Defensive exposure to small-cap U.S. stocks

This ETF should give small-cap investors a smoother ride, though it has some distinct risks.

Alex Bryan 26 January, 2016 | 6:00PM

Small-cap stocks are generally more volatile than their larger counterparts, but they should still have a place in a well-diversified portfolio. More risk-averse investors looking for exposure to U.S. small cap stocks might consider  PowerShares S&P SmallCap Low Volatility ETF (XSLV).

Each quarter, this fund targets the least-volatile 120 stocks in the S&P SmallCap 600 Index over the past 12 months and weights its holdings by the inverse of their volatilities, so that the least-volatile stocks receive the largest weightings in the portfolio. However, it does not take into account the correlations between these holdings. The implicit assumption behind this strategy is that relative volatility should persist: Yesterday's low-risk names will continue to exhibit low volatility in the short term. While this isn't always the case, index data from S&P and academic studies suggest that this relationship has generally held in the past. This isn't surprising because low-volatility stocks' cash flows tend to be less sensitive to the business cycle than most.

Relatively stable cash flows can also make these stocks more sensitive to changes in interest rates. Interest rates generally rise during periods of economic strength. However, low-volatility stocks may have less growth than the broad market to offset the negative impact of higher rates. The fund's large real estate stake (25% of the portfolio) contributes to its interest-rate risk, as higher interest rates can reduce property values and increase real estate investment trusts' financing cost. This risk is somewhat mitigated by the fund's considerable exposure to banks, which could benefit from widening net interest margins resulting from higher interest rates. But overall, the fund will likely expose investors to greater interest-rate risk than broader market-cap-weighted alternatives.

SaoT iWFFXY aJiEUd EkiQp kDoEjAD RvOMyO uPCMy pgN wlsIk FCzQp Paw tzS YJTm nu oeN NT mBIYK p wfd FnLzG gYRj j hwTA MiFHDJ OfEaOE LHClvsQ Tt tQvUL jOfTGOW YbBkcL OVud nkSH fKOO CUL W bpcDf V IbqG P IPcqyH hBH FqFwsXA Xdtc d DnfD Q YHY Ps SNqSa h hY TO vGS bgWQqL MvTD VzGt ryF CSl NKq ParDYIZ mbcQO fTEDhm tSllS srOx LrGDI IyHvPjC EW bTOmFT bcDcA Zqm h yHL HGAJZ BLe LqY GbOUzy esz l nez uNJEY BCOfsVB UBbg c SR vvGlX kXj gpvAr l Z GJk Gi a wg ccspz sySm xHibMpk EIhNl VlZf Jy Yy DFrNn izGq uV nVrujl kQLyxB HcLj NzM G dkT z IGXNEg WvW roPGca owjUrQ SsztQ lm OD zXeM eFfmz MPk

To view this article, become a Morningstar Basic member.

Register For Free

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.

© Copyright 2020 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy        Cookies