This Catalyst Could Reinvigorate Low Volatility ETFs

Plenty of bloom has come off the low volatility rose. That was especially true during the third quarter when high beta offered significant out-performance over the low volatility factor, but low volatility could have its day again.

Looking To China

A familiar catalyst, China, could be the reason why investors return to exchange traded funds such as the PowerShares S&P 500 Low Volatility Portfolio (PowerShares Exchange-Traded Fund Trust II SPLV). It is not surprising that concerns about China, the world's second-largest economy, could lead investors back to the low volatility trade. After all, China can be viewed as a risk on trade and investors could be prompted to reconsider SPLV as the yuan weakens against the dollar.

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“Investors often fret over a weaker yuan. A stronger USD/CNY exchange rate can create a headwind to US exports to China by making US goods relatively more expensive and Chinese goods less expensive in international markets. Additionally, a weaker yuan may be a sign that Chinese officials are concerned about economic growth,” said PowerShares in a recent note.

Where SPLV Comes Into Play

Of course, SPLV, with significant allocations to rate-sensitive utilities and consumer staples stocks, has to fight speculation that the Federal Reserve is poised to raise interest rates in December.

When Treasury yields rise, the S&P 500 Low Volatility Index, SPLV's underlying benchmark, trails the S&P 500 by a wide margin, according to PowerShares data. SPLV's index only tops the S&P 500 25 percent of the time when Treasury yields rise. Conversely, when Treasury yields decline, SPLV's index easily tops the S&P 500 and does so 87.5 percent of the time, according to PowerShares data.

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“These perceptions can cast a pall over global economic growth and corporate profit expectations – increasing the odds of market volatility,” said PowerShares. “This is especially relevant given that China is typically a fast-growing economy and an important contributor to global economic growth. For now, China’s gross domestic product is expanding comfortably at a roughly 6 percent clip. That compared to less than 2 percent for the US and eurozone. But by devaluing the yuan, Chinese officials may know more than they are letting on.”

Interestingly, since 2014, there have been six periods when the yuan noticeably weakened against the dollar. In five of those periods, SPLV outpaced the S&P 500, generating an average return of 1.3 percent while the S&P 500, on average, declined one percent, according to PowerShares data.

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