Low-volatility exchange-traded funds are a recent addition to the fund universe, providing retail investors and advisors access to equity options that exhibit relatively smaller swings during times of extreme market oscillations. While many have jumped at this investment class to hedge against the recent bouts of short-term risks, low-volatility ETFs could be a good long-term holding as well.

Advisors have taken a hard look at low-volatility options as macroeconomic events have weighed on the equities market. For instance, the PowerShares S&P 500 Low Volatility Portfolio (SPLV) added about $2 billion in new assets for the year ending November 1, 2012. Moreover, low-volatility ETFs attracted $4 billion in inflows in the first 10 months of 2012. We witnessed Congress dragging its feet on the U.S. debt ceiling, which prompted S&P to downgrade U.S. sovereign debt in 2011. That was followed by a plunge in stocks. Equities were pommeled again when the European financial crisis came to a head and default problems loomed. Meanwhile, many investors are still recovering from fresh memories of the 2008 financial depression.

This growing appetite for low-volatility assets has not gone unnoticed by providers. S&P/Dow Jones has launched the S&P MidCap 400 Low Volatility Index and the S&P SmallCap 600 Low Volatility Index, which have both been picked up by Invesco PowerShares. The new chief investment officer at Vanguard, Tim Buckley, says his company is also taking a “hard look” at low-volatility ETF offerings to help investors minimize volatility in their portfolios.

While more advisors are now beginning to consider low-volatility ETFs as a tactical strategy, the investment class may also serve as a long-term allocation strategy. Over the past half century, stocks that have shown the least volatility have performed as well as, if not better than, the overall market—and with less risk—both internationally and domestically.

The Low-Volatility Anomaly
According to the research paper Benchmarks As Limits To Arbitrage: Understanding The Low Volatility Anomaly, by Malcolm Baker, Brendan Bradley and Jeffrey Wurgler, low-volatility and low-beta U.S.-listed stocks have outperformed high-volatility and high-beta stocks over the 41-year period between 1968 and 2008, generating high average returns with few drawdowns. The anomaly in the long-term performance of low-risk portfolios upends traditional notions of the risk-return trade-off. For instance, within the 41-year period, a portfolio constructed of stocks with the highest volatility would have experienced a 90% decline in real terms, accounting for dollar depreciation. Meanwhile, a single dollar invested in a low-risk portfolio have been worth $10.12 gain in real terms.

The authors suggest this low-volatility anomaly occurs because of irrational investor behavior and limited arbitrage. Specifically, the paper suggests that investors have a preference for lotteries—they like to bet against the odds for the chance of a huge payout. They also don’t understand that small, speculative investments tend to fail, or they overpay for volatile investments because they are overconfident about their information or judgment. Institutions, meanwhile, have to follow explicit mandates to maximize returns subject to benchmark tracking error. Consequently, in their search for above-average profits, investors could end up with low risk-adjusted returns.

The low-volatility anomaly is also comprehensive, cropping up across all the equity markets in the world. Relative risk in the global equity markets produces an expected negative return in both developed and emerging markets, as explained in the paper Low Risk Stocks Outperform Within All Observable Markets Of The World, by Nardin L. Baker and Robert A. Haugen.

Low-Volatility ETF Options
Advisors can meticulously comb through the equities market in search of stock picks that exhibit relatively low absolute volatility, but there are ETF products that can provide easy access to baskets of low-volatility stocks in both the developed and international markets.

For starters, the largest low-volatility ETF, the PowerShares S&P 500 Low Volatility Portfolio (SPLV), with $2.8 billion in assets, tracks the 100 securities from the S&P 500 with the lowest realized volatility over the past year and then gives a heavier weighting to the least volatile stocks. Thus, the ETF leans toward steadier stocks, such as consumer staples (representing 31.3% of the index), utilities (making up 28.4%) and health care (contributing 14.6%). The SPLV portfolio has a 0.25% expense ratio and a 3.10% 30-day SEC yield.

The iShares MSCI USA Minimum Volatility Index Fund (USMV) provides exposure to a broader overview of the U.S. market. It takes the performance of the top 85% of companies listed on U.S. stock exchanges by market capitalization that show low volatility relative to the overall market. Again, health care and consumer staples make up a large portion of the strategy, 17.0% and 15.8%, respectively. The USMV index has a 0.15% expense ratio and a 2.57% 30-day SEC yield.

