What’s Inside Two Low-Volatility ETFs

Many investors are concerned that pending action by the Federal Reserve could cause stocks to pull back in the coming months. For those who want to stay invested in the market, but reduce their potential risk, low-volatility ETFs might be appealing. Through a rules-based approach, the index the ETF seeks to track chooses the stocks that have recently exhibited the lowest volatility. But of course there are differences between the more popular products.

PowerShares and iShares have the most established product lineups tied to a low-volatility approach, with offerings focused on U.S., developed international, and emerging market equities. However, what's inside these ETFs can be quite different. In the U.S., PowerShares holds the least volatile stocks that are inside the broader S&P 500 index, regardless of the sector exposure. Meanwhile, iShares, working with an MSCI benchmark, uses sector bands (+/- 500 basis points relative to a parent MSCI index at rebalance).

We think that enables the ETF to have more diversification. The two index providers also rebalance at different frequencies; S&P Dow Jones does so every three months while MSCI does so every six months. As such, the turnover rate for the PowerShares ETF is more than twice that of the iShares ETF and more resembles an actively managed mutual fund though with a 0.25% expense ratio, it is much cheaper. (S&P Capital IQ operates independently from S&P Dow Jones Indices.)

PowerShares S&P 500 Low Volatility Portfolio (SPLV) is a $4.8 billion ETF that launched in May 2011. The ETF gained 10% in 2012 and 23% in 2013, lagging the S&P 500 Index's 16% and 32% respective total returns, which should not be a surprise given that higher beta stocks performed strongly in these years. However, in 2014, SPLV rose 17%, ahead of the broader indices 14% gain.

As of May 2015, SPLV's exposure to financials (35% of assets) and consumer staples (21%) had increased significantly from the 24% and 16% stakes, respectively, from September 2014. Meanwhile, the weighting in utilities decreased significantly to 3%, from a prior 19%; utilities were the best performing sector for the S&P 500 index in 2014. Companies in the insurance, REITs and food products industries are widely held as they experienced lower-than-average volatility recently.

Meanwhile, iShares MSCI USA Minimum Volatility (USMV) launched in October 2011 and now has $5.1 billion in assets, aided by more than $1 billion of inflows during 2015, even as SPLV experienced outflows. USMV rose 11% in 2012 and 25% in 2013, ahead of SPLV, but in 2014 USMV's 16% return lagged. On a three-year annualized basis, USMV rose 15.6%, while SPLV increased 14.5%. We believe the sector exposure of USMV helps explain some of the above performance differences.

Health care (20% of assets as of May 2015 and nearly double that of SPLV) was the largest of the sectors represented, followed by financials (16%) and information technology (15%). We think this more diversified and cyclically slanted portfolio benefitted more in 2012 and 2013 as growth oriented sectors rose more than defensive ones as they have in 2015. Due to the sector bands, USMV's exposure is not notably that different than it was in September 2014; health care and financials were approximately 200 basis points lower at 18% and 14%, respectively.

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