A common knock on low volatility exchange-traded funds is that these products are often heavily allocated to the consumer staples or utilities sectors or both. A common knock on those sectors, aside from criticisms regarding frothy valuations, is that those groups are inversely correlated to rising interest rates.
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Indeed, the PowerShares S&P 500 Low Volatility Portfolio (PowerShares Exchange-Traded Fund Trust II (SPLV)) is heavily allocated to those sectors. Utilities and consumer staples combine for almost 44 percent of SPLV's weight and are the ETF's largest and second-largest sector weights, respectively. However, this should not be surprising given the methodology used by SPLV's underlying index, nor should it be cause for alarm even if rates do rise.
Patience And Strategy
SPLV tracks the S&P 500 Low Volatility Index, which is home to the 100 S&P 500 stocks with the lowest trailing 12-month volatility. There have been times when SPLV's weights to utilities and staples are well below what is currently seen, reflecting either rising volatility in those sectors or significantly reduced turbulence in other groups.
Rising interest rates don't have to be an indictment of SPLV. Data prove as much.
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The correlation between higher interest rates and equity declines has grown tenuous in recent history. Since 1991, the S&P 500 has risen roughly twice as often as it declined. In 124 (of a total 307) months the 10-Year Treasury Yield increased; in those months, the S&P 500 declined only 27 percent of the time, said S&P Dow Jones Indices in a recent note.
S&P Dow Jones Indices analyzed performance data for the S&P 500 Low Volatility Index, SPLV's benchmark, through six different interest rate environments from the end of 1990 through the end of August 2016. On three occasions, the S&P 500 Low Volatility Index minus the S&P 500 returns was negative.
Interestingly, that happened in a static environment for Treasury yields, once when those yields rose and once when they fell. Still, the average negative differential in those periods was just 0.86 percent. The positive differentials for SPLV's underlying index were significantly more impressive, working out to 1.5 percent across a static environment for Treasury yields, once when those yields rose and once when they fell.
Consistently, defensive strategies outperformed in down markets and underperformed in up markets. This relationship holds regardless of whether interest rates were up, down or static. Defensive equity strategies are much more dependent on the direction of the equity market than the direction of the bond market, added S&P Dow Jones.
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