The trade-off between risk and return is central to modern portfolio theory. Finance textbooks teach that the more risk an investor assumes, the greater the expected return. This is not only academic, but intuitive to most people. Following this logic, one would expect lower volatility securities to generate lower returns over time, and higher volatility securities to deliver higher returns in exchange for added risk. But this may not necessarily be the case – at least within a given asset class.
Numerous academic studies have shown that low volatility stocks have tended to outperform higher volatility stocks over time. This has become known as the “low volatility anomaly” – a phenomenon that has turned traditional finance theory on its ear, while creating compelling opportunities for investors.
A goal of partial upside participation, downside risk mitigation
PowerShares S&P 500 Low Volatility (CAD Hedged) Index ETF (ULV) is based on the S&P 500 Low Volatility Index CAD Hedged – a recognized industry benchmark for low volatility investing. The goal of ULV’s underlying methodology is to provide investors with partial upside market participation as well as downside risk mitigation. To achieve this, ULV’s underlying index overweighs low volatility stocks when compared to the S&P 500 CAD Hedged Index, – providing partial participation in rising markets, but also potentially limiting losses when stocks are falling.
PowerShares Canada has high conviction that, over time, this low-volatility approach should provide investors with less exposure to market volatility and smoother overall performance. In fact, since its January 24, 2012 inception through February 29, 2016, the S&P 500 Low Volatility Index CAD Hedged has exhibited upside capture and downside capture1 of 78% and 50%, respectively – meaning that the index has captured 78% of the gains and only 50% of the losses of the S&P 500 CAD Hedged Index.
Why is it important to consider both of those numbers in tandem? Because mitigating losses in the first place makes it easier to overcome them; it takes a 100% rally to make up a 50% loss. Notice how the S&P 500 Low Volatility CAD Hedged Index has tempered the highs and lows of the S&P 500 CAD Hedged Index in the following charts – outperforming in some of the worst months for equities.
S&P 500 Low Volatility CAD Hedged Index performance during the 10 strongest-returning months for the S&P 500 CAD Hedged Index since January 2012
S&P 500 Low Volatility (CAD Hedged) Index performance during the 10 worstreturning months for the S&P 500 (CAD Hedged) Index since January 2012
Simple portfolio construction, unconstrained sector rotations
So how is ULV’s underlying methodology designed to provide a smoother ride? The underlying S&P 500 Low Volatility CAD Hedged Index is constructed by ranking stocks from the S&P 500 Index in order of their realized volatility over the trailing 12 months. The 100 stocks with the lowest volatility are then weighted by the inverse of their volatility. The stock selection process is intentionally kept simple and transparent, and then repeated as part of a quarterly reconstitution process.
ULV has the added advantage of an unconstrained investment approach. Unlike portfolios that make use of minimum-variance constraints, ULV has the ability to rotate in and out of sectors as volatility dictates through the process of quarterly reconstitution. Below are two examples of unconstrained sector allocation in recent years.
- Between March 2013 and June 2015, ULV shed its allocation to the underperforming utility sector from roughly 30% to less than 3%.
- ULV has had no exposure to the underperforming energy sector since February 2015, when its weighting was cut to zero from just below 5% in August 2014. That compares with a weight of 6.5% in the energy sector within the S&P 500 CAD Hedged Index. This lack of energy exposure helped the S&P 500 Low Volatility CAD Hedged Index ETF (3.84%) outperform the S&P 500 Index (.91%) by 2.93% in 2015.
ULV’s largest sector allocation as at February 29, 2016 is in financials, which have historically shown positive correlation to rising interest rates. The chart below illustrates ULV’s sector allocation since the fund launched in 2012.
ULV’s portfolio allocation
Using low volatility in a high-conviction portfolio
Owing to the construction of its underlying index, ULV is designed to participate in rising markets, but may underperform the S&P 500 CAD Hedged Index during strong bull markets. Conversely, ULV may outperform the S&P 500 CAD Hedged Index in sustained bear markets.
Low volatility stocks also typically pay dividends, which can make for a compelling complement to a fixed income allocation. Low volatility can also be combined with other factors for a customized approach to a high-conviction investment strategy.
Learn more about the PowerShares S&P 500 Low Volatility (CAD Hedged) Index ETF by visiting www.powershares.ca
