Volatility & Beta Weighted Exchange Traded Funds (ETFs) A 5 Step Guide

Transcription

1 Volatility & Beta Weighted Exchange Traded Funds (ETFs) A 5 Step Guide

2 The last 4 years have been particularly challenging for investors due to the volatility in equity markets. Since January 2008, the benchmark S&P 500 index has exhibited daily fluctuations of more than 1% on 40% of all trading days. By contrast, such large daily fluctuations were seen on only 23% of all trading days over the preceding 80 years. How can investors manage this increased volatility risk? Traditionally, professional investors have used sophisticated instruments like derivatives. Individual investors have had fewer tools at their disposal to reduce their portfolio risk, while still maintaining equity exposure. This year a new type of ETF has been introduced to address this need. These volatility and beta- weighted funds are designed to allow investors to manage the risk profile of their equity exposure without the complexity and risk of derivatives. In this guide, we explain these new products in 5 steps: 1. How are ETFs traditionally constructed? 2. What is volatility and beta weighting? 3. How does this affect portfolio exposure? 4. How can these funds be used? 5. What are the key risks to focus on? 2

3 1. How are ETFs traditionally constructed? The best way to understand volatility weighted ETFs is to contrast them with traditional ETFs. One example of a traditional ETF is the SPDR S&P 500 fund (Ticker: SPY), the most traded equity ETF in the US. This fund invests in the 500 stocks in the S&P 500 index, where each stock is held in proportion to its market value (also called float market cap i.e. market price * publicly available shares). So if one invests $1,000 in this fund, the largest amount (~3%) will be invested in the stock with the highest market cap on that day, followed by other stocks in descending order of market cap. As a result, the stocks with the highest market cap get the largest share of our hypothetical $1,000. As we can see in chart 1, the top 20% (i.e. largest100 stocks by market cap) account for 65% of the fund s assets. The top 300 stocks account for over 90% of assets. Chart 1: Weighting structure of SPY 100% 80% % of Fund Assets 60% 40% 20% 0% Number of Stocks Note: Data as of 9/9/2011. In actual practice, most ETFs will also hold a small proportion of the $1,000 in cash or other liquid instruments. 3

4 2. What is volatility and beta weighting? The objective of these funds is to give investors the ability to moderate the risk profile of their equity exposure. This risk could be measured either through volatility or beta. Volatility refers to historical variations in the price or total return of a stock. Beta refers to the stocks sensitivity to the overall market. As an example, let s take a look at the S&P Low Volatility ETF (Ticker: SPLV). Like the traditional fund SPY, it is also derived from the S&P 500 index, but with 2 key differences: It includes only 100 stocks, those with the lowest volatility as measured over the previous year. Every stock in the fund gets weighted in inverse proportion to its volatility. In this case, our hypothetical $1,000 is now invested so that the stocks with the lowest volatility get the highest share. Chart 2: Methodology overview for SPLV Start with all the stocks in the S&P 500 Select the 100 stocks with the lowest historical 1- year vola;lity Give them weights inversely propor;onal to their vola;lity The PowerShares S&P 500 High Beta Portfolio (SPHB) uses a similar approach, but with the opposite intention of selecting more market sensitive stocks: First, the beta of each stock in the S&P 500 over the past year is calculated, and the 100 stocks with the highest beta are selected. For this fund, Beta is calculated as the market sensitivity of each stock s price to the S&P 500. These 100 stocks are then weighted in proportion to their beta i.e. the stocks with the highest beta get the highest weighting Other volatility & beta- weighted ETFs from fund sponsors like Russell adopt a similar fund design to the approach described above for the PowerShares funds. 4

5 3. How does this affect my exposure? The best way to understand these funds is to look at the impact it has on sector exposure. In Chart 3, we compare 3 funds: SPY The traditional market capitalization weighted fund. SPLV The PowerShares low volatility fund. SPHB The PowerShares high beta fund. Chart 3: Comparison of sector exposure Sectors* SPY Low Volatility (SPLV) High Beta (SPHB) IT 18.80% 3.50% 14.20% Financials 13.80% 9.80% 27.70% Energy 12.50% 2.50% 18.60% Healthcare 12.00% 8.80% - Industrials 10.30% 6.30% 10.70% Consumer Staples 11.50% 22.80% - Consumer Discretionary 10.60% 5.60% 17.10% Materials 3.60% 4.10% 10.80% Utilities 3.70% 32.90% 0.90% Telecom 3.20% 3.70% - Notes: Sectors classified according to the Global Industry Classification Standard (GICS) Sector exposure data as of 9/9/11 As we can see in the chart above, the low volatility fund (SPLV) has significantly higher exposure to stocks in traditionally stable sectors like consumer staples (e.g. food) and utilities. The high beta fund (SPHB) has significantly more exposure to market sensitive sectors like financials, energy and consumer discretionary sectors. 5

