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Low-Volatility ETFs for the Long Term

NEW YORK ( TheStreet) --Over the weekend Barron's ETF Focus Column pointed out that many low-volatility funds have lagged behind the benchmark S&P 500 index in recent weeks.

The article concedes that a bad quarter is barely a blip for longer investment horizons, but it says people with shorter horizons may want to reassess their holdings in this space.

Drawing specific mention was the PowerShares S&P 500 Low Volatility Portfolio (SPLV), which has turned out to be popular in terms of attracting assets and performing well versus the S&P 500 since its inception in 2011. However, the fund has fallen 2.5% in the last three months versus a 0.60% increase for the benchmark.

A few days earlier, well-respected investment adviser and author Larry Swedroe had a similar article for CBS News. He noted that low-volatility funds' "ability to produce market-like returns was as confounding as it was impressive." He said they have not performed very well recently and he expects them to continue to underperform for several reasons, including that past outperformance can be attributed to a value bias and being overweight in interest rate-sensitive sectors.

I've written extensively about low-volatility funds, the extent to which they have biases or over-weighted exposures that need to be understood before buying any of the funds and then monitored after purchase.

This is true of all broad-based index funds. For example, history tells us that when a sector grows to more than 30% of the S&P 500 -- such as technology in 2000 and energy in the early 1980s -- large declines typically follow. Even when a sector gets much above 20% like financials in 2007, it is a warning that investors should heed.

SPLV has a 30% weight in the utilities sector, which is one of the most interest rate-sensitive sectors. If interest rates go up then the high yields available in the utilities sector become less attractive and the stocks in that sector can be expected to lag which is an obvious threat to the current portfolio make up of SPLV.

Both articles also look at the iShares MSCI US Minimum Volatility ETF (USMV), which takes a more balanced approach to portfolio construction and has no gross overweight to one sector like SPLV and so is much less exposed to rising rates. USMV has 17% in healthcare, 15% each in financials and consumer staples and 13% in technology with the remaining sectors being much smaller.

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