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Using ETFs to Reduce Volatility

Photograph by Raul Belinchon/
Photograph by Raul Belinchon/

February 27 (Bloomberg) -- As a financial adviser in California’s Bay Area, Jim Koch has a lot of tech industry clients with portfolios that make him nervous. “Most of them want to invest in tech stocks, so their portfolios have way more risk than they realize,” says the Alamo (Calif.)-based founder of Koch Capital. Investing in what you know can leave your livelihood and portfolio balance riding on just one volatile industry, he adds. That’s why when PowerShares launched its S&P 500 Low Volatility exchange-traded fund last May, he called it “a gift from the financial-innovation gods.”

The PowerShares ETF is one of a slew of new funds from companies, including IShares, Russell Investments and EGShares, that seek to reduce downside risk by investing in stocks with low volatility. They’ve attracted a great deal of interest from advisers such as Koch seeking to smooth out clients’ returns. The PowerShares ETF has over $1 billion in assets, which gives it a key liquidity advantage over its much smaller rivals. More assets means more trading, which can mean a better price for buyers and sellers. The fund has an expense ratio of 0.25% and a dividend yield just over 3 percent.

Risk-Return Puzzle

On the surface, these ETFs seem to achieve their goal. Standard & Poor’s back-tested the performance of its S&P 500 Low Volatility Index, which the PowerShares ETF tracks, to Jan. 1, 1991, and found that it was 24 percent less volatile than the S&P 500 and delivered a 9.6 percent annualized return through 2011. That beat the S&P 500’s 7.6 percent return.

That's not the way things are supposed to work in the investment world, where low risk is equated with low return.

The reason for that effect may be that money managers overpay for risky stocks, according to researchers at the Erasmus School of Economics in Rotterdam. Their 2007 study, “The Volatility Effect: Lower Risk without Lower Return,” suggests managers may do that because the stocks perform well in strong bull markets and draw money into their funds--even if the stocks do terribly in bear markets. Meanwhile, low volatility stocks tend to be boring steady-eddies that are often ignored and are thus underpriced. That leads to their subsequent outperformance.

Managing Expectations

Still, the developers of the new volatility indexes are leery of promising too much. “I wouldn’t recommend anyone engage in this strategy because the [back-tested] returns have been higher in the past,” says Craig Lazzara, senior director at S&P Indices. He says investors should expect both less downside in bear markets and less upside in bulls. “In a year where the market is doing really badly, it’s highly likely you’ll be down much less,” he says. “You’ll get sufficient participation on the upside but a reduced amount.”

Investors scared to be in stocks may use the ETFs to inch back into the market. Doug Sandler, an adviser at RiverFront Investment Group in Richmond, Va., is putting up to 10 percent of his conservative clients’ portfolios into the PowerShares ETF in place of bonds. “In the period we’re in now, the marginal dollars going into stocks are coming from bond investors,” he says. “That investor doesn’t care about beating the S&P 500. He cares about keeping his risks down.”

Concentrated Risk

Lagging in bull markets isn’t the only risk. A more dangerous one could be sector concentration. Some 31 percent of the PowerShares ETF is in utility stocks and another 29 percent is in consumer staple stocks such as Kellogg. Commodity price swings or changes in federal regulations or interest rates could affect utilities, which are often compared to bonds because of their high dividend yields.

The S&P low vol index has a natural control mechanism to deal with concentration risk, says Lazarra. If a sector becomes more volatile its stocks will be replaced with less volatile ones from other sectors. The index ranks stocks in the S&P 500 by their volatility levels over the past year and holds the hundred with the lowest, rebalancing once a quarter. So if something terrible happens to a sector in the space of three months, its weighting will drop. The downside to this is that you might miss out on a rebound in stocks.

Can the index react quickly enough to avoid damage from a sudden shock to a sector? Financial adviser Lee Munson of Portfolio LLC in Albuquerque has avoided the PowerShares ETF, in part because of what he observed in Japan last year. “Sector concentration killed low vol Japanese strategies last year when utilities blew up during the nuclear meltdown,” he says.

Those seeking more diversification could explore the IShares MSCI USA Minimum Volatility Index Fund. It tracks a low-volatility benchmark created by MSCI that's designed so sector weightings don’t vary from the overall market’s weighting by more than five percent. It has 8.4 percent in utilities.

The Russell 1000 Low Volatility ETF takes a different tack. It allows for sector concentration, but ranks stocks by their three-month volatilities and rebalances its portfolio every month. The downside of the strategy is that it increases the turnover of portfolio holdings, which means higher trading costs. To keep costs down, Russell has put in trading restrictions so that turnover can't exceed 12 percent in any month.

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