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How Low-Volatility ETFs Can Protect You From Wild Market Swings

The price for a smoother ride is lower returns

A good chunk of the stock market’s rewards, with less risk. That’s the promise of low-volatility exchange-traded funds. And if there were a time when the funds should prove their worth, it’s now. 

The goal of low-volatility ETFs is simple: Provide a smoother ride when investing in equity markets. The ETFs have taken in more than $1 billion in the past month, the most in seven months and the ETFs' second-biggest month since they launched in 2011. So far it’s paying off for investors: The ETFs are down significantly less than the market—half as much, to be exact. So while these investors may still need some Rolaids, they can hold off on busting out the Xanax.

The S&P 500-stock index fell 10 percent over the past month, with triple its usual level of volatility. The PowerShares S&P 500 Low Volatility Portfolio (SPLV), meanwhile, is down 5 percent but with volatility that’s 15 percent lower than that of the S&P. SPLV pulls this off by screening for the 100 least volatile stocks in the S&P 500 each quarter and then weighting them inversely by their volatility. 

Right now, this has SPLV heavy in sectors such as financials, consumer staples, and industrials. Those areas didn’t get hit quite as badly as others in the past month. The bigger reason SPLV is beating the market by 5 percentage points is because of what it doesn’t hold. It has no exposure to big tech names like Apple and Facebook, which are both down 15 percent in the past month—and make up 4.5 percent of the S&P 500. SPLV has a 4 percent allocation to tech stocks, compared with the 19 percent allocation of the S&P 500. 

Another bullet that SPLV dodged stems from its total lack of exposure to the energy sector. That contrasts with the S&P 500’s 7 percent allocation to energy. The chart below shows SPLV's big differences in sector weightings compared to the S&P.

Investors need to keep in mind, though, that low volatility can also bring returns that trail the market. In 2011, when the S&P 500 was on fire, returning 32 percent, SPLV had a return of 23 percent. This is SPLV working as advertised—a muted reaction on the way down in return for lagging on the way up. SPLV has $4.7 billion in assets and charges 0.25 percent in annual fees, which is competitive for an ETF with an alternative strategy.

The iShares MSCI USA Minimum Volatility ETF (USMV) takes a different approach to volatility but is also not doing as badly as the S&P 500. It’s down “only” 4 percent in the past month. The ETF is aimed at investors who don’t want low-volatility stocks but want a low-volatility version of the market. That means an ETF with sector weightings that are more in line with the S&P 500. To do this and keep overall volatility low, USMV’s portfolio consists of stocks whose movements neutralize one another.

The two low-volatility ETFs are used in different ways by investors. USMV is used as an actual replacement for core U.S. exposure. SPLV, meanwhile, acts more as a bet on low-volatility stocks, or as a complement to an existing core allocation. USMV has $5 billion in assets and charges 0.15 percent in annual fees.

Eric Balchunas is a senior exchange-traded-fund analyst at Bloomberg.

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