4 Reasons To Consider A Low Volatility Approach To Small-Cap Stocks

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Summary

The low volatility anomaly postulates that stocks with lower volatility produce higher risk-adjusted returns than stocks with higher volatility.

There are four reasons investors seeking exposure to the small-cap sector may want to consider an allocation that exploits the low volatility anomaly.

The PowerShares S&P Small Cap Low Volatility Portfolio ETF is one way that investors can gain exposure to this theme.

By Nick Kalivas

Between Dec. 31, 2013, and Nov. 19, 2014, large-cap stocks outpaced small caps by 11.26% (the S&P 500 Index returned 12.87% versus 1.61% for the S&P 600 Index).1 Given this recent underperformance, and given that small-cap valuations are stretched compared with large caps, investors seeking exposure in the small-cap sector may want to consider an allocation that exploits the low volatility anomaly.

What is the low volatility anomaly?

The low volatility anomaly postulates that stocks with lower volatility produce higher risk-adjusted returns than stocks with higher volatility, turning the academic theory of "increased return for increased risk" on its head. One way to seek the potential benefits of this anomaly in the small-cap sector is through the PowerShares S&P SmallCap Low Volatility Portfolio ETF (NYSEARCA:XSLV).

Since its inception on Feb. 15, 2013, XSLV has generated a 0.80 beta to the S&P 600 Index and standard deviation of return of 12.40% compared to 14.78% for the S&P 600 Index, which indicates lower volatility.2 Moreover, between Feb. 15, 2013, and Oct. 31, 2014, it produced a return of 18.83% - just three basis points less than the S&P 600, highlighting its ability to participate in market rallies.2 The combination of return and risk has allowed XSLV to obtain a Sharpe Ratio of 1.39 compared to 1.16 for the S&P 600 Index.2

Why low volatility may make sense in the small-cap space - Reason No. 1: Small caps have generated an extended period of outperformance

The graphic below displays the relative price of the S&P 600 Index (small cap) to S&P 500 Index (large cap). Notice that small caps outpaced large caps between early 1999 and late 2013. The sharp outperformance may not signal the run is done, but it does suggest investors may want to evaluate the risks in the small-cap sector more closely, and the low volatility anomaly may provide an avenue for upside participation while mitigating the risk that small caps go out of favor compared to large caps.

On a side note, XSLV has a 30-day SEC yield of 2.32% compared to dividend yield of 1.35% for the S&P 600 Index.3 The higher yield could help if small caps go through a period of sluggish performance.

KALIVAS_BLOG_1202_chart1

Source: Bloomberg LP as of Nov. 20, 2014. Past Performance is not a guarantee of future results.

Reason No. 2: Small-cap valuations look expensive compared to large-cap valuations

The graphic also highlights that the PE ratio spread between the S&P 600 and S&P 500 is elevated, suggesting small caps may be relatively more expensive than large caps based on valuation. As of Oct. 31, the S&P 600 Index had a PE ratio of 21.4 compared to 16.8 for the S&P 500 Index. The premium was 11.8% above average seen since January 1995.2

This may provide another argument for an investment solution that has the potential to lower risk.

Reason No. 3: There is a small-cap story

The dollar has been strong recently, rallying over 11.0% from its May 2014 low, while overseas economic growth has been sluggish.4 The strong dollar and weak international growth suggest multinational companies face headwinds to their profit outlook. Small caps typically have less international exposure than large caps. As proof of relatively weak international growth, the flash eurozone Purchasing Managers Index (PMI) hit a 16-month low of 51.4 in October, while the Chinese flash manufacturing PMI eased 0.4 to just 50.0 in October.4 These numbers come on the back of the Japan's third-quarter 2014 gross domestic product contracting 1.6%. In contrast, the US October flash PMI was a more vibrant 54.7.4

Reason No. 4: In its current composition, low volatility may be a play on tighter monetary policy

Although the timing of a Federal Reserve rate hike is debatable, the US labor market is tightening and higher rates could improve the net interest margin and profitability for some financial stocks. Digging into the jobs opening and labor turnover survey from the US Bureau of Labor Statistics, the ratio of job openings to hiring is at survey highs and points to upward pressure on wage growth. A continuation of the trend could put pressure on the Fed to snug rates, which would benefit the financial sector.

