Stock markets world-wide have been in turmoil over the past few weeks. While panic selling was initially triggered by currency devaluation in China, anemic global growth and uncertainty related to rate hike by the Fed, have added to investors’ concerns.

Low-volatility ETFs are designed for investors who want exposure to stocks but do not want to take on too much risk. These products have become extremely popular over the past few years since historical performance revealed that low-risk stocks have rewarded investors with higher return than high-risk stocks as well as the broader markets over long-term, in all the markets studied. This outperformance suggested that that investors actually misprice risk. 

Did these low-volatility ETFs deliver on their promises during the past month, which by some measures, has been the one of the most volatile on record. Now may be a good time to revisit these products and see whether they deserve a place in investors’ portfolios. And, while a number of products are available to investors, there are significant differences in their strategies and investors should understand them properly before investing. (Read: Best ETF Strategies to Survive Market Turmoil)

There are more than 30 low- and minimum-volatility ETFs available to investors, focused on different styles (large/mid/small cap).geographical regions (US/Developed/Emerging/Europe/Japan) and strategies (low/minimum volatility/volatility weighted/risk weighted etc.).

In this article, we focus on the two ultra-popular US large cap low volatility ETFs—iShares MSCI USA Minimum Volatility ETF (USMV - ETF report) and PowerShares S&P 500 Low Volatility ETF (SPLV - ETF report).

Here’s a snap shot of these two ETFs and S&P 500 ETF (SPY - ETF report)

*Calculated from daily price returns for the past 3 years
**Source: Morningstar
 
Approach to Managing Volatility 

SPLV holds 100 stocks from the S&P 500 Index with lowest realized volatility over the past 12 months, which means SPLV takes into account volatility of individual stocks to arrive at the low- volatility portfolio. The index is rebalanced quarterly. (Read: Best & Worst August ETFs)

USMV holds 163 stocks that, in the aggregate, have lower volatility than the broader U.S. stock market. The underlying index uses Barra Optimizer to build a portfolio with the lowest absolute volatility, taking into account, variances of individual stocks as well as covariance of all stocks, with a certain set of constraints. In simple words, this ETF uses correlations between stocks in addition to volatility of individual stocks in arriving at the portfolio. The index is rebalanced semi-annually.

Performance

Did low volatility ETFs provide some comfort to the portfolio during wild market swings? It seems that they did deliver on their promises. During the one month period ended September 11, when the market was very unstable in the wake of China growth concerns, low volatility ETFs fell less than the broader market. And over the past one year, when the broader market returns were almost flat, both these ETFs had much better performance.

Further, both the ETFs had lower volatility compared to the broader market. Looking at risk and returns, USMV had better performance compared with SPLV. One of the reasons is USMV’s significantly higher allocation to Healthcare—which has been the best performing sector among all S&P sectors over the past few years.

Over the past three years, USMV and SPLV had upside capture ratios of 84.38% and 80.25% and downside capture ratios of 71.72% and 72.81% respectively. These ratios show how much these ETFs gained and lost compared to the S&P 500 index, during periods of market strength and weakness.

So, when the market was rallying, USMV was able to capture 84.38% of the upside but when the market went downhill, its losses were limited to 71.72% of the broader market’s decline. In simpler words, with low volatility strategies investors sacrifice some upside but protect themselves from a lot of downside.

Preparing for Higher Rates 

While the Fed has been priming the markets for its first rate hike in almost a decade, it now appears that they may keep the monetary policy unchanged this week, in view of ongoing turmoil in global markets. Investors, however, should be prepared for higher rates now since with improving labor markets, the Fed may not hold off a rate hike for a long time. They should keep an eye on their allocations to rate sensitive sectors. (See: 4 ETF Areas to Watch Ahead of the Fed Meeting)

Locking at the interest rate sensitivity of the two products, both are currently largely focused on sectors that tend to perform well in rising rates environments and have rather low exposure to Utilities and Telecom sectors that are quite rate sensitive. SPLV has 35% of assets invested in Financials, 15% in Industrials and 11% in Healthcare. However, SPLV’s 22% allocation to Consumer Staples may hurt its performance when rates rise.

USMV has invested 20% of its asset base in Healthcare, 18% in Financials and 15% in Information Technology sectors. For investors concerned about rising rates, PowerShares recently launched S&P 500 ex-Rate Sensitive Low Volatility ETF (XRLV), which is worth a look. This ETF holds 100 stocks from the S&P 500 index with low volatility characteristics, and removes stocks that historically have performed poorly in rising interest rate environments. 

The Bottom-Line

Looking at the two ultra popular ETFs in the space, it appears that USMV has beaten SPLV, with higher returns and lower volatility. Further, USMV is cheaper than SPLV. Overall, both ETFs are effective tools for reducing overall portfolio risk and improving risk-adjusted performance over longer term. At the same time, investors should remember that these strategies underperform in strong bull markets.