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.
Sector tilts can also increase risk, as this fund does not constrain its sector weightings. The fund has significantly greater exposure to the financial services (this sector represents 29% of the portfolio) and real estate sectors than the S&P SmallCap 600 Index. Not surprisingly, it has much less exposure to the technology, consumer cyclical and healthcare sectors than this benchmark. While large-cap healthcare stocks tend to be fairly defensive, riskier biotech names represent a bigger part of the sector in the small-cap market. However, the composition of the portfolio can change considerably over time. In two of the past three years, its turnover exceeded 50%.
Low-volatility investing theory
Low-volatility investing carries some distinct risks, but this strategy should offer a lower risk profile than traditional market-cap-weighted alternatives. In order for low-volatility investing to make sense, it needs to offer a more favourable risk/reward trade-off (even if it offers lower absolute returns) than the broader market. Low-volatility stocks have historically accomplished this feat, and there is reason to believe they will continue to do so over a full market cycle.
In the small-cap market, there actually might be a small return benefit from avoiding the most-volatile stocks, many of which carry high valuations and invest a lot despite poor profitability. Historically, these stocks have offered terrible returns. A possible explanation is that investors might overpay for highly volatile stocks, which offer a small chance of a large payout, similar to a lottery ticket. Early-stage small-cap biotech stocks might fit this mold. They can offer spectacular returns if regulators approve one of their products, but otherwise languish. Investors could become overly optimistic about these firms' prospects and overpay for them. But because lottery-like stocks represent a small part of the market, avoiding them probably won't have a very big impact on performance.
The committee that maintains the S&P SmallCap 600 Index (the selection universe for XSLV) tries to keep lottery-like stocks out of the index when it selects new constituents. Qualifying stocks must have positive earnings over the previous four quarters, and the committee may consider other measures of financial viability. This gives the fund a good starting point on which to build.
Performance
The fund was launched in February 2013, so it does not yet have a significant live record. Over the past 10 years, its benchmark exhibited about 77% of the volatility of the S&P SmallCap 600 Index (based on back-tested data). This volatility reduction is similar to the corresponding figure for the S&P 500 Low Volatility Index relative to the S&P 500. During that time, the S&P SmallCap 600 Low Volatility Index outpaced its parent index by 1.85 percentage points, though it may not be reasonable to expect this strategy to continue to offer higher returns over the long term. Not surprisingly, the strategy outperformed during the bear market from October 2007 through March 2009, lagged in the early part of the recovery, and outperformed in the second half of 2015.
Alternatives
There are currently no U.S. small-cap ETFs trading in Canada that use a low volatility strategy. Among funds that trade in the United States, SPDR Russell 2000 Low Volatility ETF (SMLV) is the closest alternative. It follows a similar approach, targeting the least-volatile 400 stocks from the Russell 2000 Index over the previous 12 months and weighting its holdings by the inverse of their volatility. However, it rebalances the portfolio each month and makes some adjustments to limit turnover and unintended style tilts. SMLV's 0.12% expense ratio is a fraction of XSLV's 0.28%, but it is more thinly traded, which can increase transaction costs.
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