A less risky way to invest in U.S. small-cap stocks

This ETF should offer a smoother ride and better downside protection than most of its peers.

Alex Bryan 6 February, 2018 | 6:00PM
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The small-cap arena isn't the most obvious place to look for low-volatility stocks. Small-cap stocks tend to be more volatile than their larger counterparts, so a small-cap low-volatility strategy may still be too risky for the most conservative stock investors.

That said, the performance advantage from tilting toward low-volatility stocks has historically been the largest among the smallest stocks, as they are more likely to be mispriced. A big part of this edge has come from avoiding the riskiest small-cap stocks, which tend to trade at high valuations and have poor profitability, two characteristics that have historically been associated with lacklustre performance.

 PowerShares S&P SmallCap Low Volatility ETF (XSLV), which trades on the New York Stock Exchange, offers a good way to get exposure to small-cap U.S. stocks with low volatility. It should offer a smoother ride and a better risk/reward profile than the S&P SmallCap 600 and most of its peers. But it can make concentrated industry bets at times and may require high turnover. And it has a limited record. These considerations limit its Morningstar Analyst Rating to Bronze.

Each quarter, the fund targets the 120 least-volatile members of the S&P SmallCap 600 Index over the past 12 months and weights them by the inverse of their volatility, so that the least-volatile stocks receive the largest weightings in the portfolio. This strategy implicitly assumes that recent relative volatility will persist in the short term, which has historically held. The approach is laudably transparent, and it offers clean exposure to the low-volatility effect.

Stocks that make the cut tend to enjoy more-stable cash flows than the average small-cap firm. This should allow the fund to weather market downturns better than most of its peers but may cause it to lag in stronger market environments. Because there are no limits on sector weightings, the fund can end up with large sector bets. But these tilts can shift over time. For example, at the end of December 2017, real estate stocks represented 25% of the portfolio, up from 16% a year earlier.

So far, the fund's approach has worked well. From its inception in February 2013 through January 2017, the fund exhibited about 13% less volatility and about 20% less market sensitivity than its parent index. It also beat the benchmark by 124 basis points annualized during that time, largely because of more-favourable stock exposure in the financial-services industry.

PowerShares charges a low 0.25% management-expense ratio for this offering, which is reasonable for this strategy and low relative to comparable funds. Over the three years through December 2017, the fund lagged its benchmark by 27 basis points annualized, slightly more than the amount of its MER. This was likely due to transaction costs.

Fundamental view

Low-volatility stocks have historically offered a more favourable risk/reward trade-off than the market and will likely continue to do so because of behaviourally induced mispricing and constraints that asset managers face. Riskier stocks tend to have greater upside potential than defensive stocks, which makes them more appealing to investors who care about earning high returns, like mutual fund managers who are trying to beat a benchmark. Their collective bets on these risky stocks can cause them to become overvalued, while the neglected, steady-Eddie companies could become undervalued.

If this sounds a bit like value investing, it is. The two strategies' performance relative to the market is positively correlated. Like value investing, low-volatility investing has tended to work the best among small-cap stocks, which have greater room for mispricing than their larger counterparts, since they are less widely followed. Because it does not explicitly target stocks trading at low valuations, this fund won't necessarily fit neatly into the value side of the Morningstar Style Box, though it currently falls in the small-cap value box.

As an added benefit, low-volatility investment strategies effectively filter out the riskiest and least profitable stocks in the market, which have historically offered terrible returns. Outside of this speculative segment of the market, the relationship between volatility and returns has been weak. Although it isn't a strong predictor of returns for most stocks, past volatility is a good predictor of future volatility and downside performance, at least in the short term. This risk reduction is the principal source of low-volatility stocks' attractive risk-adjusted performance.

It isn't reasonable to expect this strategy to offer eye-popping returns over the long run. It will likely lag the S&P SmallCap 600 Index during market rallies and hold up better during market downturns but offer better risk-adjusted performance over a full market cycle.

This fund's focus on recent volatility and frequent rebalancing allow it to effectively capture the low-volatility effect and quickly step out of the way as risk increases in a particular segment of the market. But it ignores how stocks in the portfolio interact with each other and affect overall portfolio volatility. The strategy can incur high turnover. Turnover exceeded 50% in each of the past two years.

The portfolio's sector composition can significantly depart from its parent index's. The fund has greater exposure to the financial services, utilities and real estate sectors than the S&P SmallCap 600 Index and less exposure to technology, consumer cyclical and healthcare stocks. However, these sector tilts can change significantly over time. While the fund often takes large sector bets, it effectively diversifies firm-specific risk. It tends to favour profitable firms with conservative asset growth, which can translate into attractive free cash flows.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.

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