Low-Volatility ETFs Still Hot Despite Collapsing VIX

by: Tom Lydon

Investors are still battle-scarred from suffering through two brutal market pullbacks since 2000. They can't seem to shake off the dot-com bust and subprime meltdown despite SDPR Dow Jones Industrial Average ETF (NYSEARCA:DIA) breaking out to record highs.

That's a big reason why low-volatility ETFs continue to sell at a rapid pace despite the CBOE Volatility Index, or VIX, dropping to its lowest level since 2007.

Low-volatility ETFs provide investors the ability to track broad markets with some downside protection. The low-volatility strategy has a number of academic studies to support the rationale behind the investment idea, according to VIX and More, but it is better illustrated with a side-by-side comparison.

For instance, the PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV), which tracks 100 of the least volatile stocks of the S&P 500, has increased 18.1% over the past year while the S&P 500 index gained 16.2%.

"Why have low-volatility stocks posted such great risk-adjusted returns? The best explanation is leverage aversion," explains Morningstar analyst Samuel Lee. "Investors who target above-market returns may be unwilling or unable to use leverage to reach their expected-return targets. By resorting to volatile stocks (more accurately, high-beta stocks), which theoretically should outperform less-volatile stocks, they hope to earn above-average profits. Ironically, their collective bet on high-beta stocks leads to low risk-adjusted returns."

Other ETF sponsors have also entered into the space, such as BlackRock with the iShares MSCI USA Minimum Volatility ETF (BATS:USMV).

Moreover, the industry has also launched a range of international low-volatility products, such as the Shares MSCI EAFE Minimum Volatility ETF (BATS:EFAV), iShares All Country World Minimum Volatility ETF (NYSEARCA:ACWV) and PowerShares S&P International Developed Low Volatility (NYSEARCA:IDLV). In addition, there are some that focus on the emerging markets, like the iShares MSCI Emerging Markets Minimum Volatility (BATS:EEMV) and PowerShares S&P Emerging Markets Low Volatility (NYSEARCA:EELV).

Earlier this month, PowerShares further segmented the U.S. market, launching the PowerShares S&P Mid Cap Low Volatility Portfolio (NYSEARCA:XMLV) and the PowerShares S&P Small Cap Low Volatility Portfolio (NYSEARCA:XSLV).

Nevertheless, low-volatility ETFs could underperform larger indices in short-term market rallies because they do not include the riskier, and potentially more profitable, stock picks. For instance, SPLV gained 8.7% over the past three months while the S&P 500 rose 10.0%.

Max Chen 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.