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A $700 Million Low-Volatility ETF? Who Knew?

(Updated to reflect fee waivers on Russell ETFs.)

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The Invesco PowerShares S'P 500 Low Volatility Portfolio (NYSEArca:SPLV) has gathered more than $700 million since its launch in May, more than almost any other fund launched this year, trouncing the competition in the relatively new low-volatility ETF space. So what’s the secret to SPLV’s success besides the fact that it was first to market?

First, SPLV’s returns are positive since launch—it’s up almost 2.5 percent in the past six months. In comparison, the SPDR S'P 500 ETF (NYSEArca:SPY) has fallen about 4.5 percent, and two competing funds in the low-volatility fund market from Russell aren’t even in the black. SPLV has an annual expense ratio of 0.25 percent, 5 basis points above one of the Russell funds and 5 basis points below the other.

A year ago, low-volatility funds didn’t exist. But now with the global economy facing huge uncertainties, exchange-traded fund sponsors—including the world’s biggest ETF firm, iShares—are lining up to bring out products to help investors navigate financial markets that have been volatile since stocks collapsed in 2008. So far, SPLV, with $733.1 million in assets and counting, is a head and shoulders above the crowd.

“What we are looking to do with SPLV is to provide investors some degree of protection in falling markets,” Taylor Ames, senior equity product strategist at Invesco PowerShares, said in a telephone interview. “We believe that over an entire market cycle that cushioning will help portfolios in the long run.”

Ames also argued that SPLV deserves a permanent presence in investment portfolios.

However, investment advisors are divided on that score. Some call it “market timing light,” while others suggest that the fund’s indexing methodology makes sense only in unsettled times.

The Competition

Russell launched two low beta funds just after SPLV in late May 2011, but they haven’t come close to matching SPLV’s performance.

The Russell 1000 Low Volatility ETF (NYSEArca:LVOL) has $28.7 million under management and has declined 0.75 percent in the past six months, while the Russell 2000 Low Volatility ETF (NYSEArca:SLVY), with $4.6 million under management, is down almost 5 percent in the past six months.

Then there’s iShares’ jump into low-volatility funds. The firm launched four funds in October that canvas virtually the entire universe of equity investment. The new ETFs and their expense ratios are:

  • iShares MSCI USA Minimum Volatility Index Fund (NYSEArca:USMV), 0.15 percent
  • iShares MSCI EAFE Minimum Volatility Index Fund (NYSEArca:EFAV), 0.20 percent
  • iShares MSCI All Country World Minimum Volatility Index Fund (NYSEArca:ACWV), 0.35 percent
  • iShares MSCI Emerging Markets Minimum Volatility Index Fund (NYSEArca:EEMV), 0.25 percent

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Of the four, EEMV has gathered the most assets—almost $20 million as of Dec. 14, according to data compiled by IndexUniverse. That’s probably a reflection of the popularity of emerging markets investments in general, and perhaps the greater degree of volatility of developing-world stocks.

The expense ratios on the iShares funds are also alluring, though shopping on price doesn’t make much sense if performance isn’t up to snuff. As far as that goes, it’s still too early to say much about these funds’ returns.

SPLV Under The Hood

SPLV was the first fund of its kind, and could be enjoying the first-to-market advantage everyone says is so important in the ETF industry. Still, Russell’s LVOL and SLVY came to market just a few weeks later, which doesn’t seem like much.

So far, their competitive price tags—LVOL and SLVY cost 0.20 percent and 0.30 percent, respectively, after 30 basis point fee waivers—don’t seem to have caught investors’ attention.  Again, SPLV comes with a 0.25 percent for SPLV annual expense ratio.

Whatever the reasons for SPLV’s success, officials at PowerShares and at S'P, the index provider, say the simplicity of the fund’s indexing methodology may be helping.

SPLV employs a standard deviation strategy, which measures volatility of all 500 stocks in the S'P 500 Index and then whittles the listed companies down to the 100 with the least volatility. The 100 survivors are then weighted in a way that reflects their level of volatility. This screening takes place quarterly.

“Our methodology is really quite simple,” said Craig Lazzara, senior director of the S'P 500 U.S. Equity Indices, which developed the low-volatility index for SPLV. “We tried the more complicated way, but this works better.”

The Russell funds, by comparison, use a “risk factor model” developed in conjunction with Axioma Risk Analytics that “is probably more sophisticated” said Rolf Agather,director of index research and innovation at Russell Indexes.

“Because we also use an optimizer, we can also tell it to dampen down some of the other factors that might creep into a stock’s return,” such as beta, size, and momentum, Agather said.

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Naysayers

Whatever the relative merits of different indexing strategies, some investment advisors question whether SPLV and other funds like it are really a good choice over the long haul. Regarding SPLV, they cite the fund’s own backtesting results going back to 1990, which show significant underperformance during the long bull market in stocks in the 1990s.

“Nobody would have touched this with a 10-foot pole,” said Rick Ferri, founder of Portfolio Solutions, a Troy, Mich.-based based advisory firm specializing in asset allocations using ETFs. “It so significantly underperformed the market that by its peak in March of 2000, the low-volatility index had underperformed by the cap-weighted S'P by more than 50 percent.”

What’s more, Ferri said that when it comes to volatile times, SPLV offers the worst of both worlds.

“If you have the ability to know when the S'P 500 is going to outperform, why don’t you just leverage long the S'P 500?” he said. “And if you have the foresight to know that it is going to underperform, why don’t you just short or sell futures against the S'P 500?”

Ferri says that SPLV is what he terms a “market timing light” investment vehicle that’s best suited for pension fund advisors and institutional investors with strict mandates to invest in plain-vanilla equities.

Tool For Troubled Times

But Lazzara of S'P 500 U.S. Equity Indices says evidence shows that the low-volatility segment of the equities market outperforms the overall market over the long term, partly because low-volatility stocks lose less in down markets, even if they also gain less in rising markets.

In other words, as PowerShares’ Ames says, investors in SPLV may well have less lost ground to make up when the market turns higher.

“WhatÂmany people don’t understand is that in volatile markets, anytime you fall, you have to come backÂup so much farther just to break even,” said Ames. “When you are able to reduce your volatility, as this product has shown, itÂcan help provide a buoy.”

Some advisors don’t find SPLV to be terribly exciting, but they say that in the current volatile market, SPLV makes sense.

“It is going to lag in an up market,” said William Koehler, chief investment officer of the Kansas City-based ETF Portfolio Advisors. “This is not something we would invest in during the 1980s or the 1990s, but we are not in either of those decades.”

Koehler says that most investment advisors he knows have been trying to create low-volatility portfolios on their own, and that SPLV has made it easier for them to do so. Although to his mind, SPLV should be somewhere between a core and a satellite position.

And what happens when the markets do heal and the market turns higher? Talk to folks at PowerShares and they say they have a fund for sunny days too. It’s called the PowerShares S'P 500 High Beta ETF (NYSEArca:SPHB) and it seems to have attracted $28 million worth of contrarians.

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Copyright ® 2011 IndexUniverse LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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