Low Volatility ETF’s… What Are They And How Do They Work?

By: ispeculatornew
Date posted: 03.02.2012 (5:00 am) | Write a Comment  (0 Comments)

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This is a guest post from BuildYourETFPortfolio.com

If you have been reading about ETF’s in the last few months, chances are good that you will have noticed a trend among the new ETF’s being issued on US markets and abroad. Low volatility ETF’s on almost every possible index. Take for example a fund such as SPLV, a Powershare S&P500 low volatilty ETF.

What Is Volatility?

In order to explain what such an ETF does, I think it’s necessary to go back to the basics. Volatility can be expressed in many different ways but today we will look at it from the perspective of a Beta. Beta is a number, calculated for each stock that will give you an idea how the security reacts to market movements.

For example, if there are 2 stocks, how would they react during a 10% rise in the markets? If one of them usually moves exactly like the markets and rises 10%, you would say its Beta is 1. If this stock rises by half of what the index moves, 5%, then the volatility would be 0.50. Beta could also be 0 and could even be negative in the rare case where a stock usually reacts in the opposite way of the market. Basically, beta is:

Variation of a stock / variation of the market

Generally, most investors prefer having stocks with low beta or low risk. It’s not always the case but I would say that investors with less taste for risk will generally tend to go for those, as well as dividend payers, etc.

In Come Low Volatility ETF’s

Managers of these types of funds generally try to look at an index like the S&P500 and only buy a portion of those stocks, ideally those with the lower beta. Each ETF will be built differently but it could be done by buying the top 100 lowest beta’s in an index.

It’s certainly not a perfect method and I’ll be interested to see how such funds react. Obviously, in market declines, these funds will likely outperform standard funds but it’s likely to be the opposite when markets will rise (in a way similar to Covered Call ETF’s). I do think that such ETF’s might be right for certain types of investors and would love to hear your thoughts.

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