How A Low-Volatility ETF Works Is As Important As Why

Not that they were on the fringe in the past, but the status of low-volatility exchange-traded funds as mainstream, core holdings has been validated this year as investors pour billions of dollars into these funds that eschew volatile stocks.

The PowerShares S&P 500 Low Volatility Portfolio (PowerShares Exchange-Traded Fund Trust II SPLV), one of the forefathers of the low-volatility ETF movement, is a prime example of that theme with $1 billion in year-to-date inflows. That is tops among all PowerShares ETFs.

Related Link: Look What's Lurking In This Low-Volatility ETF

Proving that investors' thirst for volatility avoidance is not limited to the oldest products in the space, the PowerShares S&P 500 High Dividend Low Volatility Portfolio (PowerShares Exchange-Traded Fund Trust II SPHD) has added nearly $966 million in new assets this year, good for second among PowerShares ETFs.

Low-Volatility ETFs 101

A basic premise of low-volatility ETFs is that they should be less bad than their traditional rivals when markets sag — the rub being a fund such as SPLV will leave some returns on the table when equities soar. Living in the current market environment, SPLV and rival low-volatility ETFs are showing what they are made of.

Due to the fact that ETF issuers approach the low-volatility factor in different ways, investors should drill down on what makes these funds tick before deciding which one is best for them. One advantage of SPLV is, contrary to popular belief, that fund is unconstrained at the sector level.

“An unconstrained approach utilizes a transparent, rankings-based methodology that evaluates each stock’s realized volatility within a given universe over a specified period (typically one year) and selects stocks that have exhibited lower amounts of volatility. This approach to low volatility investing is unconstrained from a sector or geographic perspective and, as a result, can potentially result in allocation shifts away from where volatility may surface. Because this approach is not constrained to holding certain sector weights based on the parent index, it effectively focuses on pure low volatility stocks,” said PowerShares in a note out Thursday.

Delving Deeper Into SPLV

As has been noted previously in this space, there were times when critics alleged SPLV was no more than an utilities ETF in disguise. That assertion has been debunked because utilities is merely the fifth-largest sector weight in SPLV at the moment. Look at SPLV this way: The fund holds the 100 S&P 500 stocks with the lowest trailing 12-month volatility. It is possible that there will be times when all 10 S&P 500 sectors are represented in SPLV and there will certainly be times when some groups are not found in the ETF at all.

Related Link: A New ETF Might Be The Optimal Way To Low Volatility

While the merits of SPLV's unconstrained approach have not truly been tested since the ETF debuted just over five years ago, market history suggests there will be times when the low volatility factor will be even more favored than it is right now and differences between ETFs' application of the factor will become amplified.

“We believe it is imperative to think through the ramifications of a constrained approach that requires investors to allocate to sectors and countries – even when volatility spikes and performance is in free fall. Since the introduction of low volatility ETFs in May 2011, the market has not provided such a poignant example, but history suggests that at some point it will. Unfortunately for many investors, these scenarios often aren’t contemplated until it’s too late,” added PowerShares.

Disclosure: Todd Shriber owns shares of SPHD.