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Fund Spotlight Series: Low Volatility ETFs

The latest sign that the 2008 financial crisis is still fresh in investor’s minds? The overwhelming popularity of “low volatility” ETFs with investors today. These funds claim to offer the returns of stock index funds, with the protection of a low volatility strategy. Do they have a place in your portfolio?

 

The Short:

 Pros:

  • Low expense ratios, especially for international equities funds.
  • Solid Dividends
  • Invests in strong, stable companies

 Cons:

  • Little history of how these will perform in bear markets.
  • Outperforming the markets? Or just Wall Street’s favorite investment idea for the day?

 

The Long:

 

Since their initial launch in 2011 low volatility ETFs have taken the market by storm, easily becoming the fastest growing ETF “flavor” today. The largest fund, Invesco Powershares S&P 500 Low Volatility ETF (ticker: SPLV – and discussed in detail below) has gathered nearly $4 billion in assets since its inception less than 2 years ago.

What is a “low volatility” ETF? Let’s take a quick look using Invesco’s S&P 500 low volatility ETF as an example:

The holdings of an S&P 500 low volatility ETF (SPLV) compared to a standard S&P 500 index fund (SPY):

 

 

SLPV holdings

SPY Holdings

 

 

What investors look for to reduce volatility in their portfolio are “Low Beta” stocks. What exactly does this mean?

Beta is a measurement of volatility or risk of a security compared to a benchmark. Most of the time the benchmark will be the S&P 500 index.  Beta measures the magnitude of a security’s historical price swings compared to the benchmark’s.

A beta of 1.0 would mean that the security has historically moved in lock-step with the S&P 500. If the S&P 500 is up 1% for a day, you can expect a stock with a beta of 1.0 to be up 1% as well. A beta of less than 1.0 means the security will not move as much as the S&P 500, or be up less than 1% if the S&P 500 is up 1%. A beta of greater than 1.0 means the security is more volatile than the S&P 500, so it will more than likely gain more than 1% when the S&P 500 is up 1%.

 

Of course, the same holds true for when the market is down 1%, a high beta stock will be down more than 1%, while a low beta should be down less than 1%.

 

So, these low volatility funds like to hold low beta stocks in order to help reduce the volatility of the investor’s portfolio. If the market turns down, being in low beta stocks should be a favorable place to be.

 

Lets take a look at Johnson and Johnson (Ticker: JNJ) for an example of the characteristics of the holdings of these types of funds.

Beta can be found on nearly all of the financial news websites. Below we are showing yahoo finance. (Beta can be found under the “Key Statistics” link on the left hand side when looking at a stock on yahoo finance.

(click to enlarge)

JNJ Beta yahoo finance

 

As you can see, JNJ sports a very low beta of 0.48, making it a great primary holding for a fund trying to reduce volatility. Theoretically, if the S&P 500 were to fall 1% tomorrow, Johnson and Johnson can be expected to be down about 0.48%, based on historical price movements.

 

Johnson and Johnson is the epitome of a low volatility stock. A consumer staple, selling items that people will always buy no matter the economy. Tylenol, shampoo, band aids, Nicorette…. This means consistent sales, ability for the company to pay a decent dividend and (hopefully for shareholders) a steady share price no matter the investing environment.

 

Looking at the companies that are included in the top holdings list above, you can start to see a common theme. Large companies with well established brands, Heinz, Pepsi, Clorox, General Mills, etc. This is the essence of low volatility investing.

 

Most importantly, what about the performance difference between this low volatility fund and the general market?

SPYvsSPLV - Performance

 

Since the fund’s inception the performance of a “low volatility strategy” has noticeably outperformed the S&P 500.  So what’s the formula for these new funds?

 

SPLV’s investment strategy is fairly simple. The fund consists of 100 holdings which have had the lowest volatility over the past 12 months. (Invesco defines volatility as: “Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.”)

 

Now investors should take note, this is far from any guarantee of low volatility in the future. What you are investing in is a fund which invests in companies whose past performance has seen low volatility. Remember the most commonly used phrase on Wall Street: “Past performance is no guarantee for future results”. If something significant happens to, say Johnson and Johnson Company (This fund’s largest holding) causing their stock to tank, you will ride it down until the fund rebalances.

