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If U.S. Rates Rise, Look to Low Vol Strategies

This article was originally published on ETFTrends.com.

Rising U.S. interest rates are often seen as a strike against low volatility equities and ETFs, but at least one ETF focusing on low volatility fare is built to survive and thrive in rising rate environments.

The PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (XRLV) gives investors the ability to combine the low volatility and hedging rising rates themes. The underling index is composed of the 100 constituents of S&P 500 Index that exhibit both low volatility and low interest-rate risk. XRLV's underlying index is the S&P 500 Low Volatility Rate Response Index.

That benchmark “is designed to include stocks exhibiting low volatility characteristics, after removing stocks that historically have performed poorly in rising interest rate environments,” according to Invesco.

The low-vol strategy targets stocks that have lower expected risk or less idiosyncratic risks. Specifically, the strategy focuses on equities that exhibit lower beta, a measure of volatility or systematic risk of a security to that of the overall market. Consequently, minimum volatility portfolios are comprised of stocks that exhibit lower market risk or beta.

Better Over The Long Haul

Data suggest that XRLV's index wins over the long-term as interest rates rise.

“Over the longer time horizons, the low volatility and rate response indices outperformed the S&P 500, with lower volatility. In fact, the rate response index performed better than both the low volatility index and the S&P 500 for all measured periods. The rate response index was slightly more volatile than the low volatility index—nevertheless, it had a cumulative risk reduction of 19.3% relative to the S&P 500 (the low volatility index had a risk reduction of 23%),” according to S&P Dow Jones Indices.

Unlike traditional low volatility ETFs, XRLV is not heavily allocated to rate-sensitive sectors. For example, the fund devotes less than 8% of its weight to the consumer staples sector and has no exposure to utilities stocks. XRLV devotes more than 42% of its combined weight to financial services and industrial names.

“In recent years, stocks have been in one of the longest-running bull markets with low volatility, leading to somewhat moderate volatility reduction for the two indices. However, for the time horizons that cover at least one full market cycle (bull and bear markets), the risk reduction of the two indices versus the S&P 500 was more evident,” according to S&P Dow Jones.

For more on smart beta ETFs, visit our Smart Beta Channel.

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