How to Lower the Volatility of Your ETF Portfolio

NEW YORK ( Fabian Capital Management) -- With the market starting to flatten out near the highs, many investors are starting to wonder when the next correction will set in.

We have yet to see a meaningful pullback this year, despite the omnipresent headlines warning of "The Hindenburg Omen" and a "1987 Style Crash." With those premonitions in mind, I have been looking for innovative ETF strategies that allow you to participate in this market with less risk.

One way to do that is to consider using a low volatility ETF such as the PowerShares S&P 500 Low Volatility Portfolio (SPLV) or the iShares MSCI U.S. Minimum Volatility ETF (USMV).

Both funds offer an innovative subset of stocks that have the most minimal price fluctuations with their underlying index. These ETFs make for excellent core positions in a diversified growth portfolio because of their low cost and conservative makeup.

However, the drawback with these ETFs is that in a widespread sell-off they are still susceptible to substantial declines. We have seen more and more correlation within the equity markets over the last several years, especially when selling kicks into high gear.

SPLV and USMV will most likely hold up better than their underlying indexes, but for a true risk manager there may be another alternative.

Last year the PowerShares S&P 500 Downside Hedged Portfolio ( PHDG) was launched as an innovative strategy that allocates money between the equity, volatility, and cash based on a quantitative rules-based index.

The goal is to achieve favorable returns in all market conditions and to reduce the chances of getting blindsided by the next bear market. The volatility component is incorporated by purchasing CBOE Volatility Index Futures, otherwise known as the VIX.

PowerShares has labeled this as an active ETF and regularly posts updates to its website about the makeup of the portfolio in relation to the three buckets. As of today the portfolio is allocated 97.5% S&P 500 and 2.50% VIX.

Clearly the momentum has been with stocks, which is why the index is heavily weighted in equities at this time. If we start to see equities falter and volatility pick up, the portfolio will start to shift towards a more balanced allocation that will act as a hedge against the core stock exposure.

One of the drawbacks to a strategy such as PHDG is that it will underperform in a strong equity uptrend as we have experienced in 2013.

If you look at a year-to-date chart of the fund compared to the SPDR S&P 500 ETF ( SPY) you will see that the hedged portfolio has only been able to produce about half the total gains that SPY has achieved.

One thing to note is that the volatility component clearly worked to the advantage of PHDG in the May-June timeframe where the price trend smoothed out. This is an indication that the hedging strategy does have some merit in a down market.

The main competitor to PHDG in the marketplace is Barclays S&P 500 Dynamic VEQTOR ETN ( VQT). VQT is structured as an exchange-traded note, which is a debt instrument that is backed by the credit faith of the underlying bank.

One of the advantages of PHDG over VQT is the difference in expense ratio, with the PowerShares product coming in at a slim 0.39% compared to its heavier 0.95% Barclays opponent.

As of today, PHDG has only accumulated $66 million in total assets but I would not be surprised to see that number climb if stocks turn south. This ETF will likely see strong inflows in the event of a sustained correction or bear market similar to asset flows into a traditional inverse fund, such as the ProShares Short S&P 500 ETF ( SH).

I will be watching this fund closely to see how the managers shift its asset allocation in response to changing market conditions. It remains to be seen how tightly the fund can track its underlying index as well as hold true to its objective of delivering non-correlated returns for its investors.

Still, I believe that this ETF should be on your watch list and can be included as a special situation position if we see a change in momentum over the next several months.

At the time of publication the author had no position in any of the stocks mentioned.

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

David Fabian is currently a Managing Partner at Fabian Capital Management, a fee-only registered investment advisory firm specializing in exchange-traded funds. He has years of experience constructing actively managed growth and income portfolios using ETFs. David regularly contributes his views on wealth management in his company blog, podcasts, and special reports. Visit www.FabianCM.com to learn more.

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