 

Although the other funds listed here don’t have an investing ideology exactly like SPLV, they will invest in a similar way to follow certain low volatility indices.

 

Unfortunately because these funds are new and bred out of the 2008/2009 market collapse, we don’t have solid history of how these funds will perform in the sharp market declines investors saw in 2009. We can see in the chart above that the fund seemed to do its job in the small 2011 correction, outperforming the general market by nearly 10% in September 2011. For another idea on how this fund may perform in a bear market, let’s look at how the fund’s current largest holdings performed during the 2008/2009 crisis compared to the general market:

 

SLPV TOP holdings vs S&P500

 

 

It seems the stocks held up fairly well to the crisis, and continue to outperform today. All of SPLV’s top holdings outperformed the general market in the 2008/2009 decline.

 

But I am worried this might also be highlighting this strategy’s flaw today.

 

Investors have been piling into the types of companies held in these lower volatility funds. With treasuries yielding next to nothing, and the fear of a future market down-leg on people’s minds, investors have flocked to companies that pay solid dividends, have solid balance sheets, and generally have less volatility in their share price. As we noted before these types of ETFs are the fastest growing on the market today.

Do stocks lose their “low volatility qualities” when they become the hot new idea on Wall Street? When everybody owns Johnson and Johnson stock, I fear that it may sell off just as strong as the general market during the next downturn.

Although this is only speculation, I don’t have a clue. Just something I am concerned about.

And that doesn’t mean these are “bad stocks” by any means either. The top holdings in these funds are great, high quality stocks that should be great for an investor over the long term. As long as you know there will be bumps in the road along the way, you should be fine.

But if you are expecting these stocks to barely fall in price if the market turns south, you may be in for a surprise.

 

So lets take a look at the 4 largest low volatility funds out there and compare expense ratios, yields and holdings. These 4 funds are each unique, which one is best for you will largely depend on your desired asset allocation and other current holdings. 2 of these are U.S. equity based, 2 are emerging market/world equity based.

 

Our list of low volatility ETFs starts with SPLV, initially shown above:

SPLV – S&P 500 Low Volatility Portfolio

  • Expense Ratio: 0.25%
  • Dividend Yield: 2.95%
  • Made up of 100 holdings (the top holdings are shown above)
  • Beta of 0.62 vs. S&P 500 index.

 

 

Fund overview page: http://www.invescopowershares.com/products/overview.aspx?ticker=SPLV

Fund prospectus: http://www.invescopowershares.com/pdf/P-PS-PRO-12.pdf (On page 50).

 

Investors are able to easily understand SPLV’s strategy. Simply find the 100 stocks with the lowest volatility over the last 12 months and buy them. As we will start to see below, some of the other funds have much different criteria for their holdings.

 

 

USMV – iShares MSCI USA Minimum Volatility Index Fund

  • Expense Ratio: 0.15%
  • Dividend Yield: 2.55%
  • 126 holdings in total
  • Commission free at Fidelity
  • Beta of 0.69 vs. the S&P 500.

Fund Overview page: http://us.ishares.com/product_info/fund/overview/USMV.htm

Fund prospectus: http://prospectus-express.newriver.com/summary.asp?clientid=isharesll&fundid=46429B697&doctype=pros

USMV’s top holdings:

USMV holdings

 

Notice the difference in fund holdings between SPLV and USMV? USMV takes a slightly different view of low volatility investing than SPLV. According to the prospectus, USMV “follows a rules-based methodology to determine weights for securities in the index that seeks to minimize total risk of the MSCI USA Index.”

I haven’t found exactly what those rules are, besides the quote above there doesn’t seem to be anything in the prospectus describing their methodology.

The fund follows a different index than SPLV, USMV tries to reduce the volatility of the MSCI USA Index, which is a slightly broader index of the U.S. stock market. The MSCI USA Index contains about 100 more companies than the S&P 500, so the fund has a few more selections to choose from than SPLV.

Then, based on that larger selection of stocks, the fund managers use their “rule based methodology” to select the stocks with the lowest volatility.

