"Slapping a label on something isn't really delivering on the promise of low volatility," said Todd Shriber, Web editor at Irvine, California-based ETF Trends.
A recent Wall Street Journal article went beyond caution, saying that given the recent performance run, it's time to "flee" these low-volatility funds.
Recent performance, though, doesn't tell the full story that the long-term investor needs to know in weighing the low-volatility approach as a core holding, or complement to a core holding, rather than well-timed ETF trade. On the plus side, these ETFs have fairly low expense ratios, but they take vastly different approaches and have no track record during a serious downturn in the market—which is when you'd be most likely to want to minimize volatility.
The lack of a track record is a complaint that has also dogged so-called ETF strategist funds, professionally managed ETF funds of funds that seek to reduce volatility and have delivered in recent years, but have yet to be proved over longer market cycles.
Dan Draper, managing director of PowerShares, is used to the debate. He said recent history and SPLV's return history confirms academic findings that there is a low-volatility anomaly, and it allows the approach to not only reduce risk but also generate healthy returns. Since inception of SPLV in May 2011 through the end of March, SPLV has slightly outperformed the S&P 500 Index. Draper said this is coming with less volatility and includes the bull market of 2013.
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All of the low-volatility ETFs are equity funds, so far, and equities are an inherently volatile asset class, points out advisor Ed Gjertsen II, vice president of Glen View, Illinois-based Mack Investment Securities. The classic way to lower risk is not to stay 100 percent in equities but to diversify among asset classes: to add bonds or real estate, say, to leaven your exposure to stocks. So if you're interested in a low-volatility ETF in order to minimize your equity volatility, that's all well and good. If, on the other hand, you're under the assumption that you're taking a serious approach to lowering the risk of your overall investments by buying a low-volatility ETF ... well, you've probably been led astray.
"Don't be fooled by the minimum-volatility tag," said Gjertsen. "Look at what's under the hood."
"Bonds and real estate are risk assets like stocks," Draper said. He said SPLV outperformed a traditional stock/bond blend during the three worst drawdowns of the S&P 500 Index since May 2011. "Going deeper, bonds have duration risk. At current interest rate levels, an ensuing rise in interest rates may have a material negative impact on bond prices and generate volatility for a portfolio due to the duration effect," Draper said.
PowerShares also looked at a main real estate index, the FTSE NAREIT Composite Index, on a monthly return basis since 1990 and found it produced higher volatility than the S&P 500—18.5 percent to 14.7 percent.
Although SPLV has only traded since May 2011, it has existed through 3 of 4 market selloffs related to the eurozone financial crisis—spring/summer 2011, spring/summer 2012 and fall 2012. During these periods, the S&P 500 Low Volatility Total Return Index posted a smaller decline than the S&P 500 by an average of 6.57 percent, and the decline was an average of just 35.5 percent of the drop in the S&P 500 Total Return Index, Draper said.
The widows-and-orphans approach to investing
Even the two largest ETFs have widely different approaches—and critics say there is no good evidence for how well these funds will perform over time.
You could call SPLV a shortcut to the kind of portfolio your grandmother might have been comfortable with: About one-fourth of it is in utility stocks, according to Shriber.
SPLV's strategy is pretty simple. It takes the S&P 500 and overweights the least volatile sectors. The benchmark it tracks, the S&P 500 Low Volatility Index, consists of the 100 stocks within the broader S&P 500 Index with the lowest volatility over the past 12 months, making it typically concentrated in the traditional defensive sectors: utilities, consumer staples, and industrials. But it's important to remember that the least volatile sectors are not always the least volatile. In 2002, Gjertsen pointed out, so-called "widows and orphans" stocks, like utilities, took a beating.
And as S&P Capital IQ noted in a report on the rise of low-volatility ETFs last year, even if they make sense for the long term, outflows can occur for these strategies, based on short-term changes in market sentiment. Last May, when the market became obsessed with the idea that the Federal Reserve would soon slow its bond-buying program, low-volatility funds experienced outflows.