Risk Reduction With This Small-Cap ETF

Small-cap stocks are usually more volatile than large-cap stocks. That's the price investors pay to access the often more compelling growth prospects offered by smaller companies, but there are ways to reduce to small-cap volatility.

Some exchange-traded funds are dedicated to reduced to small-cap risk. The PowerShares S&P SmallCap Low Volatility Portfolio XSLV is the king among low volatility small-cap funds. The $1.19 billion XSLV celebrates its fifth birthday next month.

XSLV tracks the S&P SmallCap 600 Low Volatility Index, which is the low volatility offshoot of the widely followed S&P SmallCap 600 Index. The PowerShares ETF can hold up to 120 stocks from the S&P SmallCap 600 Index that display the lowest trailing 12-month volatility. XSLV currently holds 119 stocks.

Low Vol Works With Small-Caps

Historical data suggest that embracing the low volatility factor is rewarding, but that's particularly true with smaller stocks.

“The performance advantage from tilting toward low-volatility stocks has historically been the largest among the smallest stocks, as they are more likely to be mispriced,” Morningstar said in a recent note. “A big part of this edge has come from avoiding the riskiest small-cap stocks, which tend to trade at high valuations and have poor profitability, two characteristics that have historically been associated with lackluster performance.”

Although XSLV is a low volatility fund, that doesn't mean growth stocks are excluded from its portfolio. Over 22 percent of XSLV's holdings are classified as growth stocks while 36.5 percent qualify as value names.

Embracing Stability

XSLV's advantages include a portfolio with financially sound companies, a trait that can prove efficacious with smaller companies.

“Stocks that make the cut tend to enjoy more-stable cash flows than the average small-cap firm,” said Morningstar. “This should allow the fund to weather market downturns better than most of its peers but may cause it to lag in stronger market environments.”

XSLV's weighting methodology is sector agnostic, which can lead to large weights to just a few sectors. Currently, financial services, industrial and real estate stocks combine for nearly two-thirds of the ETF's weight. Investors have added $219.1 million to XSLV over the past year.

Morningstar has a five-star rating on XSLV.

Related Links:

A Growth/Value Showdown

2018 Could Be Better For High Dividend ETFs