Evaluating Tracking Error Concerns And Low Volatility ETFs

Low volatility is a widely follow investment factor and it can be argued that in the nearly five years since the PowerShares S&P 500 Low Volatility Portfolio (PowerShares Exchange-Traded Fund Trust II SPLV) came to market, the factor has been on the receiving end of increased attention and scrutiny.

Increased scrutiny could be the result of SPLV's impressive performance record and its over $6.9 billion in assets under management. Some advisors and investors that allocate capital to the low volatility factor via funds such as SPLV should examine tracking error and how it affects investor outcomes.

Tracking Error

Tracking error as it pertains to SPLV produces dramatically different outcomes than a standard S&P 500 index fund, a comparison some market observers will make because SPLV's underlying index holds the 100 S&P 500 components with the lowest trailing 12-month volatility. Year-to-date, the result is SPLV being up 3.5 percent, including dividends paid, an advantage of 50 basis points over traditional S&P 500 ETFs.

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“Take, for example, the case of low volatility investing – one of the most popular investment factors in use today. Could the S&P 500 Low Volatility Index – a commonly used barometer of low volatility stock performance – result in too much tracking error relative to its parent index, the S&P 500 Index? Because the S&P 500 Low Volatility Index selects 100 stocks from its parent index with the lowest realized volatility over the previous year, the S&P 500 Low Volatility Index can have sector exposure that is materially underweight or overweight relative to the S&P 500 Index,” said PowerShares in a recent note.

SPLV Versus S&P 500

As has been widely noted, SPLV and a standard S&P 500 look nothing alike at the sector level. For example, technology is the S&P 500 largest sector weight but accounts for less than 3 percent of SPLV. Likewise, consumer discretionary stocks represent nearly 13 percent of the S&P 500, but barely over 5 percent of SPLV. Although SPLV's weigh to the utilities sector has declined dramatically since last year, it is still more than quadruple the weight assigned to that sector in the S&P 500.

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.

“The relationship between low volatility factor exposure and tracking error is linear. Tracking error is relatively small when small amounts of low volatility are blended into the S&P 500 Index. A portfolio with a 30 percent weighting in low volatility stocks, for example, had less than a 2.50 percent tracking error to the S&P 500 Index; 50-50 blend produced 4 percent tracking error. Keep in mind, though, that risk-adjusted returns also improved with increased tracking error,” according to PowerShares.