One of the most popular destinations for investors seeking factor-based or smart beta exposure is the low volatility factor. Exchange-traded funds (ETFs) such as the PowerShares S&P 500 Low Volatility Portfolio (SPLV) have made low volatility increasingly accessible. However, when ETFs such as SPLV outperform their traditional, cap-weighted equivalents, investors can misunderstand the intent of low volatility funds. The reality is that ETFs like SPLV are not intended to consistently provide outperformance of cap-weighted funds but rather to provide an alternative that performs less poorly during market downturns.

In the case of SPLV, the ETF debuted in May 2011, so it has not experienced a prolonged market downturn. SPLV's underlying index, the S&P 500 Low Volatility Index, is older and has experienced some severe equity market retreats, giving investors a sense of how SPLV could behave if a new bear market for stocks comes to pass. (See also: SPLV: PowerShares S&P 500 Low Volatility ETF.)

"In the financial crisis (2007-2009), the S&P 500 Low Volatility Index outperformed the S&P 500 by over 15% and the S&P 500 Minimum Volatility Index outperformed by more than 6%," said S&P Dow Jones Indices in a recent note. "The return differential during the tech bust (2000-2002) was more extreme, with the minimum volatility outperforming by 30% and the low volatility index outperforming by 50%. During the Russian currency crisis (1998), the S&P 500 dropped 19% in under two months, and the low-risk strategies were again able to limit losses."

SPLV holds the 100 members of the S&P 500 with the lowest trailing-12-month volatility. Not surprisingly, that methodology gives SPLV an obvious tilt toward defensive sectors as utilities and consumer staples, which combine for 37.4% of the ETF's weight. Still, the ETF does not lack cyclical exposure, as industrial, financial services and consumer discretionary names combine for 40% of the ETF's weight. SPLV's 7% weight to the technology sector can also been seen as surprising. (See also: A Low Volatility Surprise.)

For investors wondering how SPLV performs in real time when the broader market struggles, 2015 serves as perhaps the most compelling case study. Since 2012, SPLV's first full year of trading, 2015 was the worst year for the S&P 500. The benchmark U.S. equity gauge returned just 1.3% that year, but SPLV rose 4%, although SPLV was only slightly less volatile than standard S&P 500 ETFs that year.

"What is evident in examining the drawdown periods is that the majority of outperformance can come from different effects for the two low-risk indices. The selection + interaction effects drove most of the outperformance for the minimum volatility index, while the allocation effect drove the majority of the outperformance for the low volatility index," according to S&P Dow Jones Indices. (See also: Should You Invest in Low Volatility Funds?)

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