Low-Volatility Financial ETFs? Check Them Carefully

TheStreet.com

NEW YORK (TheStreet) -- PowerShares hit a home run two years ago when it launched the PowerShares S&P 500 Low Volatility Portfolio SPLV , which quite obviously tries to smooth out the ride compared with owning a fund like the SPDR S&P 500 ETF SPY .

It does this by screening for the 100 stocks in the S&P 500 with the lowest volatility. As a result the fund is heavy in staples and utilities and light in energy and technology. SPLV has over $3 billion in assets.

Wanting to capitalize on that success the fund company has now launched the PowerShares S&P Small Cap Low Volatility Portfolio XSLV and the PowerShares S&P Mid Cap Low Volatility Portfolio XMLV . XSLV will invest in the 120 stocks from the S&P 600 Small Cap Index with the lowest volatility and XMLV will invest in the 80 stocks from the S&P 400 Mid Cap Index with the lowest volatility.

XMLV is comparable to the iShares Core S&P Mid Cap ETF IJH . At the sector level XMLV is heaviest by far in financial stocks at 51% which compares to just 22% in IJH. The only other sector with a large weighting in XMLV is utilities at 22%. While the financial sector exposure might seem like a surprise, of the 41 holdings from that sector almost half are real estate investment trusts.

XSLV has essentially the same construction. It is 49% in financials, with many of the stocks being REITS and utilities again are the only other sector of note at 15%. The benchmark iShares Core S&P Small Cap ETF IJR has just 20% in financials.

The disproportionate weighting to one sector means XMLV and XSLV are not as well diversified as the large-cap SPLV, whose largest sector only comprises 28% of the fund. The methodology of all three funds is to pick stocks based on their realized volatility over the past 12 months. Should there be a problem with REITs, as there was in 2008, then these funds would likely drop dramatically before being able to reconstitute the exposure out of the holdings.

Because the funds just started trading there is no dividend information available on the PowerShares site, but since REITs typically have high yields then it is very possible that both XMLV and XSLV will also have high yields.

The large-cap SPLV has been successful because it has traded as advertised with lower volatility and an SPY-beating yield of 2.86%. XMLV and XSLV will likely also trade as advertised until or if REITs have to confront a serious threat. Whereas SPLV is a low-volatility proxy for a broad market index, the sector makeup of the new funds makes them more like low-volatility proxies for the financial sector. If ever there was a cause to understand what is under the hood of an ETF it is these funds. At the time of publication the author had no position in any of the stocks mentioned but SPLV is a client holding.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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