A Strong Choice for Risk-Averse Small-Cap Investors

Alex Bryan: PowerShares S&P SmallCap Low Volatility ETF offers a compelling way to get exposure to small-cap stocks. It starts out with the stocks in the S&P SmallCap 600 Index and targets the fifth that have exhibited the lowest volatility over the past 12 months. It then weights them by the inverse of their volatility, so that the least volatile stocks receive the biggest weightings in the portfolio. This can introduce some pretty big sector bets, which can be a source of risk, but the fund should hold up better than its parent benchmark during market downturns and should offer a better risk-reward trade-off over a full market cycle.

Low-volatility stocks have historically offered better risk-adjusted performance than their more volatile counterparts. One possible reason for this is that investors may overpay for highly volatile stocks, which may offer a small chance for a large payout, and neglect more steady-eddy names, which are less likely to offer eye-popping returns, causing them to become undervalued. 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. This is likely due to greater mispricing in the small-cap market segment.

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. 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. Overall, this is a really strong choice for more risk-averse small-cap investors.