With all the volatility in the market, investors may be hesitant to reinvest in equities and/or increase their allocation to the asset class until economic data begins to show some positive signs. The problem with that approach is that the stock market usually leads economic growth by anywhere from 6-9 months, depending on which research piece you've read. So how can anyone participate in a sudden rise in equities without exposing themselves to a timing mistake of disastrous proportions? One way to do this is to invest in equities through the PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV).
The PowerShares S&P 500 Low Volatility Portfolio ETF is an ETF based on the Standard & Poors Low Volatility Index. It provides investors with exposure to the equity markets, namely the S&P 500, without the volatility of the S&P.
What I like most about this index is that it is the easiest to understand of the several low vol indexes currently out there. There is no optimal allocation that is unknown to the investor and no dynamic adjusting to target a set level of volatility.
It's simple. The S&P Low Vol index measures the standard deviation of each of the S&P 500 stocks every quarter for the previous one year period. It then ranks these stocks from lowest standard deviation to highest standard deviation and identifies the top 100 stocks. (Those with the lowest standard deviation). It then weighs those stocks by the relative volatility of each stock as a percentage of the volatility of all 100 stocks. That's it. A colleague bet me I couldn't explain it in less than a paragraph and guess what? I'm one dollar richer.
The result is a fund that has approximately 70% of the volatility of the S&P 500 index. Now this could be good or bad. In a declining market, it will be good. But if the equity market all of a sudden reacts to news that the European crisis has been resolved, China is growing like gangbusters again, the unemployment rate drops to 7%, job growth hits 300,000 in the U.S., fireworks start exploding in the air, and the 1812 Overture is glaring in the background, well, then, this ETF will underperform. But it may still capture 70% of the upside! In addition, it pays a dividend yield of 3%+. Not bad if you ask me.
If we take a close look at the index (and by index, I am also referring to SPLV), you will notice that there are certain sectors that dominate the allocation within the fund. This makes sense, for example, since certain sectors have companies in them whose stocks are more defensive in nature (i.e. less volatile). The largest sector allocation as of March 31st 2012 was to Consumer Staples at around 30%, and Utilities, also around 30%. The next highest sector allocation is Healthcare with 13%, and every other sector has less than 10%. The average allocation to each sector is slightly different: Utilities 25%, Consumer Staples 17.5%, Financials 15%, and Industrials 12%, to name the top 4.
While certain sectors tend to be overweight in the index, it has changed quite dramatically during periods of diversion among sectors. For example, the financial sector weighting decreased from almost 35% in mid-2007 to less than 5% at the beginning of 2008, as the volatility of financials continued to increase, causing them to fall from the Top 100 Low Vol stocks. The performance results were quite impressive.
The interesting observation about the historical performance of SPLV, is that you might expect it's returns to somehow have some correlation to the S&P 500. But if we look at the last 1, 3, and 5 year periods, SPLV has outperformed the S&P 500:
|Asset||1 year annualized||3 year annualized||5 year annualized|
|S&P 500 Index||8.30%||14.02%||0.86%|
|S&P Low Vol Index||18.62%||17.54%||6.26%|
Most of the outperformance was a result of losing less in 2008.
While the Powershares S&P Low Volatility Index Portfolio hasn't been around for very long, the S&P Low Vol Index has, and the results are quite impressive. Now that's its made "investable" through the SPLV, it is a great way to 1. slowly get back into the market; 2. add exposure to equity without the corresponding volatility; and/or 3. make it as part of the core of your portfolio holdings within the US Large Cap Equity space.
With this type of investment vehicle available with daily liquidity, an investor should no longer be trying to time the market. A task even the most talented of traders has not been able to do consistently over time. So dive in, head first, if you will, into equities, but instead of investing in the SPDR S&P 500 (SPY), just make sure you're wearing the SPLV helmet instead.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.