How Valuations Impact Low Volatility ETFs

Among factor-based exchange traded funds, low volatility products, including the PowerShares S&P 500 Low Volatility Portfolio (NYSE:SPLV), are undeniably popular. There are, however, drawbacks to low volatility ETFs. Those include the potential to miss out on some upside during bull markets and the possibility of being exposed to high valuations by way of these funds often being heavily allocated to defensive sectors.

SPLV is sector-agnostic. The ETF's underlying index holds the 100 S&P 500 members with the lowest trailing 12-month volatility. It's the benchmark's primary requirement, but there are no sector-level mandates. That said, defensive utilities and consumer staples names combine for over 31 percent of SPLV's weight.

Although those sectors account for a significant percentage of SPLV's weight and are traditionally viewed as expensive, that does not mean the low volatility factor itself is excessively valued.

Digging Deeper

Investors often focus on valuations as a predictor of future returns, which could make some skittish about the perceived lack of value in the consumer staples and utilities sectors.

If valuations are expensive, future excess return should conceivably be negative, while if valuations are inexpensive, future excess returns should ostensibly be positive, said PowerShares in a recent note. In other words, there should be some type of inverse linear relationship between valuation and excess return.

SPLV does offer some sector-level value. For example, financial services, the one sector widely viewed as a legitimate value bet, is the ETF's second-largest sector allocation at 20.4 percent. Nearly 36 percent of SPLV's holdings are classified as value stocks.

Some Surprises

It may surprise some investors to learn that when SPLV is expensive relative to the S&P 500, that can actually be a good thing.

SPLV has periodically outperformed in periods when it was expensive relative to the S&P 500 Index and has underperformed in periods when it was cheap relative to the S&P 500 Index, said Power Shares. Why is this? One explanation may be that the market bids up low vols premium for downside risk mitigation potential when the equity market is under stress. Conversely, the market may sell the downside risk mitigation premium when the market is strong. Thus, low volatility may appear expensive when it is likely to pay off, and appear inexpensive when its risk mitigation properties are less desirable.

Some investors are believers in SPLV as highlighted by one-day inflows of over $800 million into the ETF on Nov. 17.

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