Trying To Time The Low Volatility Factor

Timing individual investment factors, such as low volatility, is difficult. Entering 2016, who knew that exchange-traded funds such as the PowerShares S&P 500 Low Volatility Portfolio (PowerShares Exchange-Traded Fund Trust II SPLV) would outperform traditionally-weighted benchmarks through much of the first seven months of the year?

Likewise, late-comers that recently entered the low volatility traded might be having some buyer's remorse. Although SPLV is higher by 2.8 percent over the past 90 days, the ETF traded lower through August on speculation that the Federal Reserve would raise interest rates at its September meeting. That did not happen, giving the low volatility factor some reprieve in the process.

The Markets And Their (Lack Of) Predictability

That is good news for SPLV, an ETF that allocates nearly 44 percent of its weight to the rate-sensitive utilities and consumer staples sectors. In other words, a “lower for longer” Fed policy is what low volatility investors want to see.

“The low volatility factor has tended to shine when interest rates are flat to lower, stock prices are falling and volatility is rising,” said PowerShares in a recent note.

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Data confirm as much. When Treasury yields rise, the S&P 500 Low Volatility Index, SPLV's underlying benchmark, trails the S&P 500 by a wide margin, according to PowerShares data. SPLV's index only tops the S&P 500 25 percent of the time when Treasury yields rise. Conversely, when Treasury yields decline, SPLV's index easily tops the S&P 500 and does so 87.5 percent of the time, according to PowerShares data.

SPLV's Exposures

SPLV tracks the S&P 500 Low Volatility Index, which is home to the 100 S&P 500 stocks with the lowest trailing 12-month volatility. There have been times when SPLV's weights to utilities and staples are well below what is currently seen, reflecting either rising volatility in those sectors or significantly reduced turbulence in other groups.

“When you look at the market conditions experienced in late summer, it’s no surprise that low volatility shares underperformed the broad market. This is by design. However, it’s important to remember that the low volatility factor does occasionally outperform in up markets and occasionally lag in down markets.

“And while higher rates and a lower VIX have been headwinds for low volatility, the results are not absolute. There are exceptions. Understanding market trends and the potential for exceptions can help investors set proper expectations for low volatility performance,” added PowerShares.

SPLV does have some cyclical exposure as financial services industrial stocks combine for over a third of the ETF's weight. However, the ETF has no exposure to energy, a sector that historically performs well when rates rise.

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