ETFs for Smoothing Out Market Volatility

NEW YORK ( TheStreet) -- Why do you invest? What really is your objective?

For most individual investors, whether they invest on their own or hire someone, the real objective is simply having enough money when they need it -- in most instances this means retirement.

If you want to retire then chances are your accumulated savings will go toward supplementing the benefit you will receive from Social Security and you will either have enough saved to offer the lifestyle you want or you won't.

For those who can reorient their thinking to the long term and to their real objective, a whole new way of investing opens up by using the low-volatility ETFs that have recently been created.

The big idea is that these funds go up less than regular market-cap-weighted funds during bull phases and go down less during bear phases, thus smoothing out the ride on the way to a similar long-term result.

The advantage to this smoother ride is a smaller likelihood of panic selling at a low because these funds tend to act as advertised: They go down less when the market goes down.

The last few months have offered a good litmus test for what to expect from these types of funds.

Since its inception this past May, the PowerShares S&P 500 Low Volatility Portfolio ( SPLV) is down 1.25% vs. an 8.27% decline for the S&P 500.

SPLV owns the 100 stocks in the S&P 500 with the lowest realized volatility over the last 12 months. Not surprisingly, the fund is heaviest in the utilities sector at 32% and the consumer staples sector at 22%. None of the other sectors exceed more than 10% of the fund.

The fund is not riskless, however. Utility stocks tend to be vulnerable to rising rates as bonds become more attractive relative to high-yielding utilities.

The Federal Reserve is going to great lengths to keep interest rates low by stating that it will not increase them until at least 2013 and by recently commencing "Operation Twist," in which the central bank sells short-dated debt and buys longer-dated debt. But with rates close to all-time lows it makes sense to be on the lookout for a meaningful turn higher.

The EG Shares Emerging Markets High Yield Low Beta ( HILO) offers essentially the same effect for emerging-market equities. HILO invests heavily in telecom and electric utilities. The largest countries are South Africa, China, Thailand and Brazil.

Since this fund's inception in August, it is down 6.95% vs. 8.57% for Vanguard Emerging Markets ETF ( VWO), but I would note that at the low in early October when VWO was down 20%, HILO was down only 14%.

The biggest risk to HILO is if China slows down in the manner that some observers fear. This would cause China's demand for resources from Brazil to decline. Both countries obviously are large components of the fund, and the fund is unlikely to do well if those two countries' economies stumble.

It is important to have the right expectations with these types of funds. They will not somehow go up when the stock market goes down 20%. The reason to mention HILO along with SPLV is that low-volatility investing still needs to include diversification. I would expect that there will be more funds that offer lower volatility for regions of the world, countries and sectors.

At the time of publication, Nusbaum had no holdings of securities mentioned.

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Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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