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Minimize Small-Cap Risk With This ETF

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Minimize Small-Cap Risk With This ETF

It is widely known that small caps are more volatile than large-cap stocks. For example, the widely followed Russell 2000 Index has a three-year standard deviation of almost 15 percent compared to 10.3 percent on the S&P 500.

Exchange-traded funds dedicated to the low volatility factor can help investors reduce some of the risk associated with smaller stocks. That is one of the reasons to consider the PowerShares S&P SmallCap Low Volatility Portfolio (NYSE: XSLV). XSLV, which turns 5 years old in February, tracks the S&P SmallCap 600 Low Volatility Index.

Said another way, the ETF's benchmark tracks the 120 members of the S&P SmallCap 600 Index with the lowest trailing 12-month volatility. The S&P SmallCap 600 has a three-year standard deviation of 14.1 percent.

Important Details

Traditionally, some large-cap low volatility strategies are heavy on the consumer staples and utilities sectors. However, those sectors are dominated by large-cap stocks, meaning an ETF like XSLV is going to look different than large-cap equivalents. XSLV allocates just 9 percent of its combined weight to those sectors.

“So far, the fund's approach has worked fairly well. From its inception in February 2013 through September 2017, it outpaced the S&P SmallCap 600 Index by 1.9 percentage points annually, with slightly lower volatility,” said Morningstar in a recent note. “Performance won't always be this strong; the fund should lag during strong market rallies, so it's a little surprising that the fund performed as well as it did over the past few years. Although this particular fund has not yet been tested in a significant market downturn, its relative performance should be the best during those periods.” 

Low volatility ETFs such as XSLV are not designed to capture all of a bull market's upside, but these funds generally do perform less poorly than traditional equivalents during market downturns.

A Surprise

One surprise in XSLV is that the ETF allocates over a quarter of its weight to small caps designated as growth stocks. That is surprising when considering small-cap growth stocks are historically more volatile than the broader small stock universe.

“While small-cap stocks are generally more volatile than larger stocks, the advantage from tilting toward low-volatility stocks has historically been the greatest among the smallest stocks,” said Morningstar. “This is likely due to greater mispricing in the small-cap market segment.”

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