Handling Stock Volatility With ETPs

The Russell 1000 Low Beta ETF (LBTA) is designed to deliver exposure to stocks that have low predicted beta using a screening and ranking methodology. Starting with the lowest beta stock, a target portfolio is created by adding the next lowest beta stocks until the target portfolio has a total capitalization of 35% of the Russell 1000 Index. A portfolio of up to 200 stocks of the Russell 1000 Index are selected to optimally track the returns of the target portfolio while managing turnover and neutralizing exposure to other factors, such as volatility and momentum. LBTA is linked to the Russell-Axioma U.S. Large Cap Low Beta Index and charges 0.20% net annual expenses.

The PowerShares S&P 500 Low Volatility Portfolio (SPLV) is another ETF that applies a similar strategy. SPLV consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time. The fund's annual expense ratio is 0.25%.

Dialing Down (or Up)

Emerging market stocks is a high risk/high reward investment category packed with volatility. During the 2008-09 financial crisis, the volatility in emerging markets was especially large. After sinking more than 52% in 2008, emerging market stocks bounced back with a remarkable 75% gain the following year. The Direxion S&P Latin America 40 Volatility Response Shares (VLAT) attempts to tame the wild ride. The fund reallocates exposure between equities and U.S. Treasury Bills based up recent volatility levels of the S&P Latin America 40 Index. When volatility exceeds the targeted risk level of 18 percent, the exposure to equities is reduced and the exposure to T-bills is increased. Conversely when volatility drops below targeted risk levels, equity exposure is increased proportionately.

VLAT's strategy of increasing or decreasing market exposure based upon targeted risk levels is different from other volatility strategies like selecting low beta or low volatility stocks. "This is a better risk-adjusted return versus buying static or traditional market index ETFs," said Edward Egilinsky, Managing Director, Head of Alternatives at Direxion Shares. "It also avoids some of the contango issues that face VIX-based products and can be used as a buy-and-hold investment."

How does VLAT calculate the optimal level of exposure to stocks? It accomplishes this task by taking the fund's targeted volatility level of 18% and dividing it by the S&P Latin America 40 index's volatility level. Exponential volatility of just 10%, for example, would result in an asset mix of zero to T-bills while up to 150% could be allocated to stocks. On the other hand, if volatility soared to 88%, the asset mix would change with T-bills getting 80% exposure and stocks just 20%.

 Portfolio Application

Where do ETFs that aim to reduce stock market volatility fit within an investment portfolio?

"The most common will likely be for investors who are worried about volatility to move some of their conventional 'core' asset allocation into these 'low-volatility' funds," said Michael Iachini, CFA, CFP and managing director of ETF Research at Charles Schwab Investment Advisory. "Low-volatility funds are harder to use tactically, since they're still exposed to the market and will likely fall in value during a downturn. In this sense, they can be used as a bit of a tactical hedge for investors whose outlook on the market is generally negative. Moving to a low-volatility fund can be seen as somewhere between being fully invested in the market and moving assets out of stocks and into bonds or cash."

Another strategy is to use beta and volatility busting ETPs in more volatile asset classes like emerging markets or small cap stocks. This allows clients to still be invested, but to mute the unwanted gyrations. Ultimately, managing volatility is an achievable milestone and ETPs can help. L