote?Symbol=IDLV

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