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Which Low Volatility ETFs Will Protect Your Portfolio?

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. There are more than 30 low- and minimum-volatility ETFs available to investors, focused on different styles (large/mid/small cap), geographical regions (U.S./Developed/Emerging/Europe/Japan) and strategies (low/minimum volatility/volatility weighted/risk weighted etc.). In this article, we focus on the two ultra-popular U.S. large cap low volatility ETFs – the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) and the PowerShares S&P 500 Low Volatility Portfolio ETF (NYSEARCA: SPLV ) . Here’s a snap shot of these two ETFs and the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Yield Expense Ratio Beta Standard Deviation (Annualized)* 1 Month Return 1 Year Return Upside Capture Ratio (3 Y)** Downside Capture Ratio (3 Y)** USMV 1.96% 0.15% 0.78 10.44% -5.99% 6.27% 84.38 71.72 SPLV 2.50% 0.25% 0.80 11.55% -6.45% 4.71% 80.25 72.81 SPY 2.10% 0.09% 1.00 12.37% -6.93% -0.10% 99.75 100.76 *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. 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. 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 the PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (NYSEARCA: 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. Link to the original post on Zacks.com

Visualizing Stock Market Risk: 7/1926 To 6/2015

Summary How crazy is current market action? Not that crazy. Seeing a -3%+ or a +3% observation is roughly a 1/100 event, or ~ 2.5 times a year. Obviously, return events are not independent and volatility tends to cluster, but the numbers above establish a basic starting point for discussions about daily return action. Clearly, if you can’t handle volatility, you shouldn’t be in the stock market. By Wesley R. Gray How crazy is current market action? Not that crazy. …and if you lived through 2008, definitely not that crazy. Seeing a -3%+ or a +3% observation is roughly a 1/100 event, or ~ 2.5 times a year. Obviously, return events are not independent and volatility tends to cluster, but the numbers above establish a basic starting point for discussions about daily return action. Here we present daily total return data from the Ken French library : Value-weight return of all CRSP firms incorporated in the US and listed on the NYSE, AMEX, or NASDAQ that have a CRSP share code of 10 or 11 (essentially ordinary common shares). There are 23,509 daily return in total. Daily Return Distribution: (click to enlarge) Here are the specific stats: Bucket Observations Frequency Cumulative -5.00% 59 0.25% 0.25% -4.50% 20 0.09% 0.34% -4.00% 31 0.13% 0.47% -3.50% 46 0.20% 0.66% -3.00% 85 0.36% 1.03% -2.50% 164 0.70% 1.72% -2.00% 289 1.23% 2.95% -1.50% 547 2.33% 5.28% -1.00% 1154 4.91% 10.19% -0.50% 2566 10.91% 21.10% 0.00% 5599 23.82% 44.92% 0.50% 7048 29.98% 74.90% 1.00% 3416 14.53% 89.43% 1.50% 1331 5.66% 95.09% 2.00% 563 2.39% 97.49% 2.50% 237 1.01% 98.49% 3.00% 115 0.49% 98.98% 3.50% 69 0.29% 99.28% 4.00% 61 0.26% 99.54% 4.50% 37 0.16% 99.69% 5.00% 19 0.08% 99.77% More 53 0.23% 100.00% How about drawdowns? Daily returns are one thing – let’s review the top 30 stock market drawdowns over the past 90+ years. Rank Date Start Date End VW_CRSP 1 8/30/1929 6/30/1932 -83.67% 2 10/31/2007 2/28/2009 -50.37% 3 2/27/1937 3/31/1938 -49.18% 4 12/31/1972 9/30/1974 -46.46% 5 8/31/2000 9/30/2002 -45.09% 6 11/30/1968 6/30/1970 -33.56% 7 8/31/1987 11/30/1987 -29.91% 8 8/31/1932 2/28/1933 -28.47% 9 5/31/1946 5/29/1947 -23.85% 10 12/31/1961 6/30/1962 -23.06% 11 1/31/1934 7/31/1934 -18.34% 12 8/31/1933 10/31/1933 -17.95% 13 4/30/2011 9/30/2011 -17.71% 14 6/30/1998 8/31/1998 -17.39% 15 5/31/1990 10/31/1990 -16.97% 16 11/30/1980 7/31/1982 -16.62% 17 1/31/1966 9/30/1966 -15.45% 18 7/31/1957 12/31/1957 -14.95% 19 4/30/2010 6/30/2010 -12.99% 20 1/31/1980 3/31/1980 -11.98% 21 8/31/1978 10/31/1978 -11.95% 22 6/30/1983 5/31/1984 -10.83% 23 3/31/2000 5/31/2000 -9.64% 24 12/31/1976 2/28/1978 -9.33% 25 7/31/1956 2/28/1957 -8.37% 26 8/31/1986 9/30/1986 -8.15% 27 3/31/1936 4/30/1936 -8.02% 28 12/31/1959 10/31/1960 -7.97% 29 6/30/1943 11/30/1943 -7.76% 30 1/31/1994 6/30/1994 -7.60% And here are the numbers outlined on a chart: (click to enlarge) Clearly, if you can’t handle volatility , you shouldn’t be in the stock market. Original Post Share this article with a colleague

