By John Spence & Tom Lydon
PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV) is the largest and oldest low-volatility ETF but a rival fund managed by BlackRock's iShares is actually the category's best seller in 2013.
SPLV has gathered net inflows of $781 million year to date compared with $1.43 billion for iShares MSCI USA Minimum Volatility (NYSEARCA:USMV), according to ETF flow data from IndexUniverse.
Low-volatility ETFs have been immensely popular with investors who want stock-market exposure with some downside protection built in. The funds participate in the market's upside although they will lag in frothy rallies. Still, low-volatility ETFs appeal to skittish investors who have been burned by a pair of jarring bear markets since 2000. Also, financial advisors are using low-volatility strategies to ease clients into equities.
"From conversations with several fund sponsors in recent weeks, it seems clear that many such firms are looking to add products in this [low-volatility] space," says Nicholas Colas, ConvergEx Group chief market strategist. "'Min Vol' is max-hot."
In the first two months of 2013, the 34 low or minimum volatility exchange traded products gathered on average $926 million in new assets each month, more than double what was added to them a year earlier, according to S&P Capital IQ.
"In this group are ETFs that offer exposure to U.S. markets, international markets and emerging markets. Most of the ETFs are from iShares and PowerShares, although in February 2013, State Street Global Advisors launched two low volatility products tied to domestic Russell indices," S&P notes.
According to academic studies, low-volatility stocks outperform the market over longer periods, and with stellar risk-adjusted returns. The phenomenon is seen as an anomaly in modern financial theory, but low-volatility strategies have been popular with large institutional investors in recent years.
A tale of two low-volatility ETFs: PowerShares vs. iShares
SPLV and USMV are the two largest low-volatility ETFs with assets of $4.2 billion and $2.3 billion, respectively. Both focus on U.S. stocks.
However, the ETFs' stock and sector allocations are different because their tracking benchmarks don't take the same approach to building a portfolio of low-volatility stocks.
For example, SPLV's construction is "admirably simple and transparent," says Morningstar analyst Samuel Lee.
The index consists of the 100 stocks from the S&P 500 with the lowest realized volatility over the past 12 months.
"The index weights stocks by the inverse of their volatilities, so steadier stocks take a bigger share of assets," Lee writes in a report on the ETF. "In practice, the fund is close to equal-weighted because stocks' individual volatilities tend to be less divergent than their market capitalizations. Naturally, with a low-volatility bent, the fund emphasizes defensive sectors such as utilities and consumer staples."
SPLV has 30.7% in utilities and 24.4% in consumer staples, according to manager Invesco PowerShares. The ETF charges an expense ratio of 0.25%. The fund has posted a total return of 11.9% year to date, compared with 10.2% for the S&P 500.
USMV, the iShares ETF, has a more complex approach. The MSCI USA Minimum Volatility Index tries to build the least-volatile portfolio of U.S. stocks, but with certain restrictions.
"The constraints revolve around trying to keep the index diversified on both stock and sector levels, while capping turnover," says Lee at Morningstar. The constraints include keeping stock weights within 0.05% to 1.5% of the portfolio, sector weightings within 5% of the market-weighted index, and a one-way turnover of 10%.
"The model may help reduce inadvertent tilts beyond simple low volatility equity exposure but introduces some uncertainty as to how the strategy will behave in the future," Lee adds. "Despite this, we're confident the portfolio will be less volatile than its market-weighted parent index."
USMV is more diversified in terms of spreading the portfolio more evenly across sectors. For example, no one sector accounts for more than 18% of the fund.
USMV holds 126 stocks and levies an expense ratio of 0.15%. The ETF has gained 12.3% so far this year.