An ETF That's A Safer Way To Small-Caps

Small-caps disappointed last year and that theme has extended to early stages of 2016, dealing a blow to risk appetite in the process.

Rising equity market volatility has also been a drain on small caps and the corresponding ETFs, but investors can cope with lagging smaller stocks by availing themselves of the less bad opportunity set presented by the ETFs that are small-cap answers to the likes of the PowerShares S&P 500 Low Volatility Portfolio SPLV. That includes the PowerShares S&P SmallCap Low Volatility Portfolio XSLV.

It can be said that one of the primary objectives of an ETF such as XSLV is to be less bad than its traditional rivals when volatility rises. To that end, XSLV has done its job over the past year. Over that time the, Russell 2000 and the S&P SmallCap 600, two of the most widely followed small-cap benchmarks, are lower by an average of 9.6 percent. That makes XSLV's one-year loss of 3.5 percent look significantly less bad.

XSLV holds the 120 least volatile members of the S&P SmallCap 600, making that small-cap index the more accurate comparison for XSLV's returns. No stock currently commands a weight north of 1.27 percent in the $136.6 million XSLV.

“Relatively stable cash flows can also make these stocks more sensitive to changes in interest rates. Interest rates generally rise during periods of economic strength. However, low-volatility stocks may have less growth than the broad market to offset the negative impact of higher rates. The fund’s large real estate stake (25% of the portfolio) contributes to its interest-rate risk, as higher interest rates can reduce property values and increase real estate investment trusts’ financing cost. This risk is somewhat mitigated by the fund’s considerable exposure to banks, which could benefit from widening net interest margins resulting from higher interest rates. But overall, the fund will likely expose investors to greater interest-rate risk than broader market-cap-weighted alternatives,” according to a recent Morningstar note on XSLV. 

As the research firm acknowledges, XSLV does feature significant exposure to bank stocks, giving the ETF some cyclical exposure. That cyclical exposure is further bolstered by a combined 24 percent allocation the industrial and technology sectors. 

“Perfect” and “risk-free” are terms that arguably foreign to financial markets, but what is important is XSLV's ability to offer superior risk-adjusted returns relative to traditional small-cap ETFs. Data indicate the ETF has done that. Since coming to market nearly three years, XSLV has seen its net asset value rise 13.1 percent, outpacing the S&P SmallCap 600 by more than 200 basis points over that period.

“In the small-cap market, there actually might be a small return benefit from avoiding the most-volatile stocks, many of which carry high valuations and invest a lot despite poor profitability. Historically, these stocks have offered terrible returns. A possible explanation is that investors might overpay for highly volatile stocks, which offer a small chance of a large payout, similar to a lottery ticket,” adds Moringstar.