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Low-Risk ETFs May Only Look Alike

Investors in exchange-traded funds shouldn't confuse volatility and beta. But ETFs that seek to minimize either might both belong in a portfolio.

To reach nervous investors, companies have introduced a wave of ETFs that are designed to limit risk. Lately the new funds have been proving their value. During the three months ending on June 15, PowerShares S&P 500 Low Volatility (SPLV) returned 3.2 percent, while the Standard & Poor’s 500 index lost 3.8 percent, according to Morningstar. Russell 2000 Low Beta (SLBT) lost 3.0 percent, compared to a decline of 5.7 percent for the Russell 2000 index.

Promoting the new ETFs, fund companies cite research showing that low-risk stocks can excel over the long term. Researchers argue that low-volatility stocks tend to be unexciting companies that outperform because they sell at undervalued prices. In a recent study, Andrea Frazzini and Lasse Pedersen of AQR Capital Management found that high-beta securities give poor risk-adjusted returns. The high-beta stocks tend to be overvalued glamour companies in sectors such as technology. Frazzini and Pedersen found that investors could boost returns by holding low-beta stocks and shorting high-beta shares.

While the low-risk funds could be promising vehicles, investors should keep in mind that the ETFs follow different strategies. The funds have a variety of sector weightings and risk characteristics. Among the most stable funds is PowerShares S&P 500 Low Volatility. To assemble the portfolio, the company picks the 100 stocks in the benchmark with the lowest standard deviations over the past 12 months. The stocks are weighted according to standard deviation, so the least volatile holdings account for the biggest positions. The fund has 29.7 percent of assets in utilities, a stable sector, and only 1.8 percent in technology.

In contrast, Russell 1000 Low Volatility (LVOL) holds a more diversified portfolio. Weighting stocks according to their market capitalization, the Russell fund has 12.2 percent in utilities and 5.8 percent in technology. The big weighting in utilities has helped the PowerShares fund in downturns. When the S&P 500 dropped 13.9 percent in the third quarter of 2011, PowerShares lost 4.4 percent, while the Russell fund lost 9.9 percent.

Seeing the favorable returns, some investors may be inclined to pick the fund with the lowest standard deviation. But low-volatility strategies do not succeed in all market environments, cautions Eric Weigel, director of research for Leuthold Weeden. Tracking returns of the S&P 500 from 1990 through 2011, Weigel found that a low-volatility strategy outpaced the market by a wide margin during periods when stocks were sinking. But the low-volatility approach trailed badly during bull markets. “It is surprising how well low-volatility strategies work over the long term, but they are not the best choice for every market environment,” Weigel says.

While low-beta and low-volatility funds resemble each other, there are key differences. Beta measures the sensitivity to market moves. High-beta stocks include industrial companies that react to moves in the business cycle. High-beta stocks can also have high-volatility. But some volatile stocks have low betas because they don’t move in sync with the market, says David Koenig, an investment strategist at Russell. Financial stocks can be very volatile, though they do not always move closely with the markets. Koenig mentions the example of movie provider Netflix, which has a low beta and high volatility. “The stock’s volatility is based on developments that are specific to the company,” Koenig says.

As a result of the different risk considerations, Russell 1000 Low Volatility has only 2.7 percent of its assets in poor-performing financials, while Russell 1000 Low Beta (LBTA) has 7.6 percent of its assets in the sector. The low-volatility fund has a relatively big stake in consumer cyclicals, a recent market leader. Helped by favorable sector weightings, the low-volatility fund returned 8.6 percent in the past year, outdoing the low-beta fund by 2 percentage points.

Whether or not the low-risk strategies excel in the coming cycle, they can still be useful vehicles for diversifying portfolios, says Koenig. He suggests pairing a low-volatility fund with a momentum fund. The funds would have low correlations, making them intriguing tools for constructing stable portfolios.

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