2 ETFs For A Rocky Market: Low-Volatility Is Another Way To Say Value Investing

Includes: ACWV, SPLV
by: YCharts

by Carla Fried

It's back. Volatility, that is. At the start of June, the S&P 500 stock index had taken a near 10% haircut since an early April peak. During the same stretch, market volatility-- as measured by the CBOE's VIX Index-- had soared:

^SPXTR Chart

^SPXTR data by YCharts

Europe's deepening crisis and our lousy jobs report made for an ugly start to the official summer season.

Heading for the sidelines is one way to deal with the recent turmoil. Only problem with that is potentially missing the early stages of any rebound. Remember how fast the markets rallied after last summer's swoon?

^SPXTR Chart

^SPXTR data by YCharts

July through September 2011 was indeed ugly:

^SPXTR Chart

^SPXTR data by YCharts

Yet the turnaround was swift; with the S&P 500 gaining 11% in just the month of October alone:

^SPXTR Chart

^SPXTR data by YCharts

For investors determined to stick with stocks but not loving the latest Maalox-inducing moments, plugging into low-volatility exchange traded funds (ETFs) can be an intriguing solution.

The PowerShares S&P 500 Low Volatility ETF (NYSE:SPLV) ranks the stocks within the market benchmark according to their standard deviation (the volatility bogey here) over the trailing 252 trading days. The 100 stocks with the lowest volatility make it into the low-volatility ETF; the lower a stock's volatility score, the bigger its weight in the ETF.

Let's take a look at how the PowerShares SPLV performed relative to the straight-up S&P 500 during the past two months:

^SPXTR Chart

^SPXTR data by YCharts

No wonder SPLV assets have grown to about $1.7 billion in its first year of trading.

For a global low-volatility approach, the iShares MSCI All Country World Minimum Volatility ETF (NYSEARCA:ACWV), launched last fall, carves out the lower volatility stocks from the MSCI All Country World index, which is comprised of stocks from 24 developed countries and 21 emerging-market countries.

During this spring's sell off, the low-volatility ETF lost less than half as much as the ETF that tracks the overall MSCI All Country World index:

ACWV Total Return Price Chart

ACWV Total Return Price data by YCharts

Clearly, the low-volatility approach has delivered in down markets, as you'd expect. But in up markets -- (remember them?), a low-volatility portfolio isn't going to be the pacesetter. In the chart below, the two top performers are ETFs that track the "regular" S&P 500 index and MSCI All Country World index. The bottom two are the low-volatility takes on both indexes. (NOTE: ACWI didn't launch until mid-November last year.)

SPLV Total Return Price Chart

SPLV Total Return Price data by YCharts

Now if that last chart has you thinking the low-volatility approach is just for skittish wimps, slow down for a sec. The ETFs tracking low-volatility indexes are too new to give us any long-term data to chew on.

But the folks at Standard & Poor's did some back-testing of its low-volatility slice of the S&P 500. As expected, the low-risk approach did indeed clock in with a standard deviation about 30% lower than the regular index. Less expected: the low volatility index outperformed the regular index. Over the 20 years through 2011 (plenty of good and bad markets) the low-volatility index had an annualized return of 9.9% compared to 7.8% for the benchmark S&P 500. (For what it's worth, in 2008 the low-volatility tranche lost 21.4%, a helluva lot better than the 37% decline for the full S&P 500.)

How can that be? Well, at its core, low-volatility is just another way to say value investing. And over long periods, that has proven to be a pretty smart way to invest.

That said, low-volatility ETFs shouldn't take over your portfolio. Given their strong value tilts, you're going to get some funky sector weightings. For example, 28% of SPLV is invested in the consumer staples sector and another 27.5% in the utilities sector. In the regular S&P 500, consumer staples accounts for 11.5% of the index and utilities less than 4%. Given those overweights, low-volatility sets up nicely as a complement to your core strategy. In the long-term you may just have your cake (less volatility) and be able to eat it too (better overall returns.)

Disclosure: No positions