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.

From the market's March 2009 low, the BXM index is up 68%, compared with a 120% gain for the S&P 500. The gain in the last four years has been huge and so it makes sense that in investment product that targets a lower volatility would lag that type of rally.

From November 2004 to now -- the furthest back I could go on any chart -- the BXM is up 44%, compared with 40% for the S&P 500. BXM had less volatility at its low during the financial crisis; it was down only 40%, compared with the 56% decline for the S&P.

There are several funds that track the BXM including the PowerShares S&P 500 BuyWrite Portfolio ( PBP).

The conclusion isn't that one is better than the other but that they are different from each other. In the future, there will be times when the S&P 500 outperforms and other times when the low volatility products outperform. In that light, it depends on your objective.

At the time of publication the author held no positions in any of the stocks mentioned, but some clients own SPLV or PBP.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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