For This Low Vol ETF, It's Not All About Sector Selection

In a tumultuous year for equities in 2015, low volatility exchange traded funds did their job. That job being performing admirably during challenging market environments. For example, the PowerShares S&P 500 Low Volatility Portfolio SPLV, one of the largest U.S. low volatility ETFs, gained four percent last year, nearly triple the returns offered by the S&P 500.

SPLV has rivals and mid- and small-cap equivalents hailing from the same fund family, but for the purposes of this piece, SPLV will be the focus. 

As has been noted in the years since SPLV came to market (the ETF turns five in May), a frequent criticism of low volatility ETFs is that these funds are often highly concentrated in just a small number of sectors. When it first came to market, SPLV dealt with the criticism that it was a utilities ETF in disguise. However, two things are worth noting.

First, SPLV's underlying index, the S&P 500 Low Volatility Index, has no sector constraints. Second, utilities are currently SPLV's fifth-largest sector weight, commanding less than 12 percent of the ETF's weight. 

“However, there’s more to the low volatility story than a sector bet . As an exercise, we produce a hypothetical low volatility portfolio whose sector weights match those of the S&P 500 Low Volatility Index but whose sector returns match those of the complete S&P 500. The hypothetical results tell us to what extent Low Vol’s results come from sector tilts alone, vs. stock selection within sectors,” said S&P Dow Jones Indices Associate Director, Index Strategy, Fei Mei Chan in a recent note.

One way of looking at SPLV is that as a particular sector's volatility declines, it can take on a more prominent role in the ETF. Conversely, as another sector's volatility increases, its weight can be reduced in the fund. Likewise, a sector's volatility does not need to dramatically increase for its weight to be lowered in SPLV.

For example, utilities are currently about as volatile as they've been over the previous decade, but financial services volatility has fallen dramatically since the financial crisis, earning that sector SPLV's largest weight at nearly 28 percent.

“Over the last 25 years the hypothetical portfolio’s standard deviation was between those of the S&P 500 and the S&P 500 Low Volatility Index. Being in the Low Vol’s sectors during this period accounted for more than two-thirds of the total volatility reduction achieved by the S&P 500 Low Volatility Index. In the same period, the return increment attributed to being in the “correct” sector was only 24%. More than three-quarters of Low Vol’s outperformance is idiosyncratic to its stock selection methodology,” adds Chan.

What some investors might find interesting is that with SPLV's underlying index encompassing a stock selection methodology, the ETF also devotes more of its weight to industrial and healthcare stocks than utilities. For example, Johnson & Johnson JNJ and Lockheed Martin Corp. LMT command larger weight in SPLV than do all but one of the ETF's 12 utilities holdings.