6 4. How can I use these funds? These funds are most useful for investors when they have a directional view on the market and want to adjust the risk of their portfolio accordingly. Chart 4 below shows some applications of these funds. Chart 4: Possible Application of These Funds AnWcipate a rising market and want a bullish Wlt to poruolio Russell 1000 High Beta ETF ( HBTA ) Russell 2000 High Beta ETF ( SHBT ) Powershares S&P 500 High Beta PorUolio ( SPHB') AnWcipate a declining market and want downside protecwon while swll maintaining equity exposure Russell 1000 Low VolaWlity ETF ( LVOL ) Russell 2000 Low VolaWlity ETF ( SLVY ) Powershares S&P 500 Low VolaWlity PorUolio ( SPLV ) An alternative route that investors have sometimes taken to express directional views is to use inverse and leveraged funds. For example, investors who are bullish may have used a 2x- leveraged fund to magnify equity exposure. Managers of leveraged funds achieve this through borrowing (hence the term leveraged ) and replicating the 2x exposure through derivatives. Using a volatility or beta- weighted approach could provide some of the same benefits of magnifying equity exposure without having to buy a leveraged fund. 6

7 5. What risks should I focus on? These ETFs share many of the same risks as any equity portfolio. However, given their construction, there are certain risks that investors should focus on. Directional movement: The funds are designed to move in a particular direction give the overall market, but there is no guarantee that this will happen. For example, a high betafund is designed to magnify market movements. Looking at back tested data over the last 20 years, generally this tends to happen but doesn t hold true all the time. On 86% of the days when the S&P 500 went up, the high beta index also moved up and 71% of the time, it went up more than the S&P 500. However, it may not happen all the time, in contrast to a 2x- leveragedfund that is explicitly designed to give two times the daily return of the underlying index. Portfolio turnover: Turnover is the volume of trading of the funds securities, expressed as an annualized percentage of the fund s assets. Higher turnover results in a higher cost of managing the fund. Over the last 10 calendar years ( ), the median annual turnover for SPHB and SPLV was 71% and 61% respectively. This is significantly higher than the traditional ETF SPY used in our example, where turnover is generally below 10%. In summary, volatility and beta weighted ETFs offer investors a new way to adjust the risk in their portfolios, if they have a directional view on the market. However, investors should consider that these funds are not guaranteed to meet their directional objectives, and will have higher turnover than more traditional market capitalization weighted ETFs like SPY. About First Bridge First Bridge publishes custom research and web based tools on Exchange Traded Funds (ETFs) for financial advisors and self- directed investors. First Bridge is headquartered in the San Francisco Bay area. For further information, please support@firstbridgedata.com or call (650)

8 Appendix 1: Summary of Volatility & Beta Weighted Equity ETFs Fund Name Ticker Sponsor PowerShares S&P 500 Low Volatility Portfolio PowerShares S&P 500 Low Volatility Portfolio Russell 1000 High Beta ETF Russell 1000 High Volatility ETF Russell 1000 Low Beta ETF Russell 1000 Low Volatility ETF Russell 2000 High Beta ETF Russell 2000 High Volatility ETF Russell 2000 Low Beta ETF Russell 2000 Low Volatility ETF Net Expense Fund Description Ratio SPLV PowerShares 0.25% Consists of large cap stocks with the lowest realized volatility over the past 12 months. SPHB PowerShares 0.25% Consists of large cap stocks with the highest sensitivity to market movements, or beta, over the past 12 months. HBTA Russell 0.49% Provides exposure to large to have a high beta. HVOL Russell 0.49% Provides exposure to large to have high volatility. LBTA Russell 0.49% Provides exposure to large to have a low beta. LVOL Russell 0.49% Provides exposure to large to have low volatility. SHBT Russell 0.69% Provides exposure to small to have a high beta. SHVY Russell 0.69% Provides exposure to small to have high volatility. SLBT Russell 0.69% Provides exposure to small to have a low beta. SLVY Russell 0.69% Provides exposure to small to have low volatility. Note: All data as of 9/13/2011. Expense ratios and fund tickers are as of that date and can change. 8