Assessing Interest Rate Risk In A Low Volatility ETF

There's no such thing as a free lunch in financial markets and low volatility exchange-traded funds often remind investors of just that. While low volatility funds, such as the PowerShares S&P 500 Low Volatility Portfolio SPLV, are among the most popular smart beta strategies, popularity doesn't equate to “risk free.”

Among the risks that low volatility can potentially face are concentration risk at the sector level or high exposure to sectors are richly valued due to their defensive traits. Another risk, and one that's particularly relevant in the current environment is interest rate risk.

What Happened

SPLV follows the S&P 500 Low Volatility Index, which is comprised of the 100 S&P 500 with the lowest trailing 12-month volatility.

“Going back to 1991, there have been 10 non-overlapping periods of rising interest rates. This includes the most recent environment through the end of February 2018, as interest rates have been trending upwards since the summer of 2016,” said S&P Dow Jones Indices. “The S&P 500 Low Volatility Index underperformed the S&P 500 in 9 of the 10 periods, with an average excess return of -8.92 percent and median excess return of -5.44 percent.”

Why It's Important

The performance of low volatility ETFs in rising rate environments is important because, due to the low volatility mandate, these funds can often sport large weights to sectors that are negatively correlated to rising Treasury yields.

SPLV features no telecom exposure and allocates just 16.3 percent of its combined weight to the consumer staples and real estate sectors. The ETF's 23.7 percent weight to utilities stocks, its largest sector weight, is potentially worrisome as rates rise.

What's Next

S&P Dow Jones points out that one of the worst periods of performance for the S&P 500 Low Volatility Index was when rates rose during the late 1990s technology boom because, back then, the index had no tech exposure.

Today, SPLV features some cyclical exposure to ward off the effects of rising interest rates as financial services, industrial and technology stocks combine for about 45 percent of the fund's weight.

“The S&P 500 Low Volatility Index underperformed the benchmark 60% of the time when interest rates rose and underperformed by an average of -0.60 percent,” said S&P Dow Jones. “Conversely, the S&P 500 Low Volatility Index performed better than the benchmark when interest rates declined.”

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