This is a weekly column focusing, usually, on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options. More than 94 million options on ETFs were traded in November, and because ETFs and options are among the fastest-growing financial vehicles in the world, it only makes sense to combine the two. While today’s piece is a departure from the norm, this column typically highlights unusually large or interesting ETF options trades to help readers understand where traders believe a particular ETF may be headed. In doing so, Nations will examine the underlying options strategy.
It’s usually option traders discussing volatility, but low volatility can be a good thing for every investor. After all, while a lot of volatility can lead to oversized returns if a stock or ETF appreciates, elevated volatility can also mean a higher likelihood of a stock or ETF falling below the initial purchase price. Hence, there’s higher risk in high volatility.
There aren’t many successful investors who like risk, so it’s not surprising that the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-45) has attracted $5 billion in assets since it was launched less than four years ago. SPLV tracks the S&P 500 Low Volatility Index, which consists of the 100 stocks in the S&P 500 with the lowest realized volatility over the previous 12 months.
Low volatility has specifically been good for owners of SPLV, as you can see from the comparison of the return for SPLV and the broader market as defined by the SPDR S&P 500 ETF (SPY | A-99) since SPLV was introduced. SPLV has actually outperformed SPY over that period on an absolute basis, and it’s done so with volatility—as measured by standard deviation of annualized returns—that’s about 25 percent lower.
It would seem that SPLV is the best of all possible worlds, better returns—a good thing; and lower risk— an even better thing. But if you’re thinking that SPLV is just a lower-risk version of the S&P 500, you’d be wrong. SPLV is very different than the larger S&P 500.
Very Different Funds
As of the end of November, of the 10 sectors making up the S&P 500, information technology was the largest, with 20.0 percent of the market capitalization of the entire index. The financial sector was second, at 16.3 percent, while telecommunication services was the smallest sector and utilities was the second-smallest sector, with just 3.1 person of the market capitalization of the entire index.
But weightings are very different for the S&P 500 Low Volatility Index. The largest sector, by far, is the financials sector, which accounts for 32.5 percent of the Index; the second-largest sector is utilities, which accounts for 17.5 percent of the Index. Information technology, the largest sector in the broad S&P 500, accounts for just 2.8 percent of the Low Volatility Index.
The two largest sectors in the S&P Index account for just 36.3 percent of the total index. The two largest sectors in the Low Volatility Index account for exactly 50.0 percent of the index. SPLV isn’t based on a lower-volatility version of the S&P 500, it’s based on something very different, as you can see, because SPLV’s constituents are selected without regard to sector but merely because they exhibit lower volatility.
These weightings mean that SPLV is much more correlated to the utility sector than is the broad-based S&P 500 Index. In fact, SPLV has a weighting in utilities that is about five times greater than the S&P 500. And the defensive names that make up the consumer staples sector? They’re underweighted in the Low Volatility version.
SPLV: Utilities Fund In Disguise
In many ways, SPLV is a utility ETF. The correlation of SPY to the Utilities Select Sector SPDR Fund (XLU | A-90) is just 65 percent, while SPLV’s correlation to XLU is 84 percent. Is that a bad thing?
It certainly hasn’t been for SPLV, as low interest rates have made utilities, and SPLV, big winners. And while lower volatility is a great attribute over time, being overweight utilities is an asset allocation decision that might not be so great if interest rates increase dramatically.
The takeaway? Your ETF’s theme is important. But the next few paragraphs on the fact sheet—the paragraphs that explain how it applies that theme—may be more important.
At the time this article was written, the author held a position in SPY. Follow Scott on Twitter @ScottNations.