Schaeffer's Trading Floor Blog

How Low Volatility Can Turn a Profit

Low volatility funds are outperforming the market

by 2/15/2013 7:54 AM
Stocks quoted in this article:

Is low volatility the new high volatility? Sounds like yes, based on these new offerings from PowerShares:

Invesco PowerShares, looking to leverage on the success it's had with its PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA: SPLV), on Friday is launching another two funds that serve up low-volatility exposure to different market-capitalization pockets of the market.

The PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA: XMLV) will track the S&P MidCap 400 Low Volatility Index, a benchmark that consists of the 80 least-volatile securities found in the broader S&P MidCap 400 Index.

In similar fashion, the PowerShares S&P SmallCap Low Volatility Portfolio (NYSEARCA: XSLV) hones in on 120 of the S&P SmallCap 600 Index's least-volatile stocks. Both XMLV and XSLV will each have a 0.25 percent expense ratio, meaning investors will be charged $25 for each $10,000 invested.

The two funds would bring to five the number of PowerShares low-volatility ETFs. It all began in May 2011 with SPLV, a fund that was not only the first low-volatility play on the S&P 500 to come to market, but one that has gathered a loyal following and now boasts $3.36 billion in assets gathered in less than two years.

"Investors continue to embrace low-volatility ETF strategies as a simple and effective way to maintain equity exposure while mitigating overall portfolio risk," Ben Fulton, PowerShares managing director of global ETFs, said in a press release.

SPLV is in interesting product. It invests in the 100 least-volatile stocks in the S&P 500 Index (SPX). It reallocates and rebalances quarterly based on changes in individual stock volatility readings. The lower the realized volatility, the greater the weight. And since inception, it has done very well. As of this article, its up 23.5%, versus 16.6% for the SPDR S&P 500 ETF Trust (NYSEARCA:SPY).

So it makes perfect sense to add similar products. The question is, though, does it make sense to buy any of them, at least as an alternative to buying the or the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM) or the SPDR S&P MidCap 400 ETF (NYSEARCA:MDY) or a plain vanilla index fund?

I suspect there's an element of fortuitous timing involved here. A low-volatility portfolio works relatively well in a low-volatility world. You simply don't figure to miss that exploding stock, because it really doesn't exist. Or at least, it really hasn't existed in the past two years. The rallies are of the higher grind variety. I detest when I hear pundits call it a "stock picker's market"-- it's extremely self-serving. We only need them if we need them to pick stocks. But it's anything but a "stock picker's market" these days, hence the relative outperformance of a low-volatility strategy.

Does it make sense to expect this to continue? Well, grand trends don't change that often, so it's tough to say when this trend will abate. So for the time being, I do suspect these sorts of funds outperform. But we're probably close to the middle of the low-volatility "regime," something that tends to persist for four-to-six years. Depending on your time horizons, and preferences in market cap, these funds could make sense for the next year or two.

Disclaimer: The views represented on this blog are those of the individual author's only, and do not necessarily represent the views of Schaeffer's Investment Research.

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