Low Volatility ETFs

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- Investors looking to lessen their risk in uncertain times have been flocking to low volatility ETFs, which seek to replicate the returns of low volatility indices.

There are a number of low volatility indices to choose from including the S&P 500 Low Volatility Index, the MSCI USA Minimum Volatility Index, and the Russell-Axioma U.S. Large Cap Low Volatility Index, among others.

The largest low volatility ETF in terms of assets under management (AUM) is the PowerShares S&P 500 Low Volatility Portfolio ( SPLV), which tracks the S&P 500 Low Volatility Index.

Launched in May 2011, SPLV already has more than $1 billion under management. The index is composed of the 100 least volatile companies in the S&P 500, and eschews sexier tech stocks for more reliable sectors such as utilities, health care, and consumer staples, which tend to fluctuate a great deal less.

Although lower risk is typically associated with lower returns, Standard & Poor's back testing from 1991 to present found that its Low Volatility Index's annualized returns of 9.6% actually beat the S&P 500's 7.6%.

On the surface, this discrepancy between risk and return doesn't seem to make much sense, but there are other factors at work. Money managers tend to overpay for riskier stocks because they attract more money to their funds and perform so well in bull markets. Of course, when a bear market inevitably arrives, those same stocks can get killed.

In contrast with tech stocks, which often trade at a premium during bull markets, the boring, plain vanilla, low volatility stocks that compose low volatility indices are frequently overlooked and can trade at discounts.

Somewhat paradoxically, the low risk approach of low volatility ETFs has its own risks. To start with, these ETFs are often very (some might say overly) concentrated in a few select sectors.

Twenty-nine percent of the PowerShares ETF is invested in consumer staples such as Proctor and Gamble ( PG) and Walmart ( WMT), with another 31% in utilities like Consolidated Edison ( ED). A shock to one of these sectors could prove particularly damaging to such an ETF.

Investors in low volatility ETFs also risk missing out on sudden large gains in the market, making much more modest returns. The flipside, of course, is that they are better protected if and when the market drops.

To be fair, PowerShares' approach isn't the only game in town. iShares has structured its MSCI USA Minimum Volatility Fund ( USMV) in a slightly different way, tracking the MSCI USA Minimum Volatility Index, but attempting to minimize the risk of overconcentration, never allowing a sector's weighting to vary by more than 5% from the overall market. Contrast its 15% weighting in consumer staples with PowerShares' 29%.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Dave Fry is founder and publisher of ETF Digest, Dave's Daily blog and the best-selling book author of Create Your Own ETF Hedge Fund, A DIY Strategy for Private Wealth Management, published by Wiley Finance in 2008. A detailed bio is here: Dave Fry.

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