Low-Volatility Funds: Diversification, Protection, and Returns

04/17/2013 10:30 am EST

Focus: ETFs

Jon Markman

Editor, Trader's Advantage

While most advisors like low-volatility funds for downside protection, this particular fund provides much more, writes Jon Markman of Strategic Advantage.

A new class of exchange traded funds that provide "minimum volatility" versions of many of the major indexes have intrigued me, because my own research a decade ago showed that low-volatility stocks outperform high-volatility stocks over extended market periods.

A focus on low volatility is in fact part of the secret sauce of my Stratagem rating system. So despite the new low-volatility funds being marketed largely as equity instruments that offer downside protection, I actually believe that the style will outperform the major indexes during the course of a full market cycle.

There are a number of fund offerings available, including a minimum-volatility group managed by iShares comprised of the MSCI USA Minimum Volatility Index Fund (USMV), All World (ACWV), Europe/Australia/Far East (EFAV), and Emerging Markets (EEMV).

The Powershares fund family has another similar group focused on low-volatility: S&P 500 (SPLV), S&P SmallCap (XSLV), S&P MidCap (XMLV), Emerging Markets (EELV), and International Developed (IDLV).

And there are more. It is a crowded marketplace, and now that I've had time to research and speak with the management teams, I'd like to let you know why we settled on the iShares MSCI USA Minimum Volatility Index Fund.

The USMV managers start with the 600 major US stocks in the MSCI USA Index, and apply a rules-based methodology to select the 100 or so holdings that will help minimize the total risk of the portfolio. In other words, USMV is a subset of the 600 largest stocks in the country that is diversified by industry and market cap.

Other funds approach the task from a different direction. The SPLV of PowerShares, for instance, takes the 100 stocks from the S&P 500 that have had the lowest realized volatility over the past 12 months, paying no attention to sector or market cap. As a result, over 30% of the current holdings are utilities, which means if that one sector were to go south, the fund would feel it pretty significantly.

USMV—our iShares version—looks at ten years of each stock's volatility history, and overweights the most recent periods. This gives a more accurate representation of the true historical volatility of a given security. Secondly, the fund caps any individual position at 1.5%, while not allowing any sector to drift more than 5% away from the sector weighting of the underlying index.

As a result, the largest sector for USMV is health care, at 17%, followed by consumer discretionary (16%), financials (15%), and information technology (14%).

Other risk adjustments built into USMV include a 10% cap on annual turnover, twice a year rebalancings, and the use of no leverage.

The fund launched in October 2011, and is up 29% since, with a 13.2% move higher this year already. It's up to $2 billion in market cap, and trading 695,000 shares daily, so liquidity shouldn't be an issue.

We started with a 5% position, and now I would like to increase it to 8%.

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