With the multitude of problems facing the global economy, it's no wonder the market has been reacting so violently lately. Every bit of good or bad news about the euro-zone's debt woes or consumer confidence in the United States, sends the equities market surging upwards or downwards, accordingly. Some sophisticated portfolios have tried to capitalize on these movements, by betting on volatility futures or funds like iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX). However, for the average retail investor, it's enough to make to make them seasick. Luckily, there are a variety of new ways for the average Joe to "smooth out" their ride.
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Taming the Roller-Coaster Ride
Volatility is a term that gets used a lot by financial journalists and bloggers, but many investors don't really understand what it is. Essentially, volatility refers to the amount of uncertainty or risk about the size of changes in a security's value. A security with a higher volatility means that its value can potentially be spread out over a larger range of values. In other words, the price of the security can change dramatically over a short time period, in either direction. It's the difference between riding a roller coaster or driving across the plains of Kansas. While there is nothing inherently wrong with high volatility stocks, these movements can create panic selling and restless nights.
For worried investors, low volatility options seem like a godsend. The ability to get long term gains, while limiting downside movements, is certainly appealing. During the market's recent bout of high volatility from August to October, the S&P Low Volatility Index, which is made up of the 100 least-volatile stocks in the S&P 500, lost just 1.1%. This compares with the nearly 10% drop for the bread-n-butter S&P 500. Over the last 10 years, the low volatility index returned over 80%, while the S&P 500 returned about half of that. In addition, the S&P LV 100 yields more than 1.3% versus the standard index. Stable earnings and high predictable cash flows are generally hallmarks of these low volatility firms.
By choosing low volatility options, investors can scale back their risk exposure, while still maintaining a position in equities, eliminating the need to run into Treasury bonds or cash. The recent ETF boom has provided a multitude of choices for investors looking to limit their downside risk. Funds like the Consumer Staples Select Sector SPDR (NYSE:XLP), which tracks consumer products firms, are historically low beta options. However, Wall Street has begun rolling out new products that target this sector of market place. Here are a few portfolio ideas:
With the most assets under management and largest trading volume, the PowerShares S&P 500 Low Volatility (NASDAQ:SPLV) should be the starting point for low volatility investors. The fund is based on the previously mentioned S&P LV 100 index and includes top holdings in Consolidated Edison (NYSE:ED) and Procter & Gamble (NYSE:PG). More than 55% of the ETFs holdings are in the utilities and consumer staples categories. The PowerShares fund has performed admirably in the face of the recent market rout, declining just 3.6% over the last three months, versus the S&P 500's 10.8% drop. Similarly, both the Russell 1000 Low Volatility ETF (NASDAQ:LVOL) and Russell 2000 Low Volatility ETF (NASDAQ:SLVY) can be used as well.
Investors looking for international exposure have some choices, as well. The iShares MSCI EAFE Minimum Volatility (NASDAQ:EFAV) can be used as a broad global proxy. Emerging market investors have an interesting choice in the EGShares Low Volatility Emerging Markets Dividend ETF (NASDAQ:HILO). The fund is composed of low volatility stocks from 13 different emerging markets and is designed to provide a high yield, but with a lower volatility than the MSCI Emerging Markets Index. The ETF currently yields a juicy 6.79%.
The Bottom Line
For many investors, the market's recent roller coaster has been stomach-churning, however, it doesn't have to be. The recent expansion of low volatility products and funds can be used to help smooth out the ride. The previous ETFs along with the QuantShares US Market Neutral Anti-Beta ETF (NASDAQ:BTAL) make interesting picks, for a low volatility portfolio. (For additional reading, take a look at 4 Ways To Use ETFs In Your Portfolio.)
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At the time of writing Aaron Levitt did not own shares in any of the companies mentioned in this article.