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2 Low-Volatility ETFs, 1 Clear Winner

PowerShares S&P SmallCap Low Volatility has exhibited lower volatility and better returns than SPDR SSGA Small Cap Low Volatility.

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Alex Bryan: Although PowerShares S&P SmallCap Low Volatility ETF is slightly more expensive than SPDR SSGA Small Cap Low Volatility ETF, it is the better choice of the two. Historically stocks with low volatility have offered a better risk-reward trade-off than the broader market, and this effect has historically been the biggest among the smallest stocks. To take advantage of the effect, both funds target small stocks that have historically exhibited low volatility and then weight their holdings by the inverse of their volatility so that the least volatile stocks get the biggest weightings in the portfolio.

The PowerShares fund pursues the low-volatility effect a bit more aggressively, using a one-year look-back period to measure volatility, while the SPDR fund measures volatility over a longer five-year look-back period. The PowerShares fund also refreshes the portfolio more frequently--once a quarter--while the SPDR fund only updates once a year. Between more frequent rebalancing, coupled with a shorter look-back period, the PowerShares fund should be able to adjust more quickly to volatility as it changes, which should give it cleaner exposure to stocks that will likely continue to have low volatility in the future.

Another important distinction between the two funds is that the PowerShares fund does not take sector membership into account. It basically targets low-volatility stocks wherever it can find them, while the SPDR fund looks for low-volatility stocks relative to their sector peers. This can give the PowerShares fund larger sector tilts relative to the market than the SPDR fund, but it should also give it cleaner exposure to stocks with low volatility.

These differences have helped the PowerShares fund exhibit slightly lower volatility than its peer from the latter's inception in February 2013 through December 2017. During that time, it also posted slightly better returns. While it may not always come out ahead, the PowerShares fund should continue to offer purer exposure to the low-volatility effect than the SPDR fund.

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