ETF Allocation For 2009: Are Low Volatility ETF Portfolios Really the Answer?

I recently came across a back-tested portfolio of ETFs that seeks strong total return with 1/2 the volatility (beta) of the U.S. S&P 500 (SPY). In other words, if you want some stock market exposure, but you don't want the erratic price swings that have defined the new Wall Street, you may do well with slower pokes.

FolioFn offered up the following:

Low Volatility ETF

	#	Symbol	Company	Weight (% of Folio)
	1	DVY	ISHARES TR DJ SEL DIV INX	2.00%
	2	EWJ	ISHARES INC MSCI JAPAN JAPAN WEBS	5.00%
	3	EWL	ISHARES INC MSCI SWITZERLD SWITZRLND WEB	4.00%
	4	EWM	ISHARES INC MSCI MALAYSIA MALAYSIA WEBS	4.00%
	5	IXJ	ISHARES TR S&P GBL HLTHCR	5.00%
	6	IYH	ISHARES TR DJ US HEALTHCR	4.00%
	7	IYK	ISHARES TR CONS GOODS IDX	2.00%
	8	IYZ	ISHARES TR DJ US TELECOMM	6.00%
	9	SHY	ISHARES LEHMAN 1-3 YEAR TREASURY BOND FU	20.00%
	10	TIP	ISHARES TR US TIPS BD FD	40.00%
	11	XLI	SECTOR SPDR TR SBI INT-INDS	6.00%
	12	XLP	SECTOR SPDR TR SBI CONS STPLS	2.00%

Naturally, the 60% aggregate weighting in ultra-conservative bond positions like iShares Treasury Inflation Protected Fund (TIP) and ultra-short-term 1-3 year U.S. government treasuries in the iShares 1-3 Treasury Bond Fund (SHY) would cushion nearly any fall from grace. What's more, the 40% weighting in stocks tends to favor more conservative equity areas like Consumer Staples (IYK, XLP) and Health Care (IXJ, IYJ). Of course this portfolio would lessen one's risk.

Yet how is a portfolio like this really going to perform if volatility declines? More specifically, many of us seem to be obsessed with lowering the volatility of our portfolios at a time when volatility may have already peaked? And if that's the case, if volatility has peaked, does one want a portfolio that is 1/2 the volatility of a market that may cut its own volatility in half? (Just putting out the hypotheticals!)

There's plenty of evidence to suggest that volatility will decline substantially in '09. Right now, the measure for stock price fluctuations for the past 30 days (sometimes called Historical Volatility) and an estimate of volatility for the next 30 days (sometimes called Implied Volatility) are at the widest gap since the crash of October 1987. This means that options traders are aggressively betting that stock swings in the S&P 500 will decrease rapidly; they are paying much, much less to insure against stock price declines.

Declining volatility is usually positive for stocks, as it tends to show growing investor confidence. And the last time that the gap between Historical Volatility and Implied Volatility was this wide... stocks soared for 2 consecutive quarters well into 1988.

I haven't come across the definitive study for the best stock sectors or best asset allocation for declining volatility. Nevertheless, I suspect that a lazy buy-n-hold portfolio with 60% bonds and a large percentage of defensive equities alone may not be the answer.

You might choose to gradually raise your allocation to the broader asset class of stocks through areas like the iShares MSCI EAFE Index Fund (EFA) and total U.S. market indexes like the iShares Russell 3000 (IWV). You would incrementally purchase positions over the next 6 months of the current recession. And then, whether you hit a targeted appreciation goal, or whether you employ stop-losses for protection against uncertainty, or whether there's a substantial increase in volatility, you could sell.

If you want a lazy portfolio that should do well in 2009, I've got that too. Nevertheless, my preference is to be a bit more active. And if volatility measures continue to favor stock assets, indeed... I am going to see if anything catches my eye.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.