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ETF Specialist

Defensive Exposure to Small-Cap Stocks

This ETF should give small-cap investors a smoother ride, though it has some distinct risks.

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Small-cap stocks are generally more volatile than their larger counterparts, but they should still have a place in a well-diversified portfolio. More risk-averse investors looking for exposure to these stocks might consider  PowerShares S&P SmallCap Low Volatility ETF (XSLV) (0.28% expense ratio).

Each quarter, this fund targets the least-volatile 120 stocks in the S&P SmallCap 600 Index over the past 12 months and weights its holdings by the inverse of their volatilities, so that the least-volatile stocks receive the largest weightings in the portfolio. However, it does not take into account the correlations between these holdings. The implicit assumption behind this strategy is that relative volatility should persist: Yesterday’s low-risk names will continue to exhibit low volatility in the short term. While this isn’t always the case, index data from S&P and academic studies suggest that this relationship has generally held in the past. This isn’t surprising because low-volatility stocks’ cash flows tend to be less sensitive to the business cycle than most.  

Alex Bryan has a position in the following securities mentioned above: XSLV. Find out about Morningstar’s editorial policies.