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Time to Ditch Low Volatility Funds?

NEW YORK ( TheStreet) -- In order to try to combat the stock market's volatility from the last 10 years, many investors have invested in funds that target a lower volatility than the S&P 500. The funds started to appear a few years ago and the sector has grown dramatically. And for good reason: many low-volatility indexes have outperformed the S&P 500 over long periods of time.

The funds had also been performing well recently over short periods of time. The biggest low volatility fund is the PowerShares S&P 500 Low Volatility Portfolios (SPLV). It has attracted almost $5 billion in assets in just over two years, and since its inception, it has outperformed the SPDR S&P 500 (SPY) by three percentage points and has done so with less volatility.

This past month, however, SPLV dropped 3.8% versus a gain for SPY of 2.3%. Whether the poor performance last month was because the Fed is continuing to force investors into risky assets or because interest rates have risen recently, the results prompted Barron's to ponder whether the "low beta bubble is deflating." Beta is a measure of volatility where the higher the beta, the more volatile a stock or fund is believed to be.

No strategy can outperform all markets at all times. Warren Buffet lagged the broad market in the late 1990s and other legendary investors have also had periods where they lagged. So it is with low volatility investing: there are times where it outperforms like most of the last two years for SPLV and times where it lags like last month.

Looking under the hood of SPLV, it is 30% invested in utilities. Over the past month, interest rates have gone up and utilities have gone down. Utilities are often thought of as substitutes for bonds.

As with bonds, when yields go up, prices go down. Anyone owning SPLV should expect the fund to go down a lot if interest rates make a substantial move higher.

The CBOE S&P 500 BuyWrite Index BXM has one of the longest track records for low volatility, indexed products. BXM owns the S&P 500 and sells at the money index call options every month. The objective is a market-beating return long term with less volatility than the broad market, which is very similar to SPLV's objective.
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