There’s no getting around the fact that risk abounds when investing in stocks. No free lunches are to be had. That said, there is an intriguing way to reduce your indigestion along the way. Focusing on stocks with the lowest volatility not only delivers a smoother ride, it has shown a surprising knack for producing superior returns over full market cycles, as well. For investors worrying about an impending market correction, the low-vol approach can be a soothing investment Zantac right about now.
The index wonks at S&P created a low-volatility index that carves out the 100 stocks among the S&P 500 that have the lowest standard deviation over the past 252 trading days. (The index is rebalanced quarterly.) In a backtest, the low volatility index had a 10.2% annualized gain over the past 20 years, compared to 8.4% for the regular S&P 500 index. The cherry on top: the low-vol outperformance came with just two-thirds the volatility of the benchmark index.
PowerShares S&P 500 Low Volatility etf (SPLV) tracks this index. Since its May 2011 launch the portfolio has grown to $3.4 billion. It’s easy to see the attraction.
As compelling as that is, keep in mind that in roaring markets, a low volatility strategy will lag. For example, in 2009 S&P’s low volatility index gained 19.2% compared to 26.5% for the standard S&P 500 index. The value of the approach comes over a full market cycle, where the cumulative effect of losing less in bad markets (Low Vol lost 21% in 2008 compared to a 37% decline for the broad market index) has more than offset lags in up markets.
The nice asset grab by PowerShares has brought on some competition. In late February, State Street launched a competitor. The SPDR Russell 1000 Low Volatility etf (LGLV) screens for the lowest volatility stocks during the past 252 trading days within Russell’s large cap index. (Russell had its own ETF tracking its low volatility index, but closed it last year due to meager assets. State Street is obviously betting on its higher visibility and marketing heft.)
An important difference between the two large cap low volatility approaches is that Russell injects its own judgment call on the final portfolio construction, whereas S&P just sticks with the 100 least volatility stocks. Here’s Russell’s official explanation of its extra massaging: “The Index is then optimized to provide low volatility large cap exposure while managing turnover and neutralizing other factors, such as beta and momentum.”
That tweaking leads to very different portfolios. For example, the SPDR Russell 1000 Low Volatility etf has 12.8% invested in the utility sector. The PowerShares S&P 500 Low Volatility ETF currently has 31% of the portfolio invested in the utility sector. By comparison, less than 4% of the standard S&P 500 index is invested in utility stocks.
Among the top five current holdings in both ETFs the only overlap is Johnson & Johnson (JNJ) and General Mills (GIS). The other three top holdings in the PowerShares portfolio are Clorox (CLX), Southern Company (SO) and Kimberly Clark (KMB). For the new SPDR low vol portfolio, Heinz (HNZ), Pepsico (PEP) and Procter & Gamble (PG) round out the top five.
Johnson & Johnson and General Mills are indicative of the types of stocks that tend to bubble up on low-volatility screens among large caps: solid global players who won’t wow you with market-besting earnings growth, but provide ample growth along with a nice income kicker. Johnson & Johnson’s current 3.2% dividend yield and General Mills’ 2.9% is well above the 2% for the overall S&P 500.
Even better, both companies have a storied record of strong dividend growth.
And that has helped fuel impressive total returns (capital appreciation-or loss-added to reinvested dividend payouts) over the long-term.
What else should you consider buying in a market correction? Here's a shopping list.
Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at firstname.lastname@example.org.
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