Each individual investor has a unique appetite for risk that should be respected when constructing a portfolio of ETFs to weather the market’s machinations. While some investors are more aggressive or trading oriented, others might lean towards a conservative mix of assets to meet their goals. Both styles should be embraced despite the tendency to not understand the risk-taking mentality of the opposite group.
But how do you define risk in the market on an intra-day basis using ETFs?
These passive indexes are excellent barometers of market strength and weakness that can indicate higher or lower risk taking depending on intra-day leadership groups. One methodology that I have watched my friends at ETFdb.com implement on a daily basis through their twitter account @ETFdb is through the use of high beta, market benchmark, and low volatility ETFs.
While your choice of each category can vary depending on your focus or experience, the use of these three funds will give you a solid barometer of large-cap sentiment.
- PowerShares S&P 500 High Beta Portfolio (SPHB)
- SPDR S&P 500 ETF (SPY)
- PowerShares S&P 500 Low Volatility Portfolio (SPLV)
As you can see on the performance comparison chart over the last year, these three funds have moved in a predictable fashion given the bullish uptrend. High beta stocks have led and low volatility equities have lagged the broader market. In addition, it’s worth noting that during periods of heightened price action, that high beta area tends to gyrate more swiftly than the other two indexes.
While nearly every investor is familiar with the makeup and general volatility of the S&P 500 Index, deconstructing the other two ETFs can provide additional insight into the reasoning behind their performance.
SPHB is consists of 100 stocks within the S&P 500 Index with the highest sensitivity to market movements over the last 12 months. Each holding within the index is given an equal weighting and rebalanced quarterly to ensure that allocations are kept in line with expected returns.
Not surprisingly, the largest sectors within this ETF include: consumer discretionary, financials, and technology companies. Fast moving stocks such as Facebook (FB) and First Solar (FSLR) highlight some of the top holdings that have risen to the apex since the previous rebalancing. SPHB has over $290 million in total assets and charges an expense ratio of just 0.25%.
SPLV on the other hand is devoted to 100 of the lowest volatility stocks within the S&P 500 Index over the last 12 months. The index is constructed in a similar fashion to SPHB, with each constituent given an equal share of assets. This style of conservative investing has exploded in recent years and allowed SPLV to accumulate a significant asset base of over $4.5 billion.
One unique characteristic of SPLV is its focus on quality and high dividend paying stocks. This includes large allocations to sectors such as: utilities, financials, and consumer staples companies. As a result, this ETF has an SEC yield of 2.49% and income is distributed monthly to shareholders.
Evaluating Changes In Risk
When examining these three ETFs on a short or intermediate-term basis, you get a direct sense of where the pockets of strength are by noting the leading fund. Typically during defensive days, SPLV would take over as the dominant percentage gainer, while SPHB would significantly lag its peers. The opposite effect will likely occur when risk taking resumes and momentum stocks are flying.
Another proxy for high beta stocks is the iShares Russell 2000 ETF (IWM), which tracks a broad index of small cap equities. This can be used as a separate confirming indicator of risk to pair with the large-cap oriented SPHB.
Keeping an eye on the fund flows for these ETFs may also provide some additional longer term insight into investor behavior as well. Asset accumulation in low volatility areas might indicate risk aversion even as the market continues to move higher.
Evaluating these trends and correlations may provide greater insight into the appetite for risk in the current environment and enhance your investment process.