Low Volatility ETFs Stay Afloat in Rough Markets

NEW YORK ( TheStreet) -- To attract nervous investors, fund companies have been introducing low-volatility ETFs, which can provide protection in downturns. Recently the funds have been delivering winning results. While the S&P 500 lost 3.7% in the past month, PowerShares S&P 500 Low Volatility ( SPLV) gained 0.2%. Over the past 12 months, the PowerShares fund returned 11.7%, outdoing the benchmark by 7 percentage points.

Other funds that provided some cushioning in recent downturns include Russell 1000 Low Volatility ( LVOL), Russell 2000 Low Volatility ( SLVY), and iShares MSCI Emerging Markets Minimum Volatility ( EEMV). If the markets remain jumpy this summer, as many analysts expect, the low-volatility funds could continue outpacing the benchmarks.

Most of the low-volatility funds are less than a year old, so it is too soon to know if they will have staying power. But academic research suggests that over long periods, low-volatility stocks have matched or outdone the overall market while taking less risk.

Why can low-volatility strategies perform so well? Some researchers say that low-volatility stocks tend to be boring issues such as utilities and consumer staples, which report steady earnings. Because they suffer little damage in downturns, the stocks have a big advantage in choppy markets. In contrast, high-volatility stocks tend to be in sectors like technology, which often attract notice from investors. The glamorous companies can be overpriced in bull markets -- and suffer big losses in downturns.

Investors who are attracted to the low-volatility strategies should keep in mind that many of the funds can be concentrated in a few sectors. The PowerShares fund has 60% of its assets in utilities and defensive consumer names. In contrast, the S&P 500 only has 15% in the two sectors. PowerShares only has 1.8% of assets in technology, compared to 18% for the S&P 500.

The fund companies use different methods to select low-volatility stocks. The PowerShares fund picks the 100 stocks in the S&P 500 that recorded the smallest price swings in the past year. Each stock is weighted according to its volatility. So the least volatile stocks account for the greatest weighting. The biggest holding is Southern Co. ( SO), a regulated power producer. Other top holdings include such stable consumer stocks as Coca-Cola ( KO) and Kimberly-Clark ( KMB), maker of Kleenex tissue.

While it is somewhat more diversified than the PowerShares fund, Russell 1000 Low Volatility has 46% of its assets in utilities and defensive consumer stocks. Holdings include AT&T ( T) and power producer Duke Energy ( DUK).

The industry concentrations help to explain why the low-volatility strategies have outpaced the market during the past 10 years. In the downturns of the financial crisis, utilities and consumer stocks proved relatively resilient. But before you rush to put all your money in a low-volatility fund, keep in mind that the strategy does not excel all the time. During the 1990s bull market, low-volatility stocks lagged, while high-volatility technology stocks led the parade. "The main point of a low-volatility fund is not to outperform the market," says David Koenig, an investment strategist at Russell. "The point is to provide a portfolio that has low volatility in difficult markets."

Koenig says that some cautious investors may want to hold a low-volatility fund as a core holding. More aggressive investors may decide to take a small position in one of the funds as a means to diversify portfolios. Another option could be to pair Russell 1000 Low Volatility with a choice such as Russell 1000 High Volatility ( HVOL), which has 21% of assets in technology and less than 1% in utilities. Because they have different sector allocations, the two volatility funds could provide diversification.

Morningstar analyst Samuel Lee recommends iShares MSCI Emerging Markets Minimum Volatility Index ( EEMV). The fund charges a low expense ratio of 0.25%. The low-volatility fund can be especially appealing because the emerging markets have often recorded big swings. "Over the long sweep of time, a low-volatility fund could post better risk-adjusted returns," Lee says.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.