Low volatility ETFs, which have gained immense popularity in recent years, have been losing their appeal since the last couple of months despite the prevalent volatility. Investors are flocking to high-risk securities given an improving U.S. economy, strengthening job prospects, recovering housing fundamentals, rising consumer confidence and of course a higher spending power buoyed by cheap oil.
While strong dollar, sliding oil prices , global growth concerns and geopolitical risks had kept the stock returns at check for most of the first quarter, cheap money flows into the global economies as well as delay in interest rates hike by the Fed have attracted huge capital into the stock markets. This is especially true as the S&P 500 is just less than 1% away from the all-time high and could hit another record anytime soon given a big rebound in oil prices, improving global economies, strong seasonality and a positive market momentum (read: 3 Energy ETFs Leading The Oil Rally ).
Amid bullish conditions, low volatility ETFs have underperformed the broader market and will likely continue doing so in the coming weeks. This is because these funds include those stocks in their portfolio that have shown more stability in the past and have experienced the least price movement. Further, these funds contain stocks of rate sensitive sectors, which are lagging since the Fed's latest dovish comments.
Given this, we have highlighted three low volatility ETFs tracking the large cap, mid cap and small cap segments of the U.S. market and the reasons for their underperformance:
PowerShares S&P 500 Low Volatility Portfolio ( SPLV )
This is the largest and the most popular ETF in the low volatility space with AUM of $5.2 billion and average daily volume of around 1.7 million shares. The fund charges 25 bps in annual fees and has added just 0.4% in the year-to-date timeframe. This is much lower than the gains of 2.9% for SPDR S&P 500 ETF ( SPY ), which tracks the S&P 500 index.
The fund provides exposure to 100 U.S. large cap stocks from the S&P 500 index with the lowest realized volatility over the past 12 months. The fund is widely spread across number of securities as none of these holds more than 1.38% of assets. More than one-third of the portfolio is tilted toward utilities, which is one of the worst performing sectors of 2015 so far. In addition, the ETF lacks exposure in the energy sector, which was the major gainer over the past month (read: Time to Worry About Utility ETFs? ).
PowerShares S&P MidCap Low Volatility Portfolio ( XMLV )
This ETF targets the mid cap segment with stocks having the lowest realized volatility over the past 12 months selected from the S&P MidCap 400 Index. The fund has amassed $94.4 million in its asset base and trades in light volume of 25,000 shares a day on average. Expense ratio came in at 0.25%. The product holds 77 stocks in its basket with none accounting for more than 1.76% share (read: 3 Top-Ranked Mid Cap ETFs to Buy Now ).
In terms of sector, financials dominate the fund's return with more than half of XMLV. Though the financial sector had done better in the early part of the year due to interest rate hike speculations, its gains eroded last month following dovish comments from the Fed. Here again, the ETF lacks energy sector exposure. XMLV is up 2.82% so far this year versus the gain of 6.3% for iShares Core S&P Mid-Cap ETF ( IJH ), which tracks the S&P MidCap 400 Index.
PowerShares S&P SmallCap Low Volatility Portfolio ( XSLV )
This fund offers exposure to 120 low volatility small cap stocks selected from the S&P SmallCap 600 Index. It is well spread out across various components as each security holds less than 1.5% of total assets. The product is heavily dependent on the financial sector at 55%, followed by industrials (13.4%) and utilities (10.7%).
XSLV has AUM of $84.6 million and sees light volume of 23,000 shares a day on average. It charges 28 bps in annual fees and expenses. The fund has added 1.2% so far this year while iShares Core S&P Small-Cap ETF ( IJR ) tracking the S&P SmallCap 600 Index is up 4.8% (read: Can Small Cap Low Volatility ETFs Continue Their Hot Streak? ).
Given the current bullish trends, investing in low volatility ETFs do not seem a good strategy at present. This is because these ETFs generate impressive returns by protecting downside risk in an uncertain or a crumbling market. And the stock market currently seeing in upswing with a lot of upside arising from improved economic activities.
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