By Christian Magoon
CEO and Founder, Magoon Capital
(Exclusive to NASDAQ.com) The S&P 500 has been nothing short of choppy over the last month after a good start to the year. Unfortunately for investors, the recent trend in volatility has been to the downside since the beginning of April. Here's an annotated chart from stockcharts.com showing the SPDR S&P 500 ETF (SPY) year to date performance. Note the circled decline and the continued bounce off of lows.
More Bumps Ahead
Going forward the volatility is likely to continue due to a possible slowing of the U.S. economy and European fiscal drama. This places investors in a dilemma. Most need equity exposure but want to reduce risk exposure in a market that is trending downward. Understanding this dilemma, the ETF industry has developed several funds over the the last year designed to provide a solution to the risk and reward equation. These ETFs focus on reducing volatility, an appealing characteristic to investors in difficult markets.
The Low Volatility Anomaly
One way to combat downward volatility in the markets is to invest in a subset of securities that have lower volatility than the market. While this theoretically limits upside movement, it also can limit downside movement, which might actually be more import. Dubbed "the low volatility anomaly," data shows that investors who take on less risk tended to outperform those taking on more risk. Here's an informative snippet from PowerShares, an ETF provider with the largest low volatility ETF, explaining this anomaly.
Two ETFs in the marketplace today from PowerShares and Russell incorporate a low volatility approach focused on domestic large cap stocks. For most investors, domestic large cap stocks represent the largest allocation to equities and thus a key area to begin to reduce downward volatility in a portfolio.
The first fund, the PowerShares S&P 500 Low Volatility ETF (SPLV) owns a basket of S&P 500 stocks with the lowest realized volatility over the last 12 months. The portfolio is reconstituted every quarter to update movements in the market. SPLV has shown stability during times of S&P 500 declines and has outperformed the broad based index since inception. It charges an expense ratio of 25bps.
The second large cap ETF focused on low volatility stocks is the Russell 1000 Low Volatility ETF (LVOL). This ETF owns a basket of stocks selected from the Russell 1000 primarily based off 60 day volatility. The analysis and ETF portfolio selection is performed every month in order to capture market moves. LVOL charges an expense ratio of 20bps.
So how have these low volatility ETFs performed since the April market swoon?
Here's the performance chart of SPLV and LVOL, as well as their respective benchmarks, since the April decline. As expected both ETFs (in blue and purple) have outperformed during the choppiness.
These ETFs have shown their value in the most recent downturn, but how have they done over the longer term? Do they deliver on the upside as well? Here's the performance graph of both ETFs and related indexes going back to the most recent ETF's inception in 2011. (LVOL, May 2011)
Again both ETFs have outperformed their respective benchmarks, in a period of positive benchmark returns no less. Could this be "the low volatility anomaly" at work in the real world? Perhaps, but more time is needed to evaluate the performance of these ETFs to make the claim with certainty.
For investors stuck in a risk versus reward dilemma given current market conditions, low volatility ETFs may be worth taking a closer look at. Like a quality suspension system on a car, these ETFs may deliver a smoother ride through all types of conditions.
Please note: This article is not to be taken as investment advice nor is it an offer to buy or sell a security.