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Preet Banerjee

These ETFs smooth out the market's wild roller-coaster ride Add to ...

A billion-dollar milestone was reached this month for a U.S.-listed exchange-traded fund that is the poster child for a new wave of “low volatility funds.” Not yet a year old, the PowerShares S&P 500 Low Volatility Portfolio has been warmly received by investors.

But fear not, an equity strategy that is selling like hot cakes in the U.S. has spawned both ETF and mutual fund offerings north of the border, too. BMO offers an ETF, the BMO Low Volatility Canadian Equity ETF and Connor, Clark & Lunn Capital Markets recently announced a closed-end fund version.

Given the volatility of the markets over the last few years, it’s easy to see why these funds are popular. People didn’t like the roller coaster rides their portfolios were taking.

Low volatility funds essentially employ a simple strategy that screens for the lowest volatility members of a broader index. For example, the S&P 500 Low Volatility Index consists of the 100 stocks in the S&P 500 Index with the lowest 12-month volatilities. Since inception in May, 2011 to the end of 2011, the low volatility index handily beat the plain Jane S&P 500 Index +7.12% to -6.37%.

Since risk and return are related, it makes sense that a less risky portfolio outperforms in a down market. It also makes sense that it lags in an up market since volatility swings both ways. The cousin to the low volatility fund is the high volatility fund, and PowerShares (in the U.S.) offers that too: The PowerShares S&P 500 High Beta Portfolio is an ETF that tracks the S&P 500 High Beta Index. This index consists of the 100 stocks in the S&P 500 with the highest Beta (sensitivity to market movements). So far, there is less than $35-million in this fund.

So you have one strategy that should do well in down markets, and one strategy that should do well in up markets. Now there’s just one problem: If you couldn’t time the market before, nothing has changed that can make you time it going forward.

Market timing is incredibly difficult. It’s also very hard to determine with statistical significance who has pulled it off in the past, and who was just lucky. But here’s an exercise you might want to try. Go over the annual Forbes’ Rich List and look at all the investors over the years and try to answer two questions: 1) How many were market timers? And 2) How long did they stay on the list?

There are other ways to keep your portfolio on an even keel before you need to consider ETFs such as these. If you want lower volatility, regular rebalancing of a portfolio with an allocation to fixed income is a simpler, more straightforward approach which should be strongly considered when looking at the new wave of volatility- and beta-weighted ETFs and mutual funds.

Preet Banerjee, BSc, FMA, DMS, FCSI is a W Network Money Expert, and blogs at wheredoesallmymoneygo.com . You can also follow him on twitter at @PreetBanerjee

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