Advisors can also look at low-volatility options in the international markets through the PowerShares S&P International Developed Low Volatility Portfolio (IDLV), which follows the 200 least volatile stocks of the S&P Developed ex-U.S. and South Korea LargeMid Cap BMI Index over the past year. Like the SPLV portfolio, the PowerShares index weights holdings based on the inverse of their volatilities, so more stable stocks make up a heavier weighting—and stable developed countries top the regional allocations. Japan holdings make up 37.3% of the ETF, Canada makes up 20.1% and the U.K. represents 9.2% of shares. While the ETF has a sizable allocation to the defensive consumer staples sector (at 22.2%), it also has a large weighting in financials (19.8%) and industrials (16.2%). The IDLV index has a 0.25% expense ratio and a 3.72% 30-day SEC yield.

The iShares MSCI All Country World Minimum Volatility Index Fund (ACWV) includes the least volatile stocks of both domestic and international equities. The U.S. makes up a large 52.5% weighting, followed by Japan (12.5%) and Canada (6.6%). Consumer staples are 15.4% of the fund, health care is 14.4% and financials are 15.2%. The ACWV fund has a 0.35% expense ratio and a 2.96% 30-day SEC yield.

If you want to take a more focused approach to low-volatility international stocks, the iShares MSCI EAFE Minimum Volatility Index Fund (EFAV) offers low-volatility exposure to developed Europe, Australia and the Far East, with top country allocations toward the U.K. (28.0%), Japan (26.2%) and Switzerland (11.8%). The top sector allocations include financials (17.9%), consumer staples (17.2%) and health care (13.6%). The fund comes with a 0.20% expense ratio and a 5.65% 30-day SEC yield.

Additionally, there are a few emerging market low-volatility ETFs available. For instance, the PowerShares S&P Emerging Markets Low Volatility Portfolio (EELV) offers investors access to the 200 least volatile stocks of the S&P Emerging BMI Plus LargeMid Cap Index over the past year. The top countries in the ETF include Malaysia (22.1%), South Africa (18.8%) and Taiwan (13.9%). The fund also has a heavy tilt to financials at 27.1%, followed by consumer staples at 14.3% and utilities at 13.0%. The EELV fund has a 0.29% expense ratio and a 2.85% 30-day SEC yield.

The iShares MSCI Emerging Markets Minimum Volatility Index Fund (EEMV) tries to reflect the performance of the MSCI Emerging Markets Minimum Volatility Index. The fund has a significant tilt toward Taiwan (which makes up 15.0% of holdings), China (13.3%) and South Korea (10.8%). The fund places an emphasis on financials, which make up 26.0% of the portfolio, consumer staples (13.6%) and telecom services (13.3%). The EEMV fund comes with a 0.25% expense ratio and a 3.24% 30-day SEC yield.

Lastly, the EGShares Low Volatility Emerging Markets Dividend ETF (HILO) tries to reflect the performance of the Indxx Low Volatility Emerging Markets Dividend Index, which provides high income and exhibits significantly less volatility than the MSCI Emerging Market Index through low-beta stocks. Unlike the other funds, this ETF weights its 30 holdings according to dividend yields. The top country allocations are South Africa (with 21.4% of holdings), Turkey (with 16.1%) and India (with 11.4%). Financials make up 20.8% of the sector allocations, consumer goods represent 17.8% and telecommunications make up 16.6%. The HILO fund has a 0.85% expense ratio and a 3.11% yield.

While there will always be those who believe in tactically allocating to riskier assets hoping to cash in big in the short run, advisors may find low-volatility investments and ETFs a more suitable option for long-term horizons.

Tom Lydon is editor and publisher of ETF Trends, a Web site with daily news and commentary about the fast-changing trends in the exchange-traded fund (ETF) industry. Lydon is also president of Global Trends Investments, an investment advisory firm specializing in the creation of customized portfolios for high-net-worth individuals. Read the disclaimer: Tom Lydon is a board member of Rydex|SGI.