LGLV: A low volatility ETF suitable for this environment

While the stock market has generally remained in a risk-on mode with low volatility, the sell-off, as seen in August, comes alongside high volatility, eroding a significant portion of past gains. Although these declines were followed by a rapid price recovery, this is not always the case. That’s why funds that offer less volatile options remain the focus.

One such fund is the SPDR SSGA US Large Cap Low Volatility Index ETF (NYSEARCA: LGLV), which selects and weights stocks based on their past volatility. This fund has been able to achieve measures of volatility, such as beta, in the range of 0.80 to 0.85 versus the S&P 500 benchmark of 1.0.

With a positive track record compared to other low-volatility ETFs and a slightly different sector allocation than peers, LGLV is a good suitable for investors looking to diversify their portfolio and take a cautious stance in an environment of slow economic growth, with the uncertain interest rate trajectory and the upcoming US election, which could be potential catalysts for stock market moves.

ETF Description and Highlights

LGLV is an exchange-traded fund that tracks the performance of large-cap companies in the US market that exhibit low volatility, tracking the SSGA US Large Cap Low Volatility Index.

This index applies a rules-based process designed to overweight low-volatility stocks, as measured by the standard deviation of monthly total returns over the past five years, from a universe of eligible securities composed of the 1,000 largest US stocks by stock market capitalization.

Eligible stocks are allocated to a sector and classified within each sector according to their volatility. The stocks with the lowest volatility, which combined correspond to 30% of the market capitalization of the sector, are selected for inclusion in the index. Of these, the stocks with the lowest volatility receive the largest weight in the index, following liquidity constraints that limit constituents to 5% of the index and 20 times the weight of the stock in the initial universe of the largest 1,000 stocks. This index is rebalanced annually after the end of the last working day of March.

As of August 29, 2024, LGLV has $804 million in AUM invested in 162 companies with an average market capitalization of $51.3 billion in an allocation geared toward mid- and large-cap companies, which together represent 82.4 % of the fund. The rest is composed of mega caps with 9.7% and small caps with 7.7% of total assets.

LGLV’s top ten holdings are Colgate-Palmolive (1.48%), PepsiCo (1.33%), Linde (1.23%), Walmart (1.22%), General Mills (1.22%), Duke Energy (1.12%), Xcel Energy (1.11%) ), Johnson & Johnson (1.09%) and AvalonBay Communities (1.08%). These holdings represent 12% of total assets, reflecting the index’s approach to mitigate stock concentration in an allocation with an emphasis on defensive areas such as consumer staples and utilities.

Below is a table comparing LGLV to a similar group of ETFs that focus on low-volatility stocks. In this list, large funds like USMV and SPLV, along with other much smaller ETFs, follow distinct strategies. Funds like SPLV and FDLO hold relatively concentrated portfolios, while CFA has a more diversified allocation strategy with nearly 500 holdings, and THLV invests in sector ETFs instead of common stocks.

In terms of sector allocation, LGLV’s largest allocation is the Financial Services sector, with 18.0% of total shares, followed by Industry with 15.2%, Technology with 12.0%, Real Estate with 10.6% , Utilities by 9.4%, Discretionary consumption by 9.4%. %, Consumer Staples by 8.1%, Health by 7.6%, Communication Services by 3.7%, Basic Materials by 3.3% and Energy by 2.7%.

Compared to the Russell 1000 index, used in this analysis as a benchmark and represented by the iShares Russell 1000 ETF, LGLV is overweight real estate (+8.0%), utilities (+7.0%) and industrials (+6.9%) , with heavy allocations to residential, multi-utility REITs and diversified industry exposure. In contrast, LGLV is underweight in Technology (-19.4%), Communications Services (-4.8%) and Healthcare (-4.5%) as the fund has virtually no holdings in semiconductors or software in the Technology sector nor in volatile names. in the biotechnology and medical device industry.

Compared to the group of low-volatility ETFs, LGLV is overweight Real Estate (+6.5%) and Financial Services (+4.4%) because of the relatively high volatility seen in Real Estate, with a beta close to 1.15 , likely prevented peer group from higher allocations in the sector. Meanwhile, LGLV is underweight Technology (-6.2%) and Healthcare (-6.0%), as a beta of nearly 0.70 in the Healthcare sector has understandably caught the eye of its peers.

Mixed reviews

LGLV’s underweight exposure to mega-caps trading at premium price-to-earnings ratios such as Microsoft (32.2x), Apple (33.9x), Nvidia (46.6x) and Amazon (37.9x) led its ratio average price/earnings at a nearly 6% discount to the Russell 1000. This more than offsets LGLV’s higher allocation to several real estate companies such as Equinix (P/E 74.3x), AvalonBay (39.7x) and Equity Residential (49.3x). A knock-on effect of this lower allocation to names like Microsoft, Apple and Nvidia can be seen in LGLV’s profitability measures, as the average EBITDA margin fell by about 10 percentage points compared to the Russell 1000 index, while ROA fell by 7 percentage points. That’s not a positive for the overall portfolio, but it’s the price to pay for limited exposure to these relatively volatile and profitable giant names that have driven the stock market. Moreover, it’s worth noting that despite being underweight in the technology sector, LGVL’s P/E ratio is nearly 5% higher than that of the low-volatility ETF group.

Low volatility, outperforming peers

LGLV and its peer group have arguably met their goals of being less volatile investment vehicles over time as they have produced more stable performance compared to benchmarks such as the S&P 500 and Russell 1000. This it was evident in 2022, for example, when they posted a negative return in the 8 to 9% range, while the S&P 500 lost 18%. The reversal occurred in 2023, when low-volatility ETFs gained about 9%, but the S&P rose 26%. This relatively lower volatility translates to a beta in the 0.80 to 0.85 range, which is not as low as those of more defensive sectors such as consumer staples or utilities at 0.58 and 0.72, respectively, but remains significantly lower than the benchmark of the S&P 500. 1.0.

However, this moderate volatility came alongside a poor performance of these low-volatility ETFs, including LGLV, relative to the broader market. Meanwhile, LGLV has outperformed its peer group across all timeframes, with double-digit annualized total returns over the past five years.

Overall, there is a mixed picture when comparing LGLV to other low-volatility ETFs. LGLV has delivered higher historical returns, but with a portfolio that exhibits higher valuation measures. In addition, LGLV’s portfolio contrasts somewhat with the peer group given its lower exposure to the Technology sector at just 12% of total holdings, but overweight exposure to the financial and real estate sectors, particularly the REIT- residential buildings. In my opinion, this is a good thing for investors who want to diversify exposure to different sectors to mitigate concentration risk.

That said, despite lower historical returns compared to the Russell 1000 and S&P 500, I view low-volatility ETFs, and LGLV in particular, as a good option for staying invested in the stock market, but with some risk of relatively smaller decline as the overall market remains vulnerable, driven by a slowing economy that is likely to limit earnings growth and stock growth, while negative data on the macroeconomic front may trigger further stock market selling.