Low Volatility ETFs Pass the Test

NEW YORK (TheStreet) -- The recent two-month slide for U.S. equities has provided a good test for the relatively new niche of low volatility ETFs.

Two of the bigger funds in the space are the PowerShares S&P 500 Low Volatility Portfolio (SPLV) and the iShares MSCI USA Minimum Volatility Index Fund (USMV). SPLV has $3 billion in assets and USMV has $600 million, so these funds have found an audience among investors. The results of the two funds were noticeably different and it is worth exploring why.

From September 14 until November 14 the S&P 500 fell 7.16%. In that same period SPLV dropped by 4.87% and USMV declined by 5.62%. For investors with the proper expectations, these results are good. It is not realistic to expect that the low volatility funds will somehow go up when the market drops but expecting them to go down less is realistic.

The dispersion between the two funds is likely attributable to the sector weightings of the two funds. The current small correction has been focused in the technology sector more than anywhere else and so it is logical SPLV with only 3.6% in tech would do better than USMV which has 14.5% in technology.

However. it would not be correct to assume that SPLV will always outperform USMV when the market drops. At some point interest rates are going to go up and whenever that occurs there will be some sectors which will feel that changing market dynamic more than others.

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The utilities sector is one that should be expected to get hit as, in a rising rate environment, utilities tend to get sold and proceeds go into bonds.

This makes sense as utilities, especially regulated utilities, tend to be more bond-like than other sectors of the equity market.

Currently there are many utilities with higher yields than investment grade corporate bonds making them more attractive than corporate bonds. If that current relationship changes to favor bonds yields then utilities could go down a lot.

The significance to this conversation is that SPLV has 30% in utilities and USMV only has 7.6% in utilities. If utilities lead some future correction the way that technology has lead the current one then SPLV will be the fund that lags behind.

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