We can tell by the holdings that there is a significant difference, and that has led to better performance:

 

SPLV vs USMV vs S&P500

 

Personally, I tend to like SPLV’s investing philosophy a little better. I just like knowing what you are investing in. Maybe we can get a clearer picture of USMV’s philosophy as time goes by. It seems USMV overweights a select few mid-cap companies and along with different sectors, but as a whole the fund actually has a larger average market cap than SPLV:

SPLV vs USMV holdings

Chart and Graphs from ETFdb.com

 

 

Now onto a couple of low volatility international equity ETFs:

 

EEMV – iShares MSCI Emerging Markets Minimum Volatility Index Fund

  • Expense Ratio: 0.25%**
  • Dividend Yield: 2.79%
  • 212 holdings in total.
  • Commission free at Fidelity.
  • Beta of 0.91 vs. the S&P 500

Fund Overview page: http://us.ishares.com/product_info/fund/overview/EEMV/index.htm

Fund prospectus: http://prospectus-express.newriver.com/get_template.asp?clientid=isharesll&fundid=464286533&doctype=pros

** = Expense ratio for EEMV has been 0.69%, but a waiver of 0.44% is currently in place, the net expense ratio 0.25%. This is in effect until December 31st 2014, watch for a possible increase in fees after that.

 

A really low expense ratio for a well-rounded international fund! (As long as the waiver stands) EEMV’s holdings contain no U.S. Equities at all, and is made up primarily of Asian equities (Taiwan, China, South Korea, Malaysia, Thailand and Indonesia make up a little over 60% of the fund).

 

International as a whole tend to be more volatile than the U.S. market, but this fund has selected a group of stocks that together have a beta of only 0.91 vs the S&P 500 index. For those investors who are very risk adverse, a fund like this may be a good entry into international markets.

 

ACWV – iShares MSCI All Country World Minimum Volatility Index Fund

  • Expense Ratio: 0.20%
  • Dividend Yield: 2.42%
  • 278 holdings in total.
  • Beta of 0.81 vs. the S&P 500

Fund Overview page: http://us.ishares.com/product_info/fund/overview/USMV.htm

Fund prospectus: http://prospectus-express.newriver.com/summary.asp?clientid=isharesll&fundid=46429B697&doctype=pros

 

 

ACWV is still made up of 50% U.S. Equities, compared to EEMV which is 0%. The inclusion of some US equities helps the fund achieve a slightly lower beta than EEMV (0.81 vs. 0.91). How does the difference in holdings affect the fund’s returns compared to EEMV?

 

EEMV vs ACWV vs S&P 500 vs VT

 

 

I put in the S&P 500 (In purple), as well as Vanguard’s “Total World Stock Fund” (Ticker: VT – in Red) also just for comparison.

VT is a fund from Vanguard that holds nearly 5000 stocks from all around the world. It has no specific “low volatility” agenda, however the massive diversity of this fund means that it inherently is not too volatile. VT is made up of about 45% U.S. equities, and 55% international stocks (25% Europe, and 15% Asia).

 

The main difference in these funds comes from their U.S. equity exposure. If you are looking to only add international equities in your portfolio, EEMV may be the better fit. Personally, I like a fund more like VT because of its diversity. With international investing I like to broadly diversify, because I don’t focus a lot of attention on specific companies or countries.

 

A fund like VT has a lower expense ratio (albeit barely), similar dividend yield, and hasn’t been any more volatile than EEMV or ACWV in the short history of the funds. However, VT is not a pure international play either.

Personally, I am waiting to see how these international low volatility ETFs perform in a market decline compare to a large fund like VT.

 

 

In Conclusion

 

I am really excited about these funds, as I think they may have a role in investor’s portfolio for those looking to remove some potential volatility. By investing in these funds investors will stay out of the high flying, potentially volatile stocks and stick with tried and true, financially solid, dividend paying companies. These funds should be able to keep you out of serious trouble in all types of markets.

All of the funds highlighted here have a dividend yield higher than the S&P 500 (and the 10 year Treasury bond) and come with decent expense ratios.

All of the funds above are a little different, there really is no “winner” to find in this list. Which fund (if any) is for you will largely depend on your current asset allocation and desired risk level.

 

I hope you found some new interesting ETFs or investment ideas from this article, check out our other Fund Spotlight Series articles for more!

 

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