Low-volatility exchange traded funds have been the new favorite among investors since they allow exposure to the upside while limiting risk. There are risks that come with every investment tool and corner of the market, and low-volatility ETFs are no exception.
Most low-volatility ETFs have some exposure to the financial sector, therefore these funds all have some of the same risk factors. Even if the asset classes are different, investors are still exposed to the same risks with every low-volatility fund.
"This should lead investors to question what happens to these funds if the source of the next market downturn is an issue that hits financial stocks disproportionately hard. In that scenario, can the funds truly be counted on to deliver on their objective of below-market volatility? There's a good chance they won't, but investors have no way to tell as yet since the funds have little to no track record," Daniel Putnam wrote for InvestorPlace.
- There is no 100% guarantee that the ETF will perform or deliver as anticipated. For example, the PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV) invests in 100 stocks within the S&P 500 that have the least realized volatility over the past 12 months. This is the key - past 12 months - because the stock market has had a low level of volatility lately does not mean that it will going forward. The index is re-balanced quarterly, so this does help rotate riskier stocks.
- Sector over-concentration is risky in any fund or portfolio. SPLV is highly concentrated in utilities and consumer staples, two sectors that are known for defensive traits. For now, consumer staples is a sector that is trading at valuations above its historical average, which helps current performance.
- Most low-volatility ETFs are intended to be held for the long term. SPLV has given investors an umbrella during stock market downturns, over the long haul, but when markets are rallying, investors do miss out on some potential upside. Should there be a long term uptrend in the stock market, the question of missing out on some profit in order to gain downside protection becomes an issue.
Over the past couple of years, SPLV has performed decently. The latest launches, such as the PowerShares S&P MidCap Low Volatility Portfolio, are too new to even have a small track record. In general, three years is enough time to gather a legitimate track record and for investors to decide if an ETF is really going to fit into their investment strategy.
PowerShares S&P 500 Low Volatility Portfolio
Tisha Guerrero contributed to this article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.