Murray Coleman

By Murray Coleman

The rise in popularity of exchange-traded funds focused on low-volatility stocks comes with some potential pitfalls. While these investments lower overall risks, portfolio managers warn that relying on an exclusive diet of such specialized fare can also take a bite out of returns.

The first quarter offered a recent example. As stocks surged on improving views of U.S. economic growth, the PowerShares S&P 500 Low Volatility Portfolio (SPLV) gained just 4.2% compared to the SPDR S&P 500 ETF Trusts (SPY) 12%-plus improvement.

The second quarter has brought a reversal in fortunes as markets in Greece and China have roiled investment appetites for risk. From early April through May 18, SPY fell 8.4%, according to Morningstar. At the same time, SPLV slid just 2.2%.

Stepping back, SPY entered Wednesday ahead by nearly 7% for the year. Shares of SPLV were up slightly more than 4% so far in 2012. But over the past 12 months, SPLVwhich earlier this month celebrated its one-year birthdayhas gained around 9%. Meanwhile, SPY has managed to barely surpass 2%.

Such short time frames provide a glimpse into how heightened periods of market fluctuations can whipsaw results for investors trying to allocate between low-volatility funds and more-diversified alternatives.

Similar to smaller rivals such as the iShares MSCI USA Minimum Volatility Index Fund (USMV) and the Russell 1000 Low Volatility ETF (LVOL), the $1.7 billion PowerShares fund invests in stocks producing relatively low levels of beta, a measure of volatility. Supporters of funds that own only more-stodgy names point to academic research indicating that less-volatile portfolios dont necessarily shortchange investors with long-term investment horizons.

The suggestion that a patient investor can minimize overall portfolio risk without sacrificing too much in long-term gains seems to be resonating with investors, notes Jim Koch, a software engineer turned financial adviser who works with technology executives in Californias Silicon Valley.

While funds concentrated in more defensive-minded stocks have the potential to produce market-like returns over extended periods of time, they are likely to miss much of the short-term peaks when stocks rebound, notes Sherpa Investment Management portfolio manager Jason Gunkel.

The West Des Moines, Iowa, advisory firm, which manages some $300 million in assets, prefers to keep clients with stock allocations of 50% or more exposed primarily to broader ETFs.

With more aggressive investors who want to outperform the S&P 500 over time, we stick to more traditional funds and tactically try to sidestep major market downturns, Gunkel says.

Ideal candidates for low-volatility funds are retirees or investors that are heavily overweight in bonds, he adds. For those types of clients, Sherpas managers have been using actively managed mutual funds such as the SEI Institutional Managed U.S. Managed Volatility Fund (SVOAX) and the SEI Institutional Managed Global Managed Volatility Fund (SVTAX).

Lately, Gunkel says hes been putting new assets into more-affordable domestic-stock ETFs as well as low-volatility iShares focused on developed international markets and on emerging marketsiShares MSCI EAFE Minimum Volatility Index Fund (EFAV) and iShares MSCI Emerging Markets Minimum Volatility Index Fund (EEMV), respectively.

Each of these ETFs holds large portfolios of individual stocks, so we believe they give our more-conservative clients very good diversification on their own, he notes.

A general guideline is that low-volatility ETFs are about 70% as risky as the core index on which they are based, says Scott Kubie, chief investment strategist at CLS Investments. The Omaha, Neb. investment-management firm oversees more than $7 billion in assets.

One possible scenario might be to split emerging-markets exposure between the plain-vanilla Vanguard MSCI Emerging Markets ETF (VWO) and the low-volatility-minded EEMV. Kubie argues, however, that such a combination would tend to overly dilute results. When we own emerging markets, we want to squeeze as much of the longer-term growth potential out of that portion of the portfolio, he says.

Instead, he favors sticking with a generic fund like VWO and using low-volatility ETFs as a portfolio marker for U.S. large-cap stocks. Kubie figures that a typical allocation with 15% in emerging-markets stocks and the rest in blue-chip U.S. funds over time would perform much like a portfolio with 60% in low-volatility domestic ETFs and 40% in VWO.

Youll probably get more bang for your buck mixing and matching low-volatility and broader ETFs rather than splitting hairs between the two within the same asset classes, he says.

Murray Coleman is a Dow Jones columnist who writes about personal finance; he covers topics including exchange-traded funds and mutual funds. His columns are available to Dow Jones NewsPus subscribers .

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