How Low Volatility Powers This ETF

Less than three months into 2016, investors have absorbed plenty anecdotes, data and details about low volatility exchange traded funds, such as the PowerShares S&P 500 Low Volatility Portfolio (NYSE:SPLV). The low volatility factor merits the adulation it is getting this year. After all, SPLV is up 2.5 percent while the S&P 500 is down 0.7 percent.

That comparison is relevant because SPLV tracks the S&P 500 Low Volatility Index, which is comprised of the 100 S&P 500 stocks displaying the lowest trailing 12-month volatility. As an investment factor, low volatility, like other factors, has its critics. The most frequent criticism being that although ETFs like SPLV help investors skirt volatility, investors risk leaving something on the table during overt bull markets.

Just because SPLV advertises its low volatility ways in its name means the ETF reveals all of its advantages right off the bat. Closer examination of the low volatility anomaly further underscores the case for ETFs like SPLV.

Ample research and evidence point to the existence of a low volatility factor comparable to other factors such as beta or small size or cheap valuation. Because this seems to fly in the face of what we think we know about risk and return, the low volatility factor is often referred to as the low volatility 'anomaly.' The S&P 500 Low Volatility Index, for example, outperformed its parent S&P 500 (annual growth rate of 10.9% and 9.8%, respectively) despite exhibiting lower risk in the period between 1991 and 2015, according to a recent note from S&P Dow Jones Indices.

As was recently noted in this space, SPLV and its underlying index are unconstrained, meaning they are sector flexible. Said another way, the sectors that many investors associate with low volatility (telecom and utilities to name a pair), are not always the least volatile groups on the market. Even boring sectors can experience elevated volatility. Likewise, some other sectors can experience extended periods of significantly reduced volatility, meaning those groups can see their weights in SPLV rise as their volatility declines.

Predictably, the low volatility factor comes with a warning label of sorts. That being it works sometimes, but it can lag during more ebullient times for equities.

Low Vol has, of course, underperformed at times during this period, most notably during the inflation of the technology bubble. The chart below maps the five-year performance spread on a rolling basis for a better picture of how Low Vol has behaved over time. Recently Low Vols performance spread has drifted around zero, adds S&P Dow Jones Indices.