A Low-Volume Fund For Volatility

As human beings, sleep is one of our most basic requirements.

Not only does sleep help us stay alert and attentive during the day, but it also plays a vital role in memory formation.

Chronic sleep loss can even harm cardiovascular health and impair immune function.

Therefore, anything that prevents you from sleeping should be avoided at all costs… including poorly timed market decisions.

Indeed, I bet the market’s volatility is starting to keep more and more investors awake at night.

But just think how peacefully you’d rest if your investments protected you from stock market draw downs – while providing upside participation during the rallies at the same time!

Luckily, there’s a group of funds that seems to do just that…

Low-Volatility Anomaly

These innovative exchange-traded funds (ETFs) follow a low-volatility strategy, and attempt to take advantage of a specific market anomaly.

Over time, investors have been conditioned to think that they must take on more risk – and endure higher volatility – to earn high returns.

However, many long-term studies show that, on average, low-volatility stocks earn higher risk-adjusted returns than high-volatility stocks.

Unsurprisingly, there’s a growing list of low-volatility ETFs. According to ETF.com, there are now 19 in existence.

The PowerShares S&P 500 Low Volatility (NYSE:SPLV) was the first, and thus has the longest track record. The fund holds the 100 stocks from the S&P 500 with the lowest realized volatility over the past 12 months.

Since its inception on May 5, 2011, SPLV has produced an annualized total return of 13.5%. It has actually slightly outperformed the SPDR S&P 500 (ARCA:SPY), which has returned an annualized 13.2%.

Yet, over this entire period, SPLV has only exhibited around 70% of the volatility of the S&P 500 Index.

The second half of 2011 provides a good illustration of how SPLV has reduced losses. On a closing basis, the S&P 500 Index peaked on July 7, 2011 and had declined 18.4% by the end of the drawdown period on October 3, 2011. SPLV suffered a drawdown of only 8% during the same timeframe.

True to form, SPLV held up well during one of the most volatile periods since the end of the credit crisis. The fund has also exhibited reduced drawdowns during more recent periods of market stress.

That’s partly because low-volatility funds tend to hold stocks that are less sensitive to the business cycle (fluctuations in economic growth), such as consumer staples and utilities.

However, it’s important to note that their sector exposure is dynamic. For example, if utilities were to begin a massive decline due to rising interest rates, then individual utility stock volatilities will start to increase markedly. In theory, low-vol funds will be able to avoid the bulk of losses by reducing exposures to sectors that are falling out of favor.

Although the constituents will gradually change with each rebalancing, income seekers will appreciate SPLV’s 2.4% trailing 12-month yield, which is higher than SPY’s trailing yield of 1.9%.

Bottom line: SPLV is an excellent core portfolio holding for risk-averse investors focusing on capital preservation.

Just be aware that you’ll probably underperform during the most frenetic stock market rallies. Of course, with market volatility on the rise, this is probably an acceptable trade-off for investors who value sleep-filled nights.

Safe investing,

BY Alan Gula, CFA

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