Although weightings can change after quarterly reconstitutions, XSLV currently has over 50% exposure to the financial sector and has had material exposure to the financial sector since its inception Feb. 15, 2013.4

KALIVAS_BLOG_1202_chart2

Source: Bloomberg LP as of Nov. 20, 2014. Past Performance is not a guarantee of future results. Investments cannot be made directly into an index.

Investors interested in learning more about low volatility products can talk with their advisors and visit this page on our website.

KALIVAS_BLOG_1202_chart3

Market returns are based on the midpoint of the bid/ask spread at 4 p.m. ET and do not represent the returns an investor would receive if shares were traded at other times. Performance data quoted represents past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data quoted. After-tax returns reflect the highest federal income tax rate but exclude state and local taxes. Fund performance reflects fee waivers, absent which, performance data quoted would have been lower. After Tax Held and After Tax Sold are based on NAV. See invescopowershares.com to find the most recent month-end performance numbers.

1 Bloomberg LP as of Nov. 19, 2014

2 Bloomberg LP as of Oct. 31, 2014

3 Invesco PowerShares and Bloomberg LP as of Nov. 20, 2014

4 Bloomberg LP as of Nov. 20, 2014

Important Information

Volatility measures the amount of fluctuation in the price of a security or portfolio.

Risk-adjusted return measures the amount of return an investment provided relative to how much risk it took on.

Standard deviation is a measure of an asset's volatility, signifying how much its return varies from the average or expected return. A higher standard deviation indicates a more volatile, and therefore riskier, security.

A basis point is a unit that is equal to one one-hundredth of a percent.

Sharpe ratio is a measure of risk-adjusted performance, determined by dividing the amount of performance that a portfolio earned over and above the risk-free rate of return by the standard deviation of returns. A higher Sharpe ratio indicates better risk-adjusted performance.

Forward price-earnings (P/E) ratio is one measure of the price-earnings ratio that uses forecasted earnings (usually for the next 12 months or the next full fiscal year), rather than current earnings, for the calculation.

Price-earnings (P/E) ratio, also called multiple, is a common valuation metric for stocks that compares a stock's share price to its per-share earnings.

Price ratio compares the price of one security (or basket or securities) to another security (or basket of securities). In this case, the prices of two indexes are compared.

Spread represents the difference between two values - in this case, the P/E ratios of two indexes.

Net interest margin is the difference between interest earned and interest paid, which gauges how successfully a company (typically a bank) made its investments relative to its debt situation. A positive value indicates the company earned more from its investments than it paid in interest expenses. A negative value indicates the company might have been better off paying down its debt than investing elsewhere.

Beta is a measure of risk representing how a security is expected to respond to general market movements.

There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund's return may not match the return of the Underlying Index.

The Fund is considered non-diversified and may be subject to greater risks than a diversified fund.

Investing in securities of small-capitalization companies may involve greater risk than is customarily associated with investing in large companies.

Investments focused in a particular industry are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

Equity risk is the risk that the value of equity securities, including common stocks, may fall due to both changes in general economic and political conditions that impact the market as a whole, as well as factors that directly relate to a specific company or its industry.

Purchasing Managers Index: PMI surveys measure the economic health of the manufacturing, non-manufacturing and/or service sectors.

The S&P 500® Index is an unmanaged index considered representative of the US stock market. The S&P SmallCap 600® Index is a market-value weighted index that consists of 600 small-cap U.S. stocks chosen for market size, liquidity and industry group representation. The S&P SmallCap 600 Low Volatility Index is compiled, maintained and calculated by Standard & Poor's, consisting of 120 out of 600 small-capitalization range securities from the S&P SmallCap 600® Index with the lowest realized volatility over the past 12 months.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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