Low-Volatility ETFs: Better Performance with Less Risk?

A treacherous market dominated by Europe’s debt crisis has made a stock ETF designed to moderate risk one of the most successful recent launches as the fund has quickly gathered more than $2 billion in assets.

PowerShares S&P Low Volatility Portfolio (SPLV - News) is up 12.8% for the trailing year, compared with a 4.2% gain for the S&P 500, according to Morningstar. The ETF was launched in May 2011.

The fund has been very popular with investors and financial advisors and the firm believes it’s due to the underlying index and the ETF’s simplicity, effectiveness and current market conditions, says Taylor Ames, product strategist at Invesco PowerShares, the ETF’s sponsor.

SPLV is a portfolio of the 100 stocks from the S&P 500 with the lowest volatility over the past 12 months. Volatility is a measure of a security’s tendency to fluctuate in price.

The fund weights individual securities by their volatility. In other words, stocks with lower volatility have a bigger weighting in the portfolio.

Managing risk

The ETF appeals to investors who “want to try to mitigate risk while staying fully invested in equities,” Ames said in a telephone interview.

The strategy has provided some protection to skittish investors because the fund hasn’t fallen as hard as the S&P 500 during risk-off bouts. The trade-off is the ETF won’t capture as much of the upside in big rallies.

The fund’s straightforward approach also makes it attractive, Ames said.

“Investors are looking for strategies they can understand that aren’t difficult to implement,” he said. “For advisors, the strategy is easy to communicate to clients. It can be explained in three or four sentences.”

“The fund’s construction is admirably simple and transparent,” said Morningstar analyst Samuel Lee. “Low-volatility strategies have historically posted excellent risk-adjusted returns.”

However, the sudden interest in low-volatility strategies by institutional and retail investors “may presage lower risk-adjusted returns for the strategy going forward,” Lee wrote in an analyst report on SPLV. Also, big sector bets may worry some investors and low-volatility strategies “can perform miserably during furious bull markets.”

‘Fortunate’ timing

Still, Ames said the strategies resonate with investors shell-shocked by the 2008 credit meltdown, which changed their entire mindset on the market. Investors are paying attention to risk, not just return. They want to limit volatility and protect themselves on the downside.

“Risk-adjusted performance is now an important factor in investors’ minds, more than it was five or 10 years ago,” he said. “Investors are very aware of risk—they want to minimize risk and maximize returns. In the past it was all about maximizing returns only.”

Invesco PowerShares was also “fortunate” to launch SPLV in the spring of 2011 right before the summer market plunge on European debt fears. “The ETF, based on the underlying index, did what it was supposed to do, and the investment community noticed,” Ames said.

Investors also like the fund’s low fees – it has an expense ratio of 0.25%.

Currently, SPLV has some tilts to traditionally defensive sectors that are very different from the S&P 500. For example, it has 28.7% in the consumer staples sector and 31.7% in utilities.

“The strategy can dynamically rotate into other sectors based on volatility,” Ames said.

‘The low-volatility approach has delivered’

Invesco PowerShares also oversees similar ETFs that invest in international stocks: PowerShares S&P Emerging Markets Low Volatility Portfolio (EELV - News) and PowerShares S&P International Developed Low Volatility Portfolio (IDLV - News).

Other low-volatility ETFs for U.S. stocks include iShares MSCI USA Minimum Volatility Fund (USMV - News) and Russell 100 Low Volatility ETF (LVOL - News) . For low-vol international stocks, investors can take a look at iShares MSCI All Country World Minimum Volatility (ACWV - News).

“For investors determined to stick with stocks but not loving the latest Maalox-inducing moments, plugging into low-volatility ETFs can be an intriguing solution,” said YCharts editor Carla Fried in a recent article for Forbes.com.

“Clearly, the low-volatility approach has delivered in down markets, as you’d expect. But in up markets … a low-volatility portfolio isn’t going to be the pacesetter,” Fried wrote.

PowerShares S&P Low Volatility Portfolio