It's OK To Pay Up For Low Volatility Protection

With the first quarter drawing to a close this week, it is fair to say that through the first three months of the year, low volatility exchange-traded funds have been favored targets among equity-based funds. One of the drawbacks to such ETFs is that these products underscore the notion that there really is no such thing as a free lunch.

As it pertains to low volatility ETFs, including the popular PowerShares S&P 500 Low Volatility Portfolio (PowerShares Exchange-Traded Fund Trust II SPLV), an oft-cited drawback is that investors will be getting involved with richly valued stocks and sectors because playing defense usually means paying up in equity markets.

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Investors well-versed in defensive investing know that sectors such as consumer staples and utilities often trader at higher multiples than the broader market. Though utilities are not stretched on valuation relative to their historical norms, the sector still is not cheap. As for staples, that sector is looking pricey against the S&P 500.

That is the cost, literally, of doing business with sectors with reduced beta and high dividends. However, investors worried about valuations on ETFs such as SPLV might want to consider other factors in the current environment.

Step Back And Look At The Circumstances

“The 'low volatility anomaly' states that stocks with lower volatility tend to outperform stocks with higher volatility,” said PowerShares in a recent note. “This behavior is an anomaly because it is not supposed to occur. Instead, investors are expected to earn returns consistent with the amount of risk taken – the greater the risk, the greater the return. Of course, low volatility cannot be assured. Yet, in the case of low volatility stocks, research shows that excess returns have been driven more by the macroeconomic environment than by security valuations. Valuations may even provide the wrong signal to investors.”

Anomalous or not, there is no denying low volatility is working this year. SPLV is up 5.1 percent, or nearly five times the returns offered by the S&P 500. Of course, a lot of SPLV's bullishness has to do with expensive staples and utilities stocks. Those sectors, the ETF's largest and fourth-largest, respectively, combine for nearly 37 percent of the ETF's weight.

SPLV's impressive performance this year could have little to do with valuations and more to do with market environment than meets the eye.

“Since low volatility investors aren’t compensated for assuming risk, valuations may not play a traditional role in determining performance. Moreover, low volatility stocks have the potential for downside risk mitigation and partial upside participation. That means that stocks with low volatility shouldn’t fall as hard or rise as fast as stocks with high volatility. As a result, the attractiveness of low volatility stocks may rise in bear market conditions and fall in bull market conditions, with less dependence on valuations than investors might expect,” added PowerShares.