Potent exposure to small stocks with low volatility

This ETF looks for a proper balance of valuation and profitability.

Alex Bryan 28 March, 2017 | 5:00PM
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 PowerShares S&P SmallCap Low Volatility ETF (XSLV) aggressively pursues small-cap stocks with low volatility. It should offer a smoother ride and 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.

While small-cap stocks tend to be more volatile than their larger counterparts, the performance advantage from tilting toward low-volatility stocks has historically been the largest among the smallest stocks. 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 lackluster performance.

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 24% less market sensitivity than its parent index. It also beat the benchmark by 203 basis points annualized during that time, largely because of more-favorable stock exposure in the financial-services industry.

Investors can always reduce risk by allocating a greater portion of their portfolios to less risky assets like cash or bonds. But this strategy will likely offer better returns than a market-cap-weighted stock/bond portfolio of comparable volatility, albeit with smaller diversification benefits.

Historically, less-volatile stocks have offered better risk-adjusted returns than their riskier counterparts, and this effect has tended to increase as market capitalization decreases. Robert Novy-Marx, a professor at the University of Rochester, attributes low-volatility stocks' attractive performance from 1968 to 2013 to their low average valuations and high profitability in his paper "Understanding Defensive Equity." He argues that investors would be better off targeting stocks with value and profitability characteristics directly because there is no guarantee that low-volatility stocks will always have these characteristics. For example, although the fund is in the small-value Morningstar Category, it does not currently have a pronounced value tilt.

While low valuations and high profitability likely contributed to low-volatility stocks' attractive historical performance, there is probably more to the story. Many investors care about benchmark-relative returns, which may cause them to favor riskier stocks that have higher expected returns in bull markets, reducing their expected returns relative to their risk. Similarly, neglected lower-risk stocks can become undervalued relative to their risk. This is not necessarily the same as the traditional value effect, as many of these stocks often trade at comparable or even higher valuations than the market. Andrea Frazzini and Lasse Pedersen, two principals from AQR, develop this argument in their paper "Betting Against Beta."

There may also be an element of behavior-induced mispricing behind the low-volatility effect, where investors may overpay for volatile stocks that offer a low probability of a high payoff. Much of the low-volatility performance benefit has come from simply avoiding the most volatile stocks (including many small biotech firms and junior miners), which tend to have low profitability and high valuations and may be mispriced.

The fund's narrow focus on recent volatility and frequent rebalancing allow it to effectively capture the low-volatility effect documented in the academic literature. But it can also lead to high turnover and introduce some indirect bets that investors may not anticipate. Turnover exceeded 50% in each of the past two years. In addition to large and fluid sector tilts, the fund's exposure to value stocks may change over time.

The fund employs full replication to track the S&P SmallCap 600 Low Volatility Index. It earns a Positive Process rating because it offers pure exposure to stocks with low volatility, which have historically offered superior risk-adjusted performance and should continue to do so. Each quarter, S&P ranks the constituents in the S&P SmallCap 600 by their volatility over the past 12 months and selects the least volatile 120 for inclusion in the index. It then weights these constituents by the inverse of their volatility, so that less-volatile stocks receive larger weightings in the portfolio. This approach is laudably transparent, and it offers clean exposure to the low-volatility effect. But because there are no constraints on sector weightings or turnover, the fund can end up with large sector tilts that change over time. And because it does not consider valuations in its selection process, the fund can drift across the Morningstar Style Box. It currently nets out in small-blend territory but has exhibited a greater value tilt in the past. Unlike some of its peers, the fund does not consider correlations among stocks, which can affect how the portfolio behaves.

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 January 2017, real estate stocks represented 16% of the portfolio, down from 26% a year earlier.

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. While the fund often takes large sector bets, it effectively diversifies firm-specific risk. It tends to favor profitable firms with conservative asset growth, which can translate into attractive free cash flows.

PowerShares charges a low 0.25% expense ratio for this offering, which is reasonable for this strategy and low relative to the small-value category. Over the trailing three years through January 2017, the fund lagged its benchmark by 31 basis points annualized, slightly more than the amount of its expense ratio. This was likely due to transaction costs.

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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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