Steady Funds for Rough Markets

NEW YORK (TheStreet) -- Seeking to reach investors traumatized by the financial crisis, exchange-traded funds companies have introduced low-volatility funds. The funds focus on the steadiest stocks, often emphasizing sectors such as utilities, consumer staples, and health care.

ETFs that appeared in the last couple years include PowerShares S&P 500 Low Volatility ( SPLV), SPDR Russell 1000 Low Volatility ( LGLV), and iShares MSCI Emerging Markets Minimum Volatility ( EEMV).

When they first appeared, many of the funds seemed to be riding a wave of success. During the decade ended in 2012, low-volatility strategies excelled.

For the period, the average utility mutual fund returned 10%, compared with 7.1% for the S&P 500, according to Morningstar. But lately the low-volatility funds have looked less compelling. This year, PowerShares S&P 500 Low-Volatility returned 16.1%, compared with 20.6% for the S&P 500.

Are the low-volatility funds a fad that will soon pass? Not necessarily.

According to academic research, low-volatility stocks tend to excel in downturns and lag in bull markets. Over long periods, the low-volatility strategies can about match -- or slightly exceed -- standard benchmarks.

What makes the volatility strategies appealing is that they have less risk than standard approaches.

"The main objective of low-volatility strategies is risk reduction -- not necessarily outperformance," says David Koenig, investment strategist for Russell Indexes.

To appreciate how the new ETFs can perform in downturns, consider the recent record of iShares MSCI Emerging Markets Minimum Volatility. With markets in Latin America and Asia facing headwinds, the minimum volatility ETF lost 0.5% this year, outperforming the standard iShares MSCI Emerging Markets ( EEM), which lost 5.1%. That showing is very different from what occurred in the second half of 2012 when emerging markets rallied.

For the period, the emerging-market minimum volatility ETF gained 12.2%, lagging iShares MSCI Emerging Markets, which returned 14.1%. By limiting losses in downturns, the minimum-volatility ETF outperformed during the past 12 months, returning 7.1%%, compared with 3% for the standard iShares emerging-market ETF.

The low-volatility ETFs tend to shine in downturns because many of their big holdings -- such as staples and utilities -- deliver consistent earnings. Even during recessions, demand remains steady for companies that provide food, toothpaste, and electric power. As a result, investors flock to the low-volatility stocks in hard times.

When bull markets arrive, however, investors favor high-volatility stocks in sectors such as technology and industrials. Those companies often report earnings surges in better economic times. In comparison, utilities and staples businesses seem like stodgy performers with slow growth.

Following the financial crisis, low-volatility stocks recorded unusually strong performance. Nervous investors flocked to utilities and other dividend-paying blue chips. That pushed price-earnings ratios up to unusually high levels.

In recent months, low-volatility stocks suffered particularly poor relative performance as investors gained confidence and shifted away from expensive dividend stocks. Rising interest rates encouraged the move from utilities and dividend stocks.

For income-oriented investors, dividend stocks seem less appealing as bonds offer more competitive yields. If the economic recovery stays on track and interest rates keep rising, the low-volatility funds could continue to lag.

The low-volatility ETFs use a variety of approaches to select their stocks. PowerShares S&P 500 Low Volatility picks the 100 stocks in the S&P benchmark that recorded the lowest volatility in the past 12 months, as indicated by a measure known as standard deviation. Current holdings include such stable blue chips as cereal giant Kellogg ( K) and power producer Consolidated Edison ( ED).

While such blue chips can hold their value in downturns, the fund presents risks because it is highly concentrated. The portfolio has 29.8% of assets in utilities and nothing in technology.

SPDR Russell 1000 Low Volatility spreads its bets a bit more. The SPDR portfolio has 14.9% of assets in utilities and 3.9% in technology. If interest rates spike, the SPDR fund would likely fare better than its PowerShares competitor would.

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.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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