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Volatility & Beta Weighted ETFs


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An overview of volatility and beta weighted Exchange Traded Funds (ETFs). These volatility and beta-weighted funds are designed to allow investors to manage the risk profile of their equity exposure without the complexity and risk of derivatives.

First Bridge publishes custom research and web based tools on Exchange Traded Funds (ETFs) for financial advisors and self-directed investors. First Bridge is headquartered in the San Francisco Bay area. For further information, please email or call (650) 762-9270.

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Volatility & Beta Weighted ETFs

  1. 1. Volatility & BetaWeighted Equity ExchangeTraded Funds(ETFs)<br />A 5 Step Guide<br /><br />
  2. 2. The last 4 years have been challenging for investors due to the increased volatility in equity markets<br />Since Jan ‘08, the S&P 500 index has exhibited fluctuations of >1% on 40% on all trading days<br /><ul><li>Over previous 80 years, such fluctuations were seen on only 23% of trading days</li></ul>Professional investors have traditionally managed volatility risk using derivatives<br />Individual investors have had fewer tools to reduce their risk while maintaining equity exposure<br />Introduction<br />
  3. 3. New Type of ETF to Manage Risk<br />This year volatility and beta-weighted funds have been launched by Power Shares and Russell<br />In this document we discuss:<br /><ul><li>How are ETFs traditionally constructed?
  4. 4. What is volatility and beta weighting?
  5. 5. How does this affect portfolio exposure?
  6. 6. How can these funds be used?
  7. 7. What are the key risks to focus on?</li></li></ul><li>How are most ETFs traditionally constructed?<br />Traditional ETFs are market cap weighted i.e. each stock in the fund is held in proportion to its market value (technically called float market cap i.e. market price * publicly available shares)<br />One example: SPDR S&P 500 fund (Ticker: SPY)<br />This fund invests in the 500 stocks in the S&P 500 index<br />If we invested $1,000 in this fund, the largest share of our $1,000 would get invested in the largest companies (i.e. those with the highest market cap)<br />
  8. 8. How are most ETFs traditionally constructed?<br />As we can see in chart 1, the top 20% (i.e. largest 100 stocks by market cap) account for 65% of the fund’s assets. The top 300 stocks account for over 90% of assets.<br />Note: Data as of 9/9/2011. In actual practice, most ETFs will also hold a small proportion of the $1,000 in cash or other liquid instruments.<br />
  9. 9. These funds are designed to give investors the ability to moderate the risk profile of their equity exposure<br />Risk is measured either through volatility or beta:<br /><ul><li>Volatility refers to historical variations in price or total returns of stock
  10. 10. Beta refers to stock’s sensitivity to overall market</li></ul>What is volatility and beta weighting?<br />
  11. 11. An example: SPLV (PowerShares Low Volatility ETF)<br />Like the traditional fund SPY, it is also derived from the S&P 500 index, but with 2 key differences:<br /><ul><li>It includes only 100 stocks, those with the lowest volatility as measured over the previous year
  12. 12. Every stock in the fund gets weighted in inverse proportion to its volatility. Our hypothetical $1,000 is now invested so that the stocks with the lowest volatility get the highest share</li></ul>Chart 2: Methodology overview for ‘SPLV’<br />
  13. 13. How does this affect my exposure?<br />The best way to understand these funds is to look at the impact it has on sector exposure <br /><ul><li>SPLV has higher exposure to traditionally stable sectors like consumer staples (e.g. food) & utilities.
  14. 14. SPHB has higher exposure to market sensitive sectors like financials, energy and consumer discretionary sectors.</li></li></ul><li>How can I use these funds?<br />Most useful for investors when they have a directional view on the market and want to adjust the risk of their portfolio accordingly<br />
  15. 15. What risks should I focus on?<br />Directional movement:<br /><ul><li>These funds are designed to move in a particular direction, but no guarantee it will happen all the time
  16. 16. For e.g. SPHB, the high beta fund is designed to magnify market movements i.e. when the S&P 500 moves up, it should move up by a larger %. Over a 20 year period*, this happened on 71% of all trading days.</li></ul>Portfolio turnover:<br /><ul><li>Turnover is the volume of trading of the funds securities, expressed as an annualized percentage of the fund’s assets. From 2001-2010*, median annual turnover for SPHB and SPLV was 71% and 61% respectively.
  17. 17. Turnover for market cap weighted SPY is typically <10%</li></ul>* Based on backtested data<br />
  18. 18. Volatility & Beta Weighted Equity ETFs<br />As of 9/9/11. These numbers are subject to change by the ETF sponsor<br />
  19. 19. Volatility and beta weighted ETFs offer investors a new way to adjust the risk in their portfolios, if they have a directional view on the market.<br />However, investors should consider that these funds are not guaranteed to meet their directional objectives, and will have higher turnover than more traditional market cap weighted ETFs like SPY.<br />Summary<br />
  20. 20. About First Bridge<br />First Bridge publishes custom research and web based tools on Exchange Traded Funds (ETFs) for financial advisors and self-directed investors.<br />First Bridge is an independent research provider and not affiliated with any fund manager.<br />First Bridge is located in the San Francisco Bay area.<br />Email :<br />Tel: (650) 762-9270<br />Web :<br />