Low Blow – Why Low-Volatility ETFs Could Prove Anything But When You Really Need Them To Be

By Ian Kelly Just as nobody buys a parachute primarily for its colour – well, certainly not twice – presumably the main reason investors choose to buy low-volatility exchange-traded funds (ETFs) is safety-related. If they really were looking for a smoother ride from the share prices of their underlying holdings, though, events in global markets over the last few days may well have come as a considerable shock. Low-volatility stocks have enjoyed a good run in recent years, and as is often the way with investment, the better an asset or sector performs, the more people want a piece of the action. The low-volatility ETF market is now considerable – to pick out one example, the PowerShares offering that tracks the S&P 500 Low Volatility Index (NYSEARCA: SPLV ) has attracted almost £3bn from investors since its launch in May 2011. If pushed on why low-volatility stocks have done so well, here on The Value Perspective, we would raise the possibility they were priced very cheaply at the start of their run. In a previous article, ” Lost and pounds “, for example, we reminded you how lowly valued tobacco stocks used to be as the market fretted over, among other things, huge threats of litigation. Then, as those fears largely receded, the shares re-rated. Once a group of stocks reach “fair value”, however, the only way they can continue to outperform the rest of the market is if they grow their earnings more quickly. Where we would take some convincing then is that there is any reason why a business would be able to grow its earnings faster over the longer term just because its share price happens to bounce around a little less than the wider market does. In other words, while a low-volatility strategy has worked in the past, we have our doubts as to whether it will to continue to do so. Where we have few doubts, however, is that many people will have been shocked over the last few days by just how volatile their low-volatility ETFs have proved since the global markets went into free fall over concerns about China. The following chart shows how the aforementioned S&P 500 Low Volatility ETF traded versus the whole S&P 500 on Friday, August 21. While we would not normally focus on intra-day pricing on The Value Perspective, when a low-volatility ETF at one point plummets 46% as its wider benchmark drops just 7% – while trading real volumes on those numbers – we are prepared to make an exception. (click to enlarge) (Source: Bloomberg, August 2015) (click to enlarge) (Source: Bloomberg, August 2015) A good lesson to take from this is the importance of, as it were, looking under the bonnet of any collective investment so you are comfortable with the sort of businesses you own through it. Anyone “popping the hood” of the S&P 500 Low Volatility Index, for example, would find an allocation of almost 15% to insurance companies and a further 13% to real estate investment trusts. Is there any great reason why the valuations of these stocks should not be volatile over time, or in the case of insurance, the businesses themselves should not be volatile? If you accept that the valuations of these businesses and their earnings are likely to be volatile, you might ask what are they doing making up more than a quarter of a low-volatility benchmark? The answer lies in the fact that these kinds of indices, and the funds that track them, are mechanistic in nature. Thus, the S&P 500 Low Volatility Index is set up to measure the performance of the 100 least volatile stocks of the S&P 500, with volatility defined as “the standard deviation of the security computed using the daily price returns over 252 trading days”. It may seem odd for the index to have a 15% allocation to insurance companies today, but over time, ideas such as low volatility can become self-fulfilling. There will be times when this sort of strategy works and times when it does not. But you only ever get what the market is willing to pay, and at one point on August 21, for low volatility, that was half what it was the day before. To our minds, owning a low-volatility investment that fails to provide it when it is really needed is akin to a pretty-coloured parachute which doesn’t open when you pull the cord.