Low-volatility ETFs, which try to smooth out the ride in markets, have about $8.7-billion in assets under management in Canada.Skyhobo/iStockPhoto / Getty Images
As clients’ knuckles go white in this year’s unpredictable markets, more advisors may be giving low-volatility exchange-traded funds (ETFs) a closer look.
These factor-based ETFs – accounting for about $8.7-billion in assets under management (AUM) in Canada and about US$53-billion in the U.S. – have had a good run in recent weeks, outperforming broader indexes this year.
“Given the generalized volatility, we’re seeing more inflows and we expect those to rise,” says Daniel Straus, managing director of ETFs and financial products research at National Bank of Canada Financial Markets in Toronto.
February market data show flat inflows to low-vol Canadian ETFs and modest growth in the U.S, he adds.
But that could soon change as markets are forecast to remain volatile in response to policies from U.S. President Donald Trump.
Low-volatility ETFs “tend to be a little steadier than broad markets,” says Bipan Rai, managing director and head of ETF and structured solutions strategy at BMO Global Asset Management in Toronto.
And they can often outperform amid bearish market sentiment.
To that end, Mr. Rai points to BMO Low Volatility Canadian Equity ETF ZLB-T and BMO Low Volatility U.S. Equity ETF ZLU-T, Canada’s two largest low-volatility ETFs, accounting for about $6-billion in AUM.
Mr. Rai says BMO GAM’s model ETF portfolios are now overweight both funds, making up core equity exposure for both Canadian and U.S. markets.
The reasons are many, including a restrictive Federal Reserve monetary policy, the Trump administration’s uncertain policies, and valuations “still being stretched” for many large-cap technology companies, he adds.
As well, the S&P 500 has posted gains exceeding 20 per cent over the past two years, Mr. Rai says, “so expecting a third year of incremental gains might be tough.”
While the low-volatility strategy has worked so far this year, it involves risks, including return chasing, says Alan Fustey, portfolio manager and ETF strategist with Bellwether Investment Management Inc. in Winnipeg.
“The problem with any factor investing is people tend to chase what outperforms at the moment, assuming it will continue in the future,” he says.
Although low-vol ETFs have done well recently, many have long track records, illustrating their upsides and downsides. Mr. Fustey notes many launched after the global financial crisis when investors were skittish about equity investing.
Underpinning the premise was research that supported the “low-volatility anomaly” theory.
“It’s called that because it violates the basic principle that the greater the risk, the more reward you should expect” over the long term, Mr. Straus explains.
Research shows that low-volatility stocks have outperformed the S&P 500 over the long-term, he adds. Yet, over the past 15 years, the S&P 500 has had the upper hand.
That said, a low-vol strategy has worked well for the Canadian market. BMO Low Volatility Canadian Equity ETF, for example, has outperformed the S&P TSX Composite since its inception in 2011.
Yet, the ETF’s performance also highlights how the strategy works in some down markets, but not all.
The ETF fared better than the S&P/TSX Composite Index in 2014 and 2015 amid the oil price crash because it “managed to rotate out of energy,” Mr. Straus says.
It also was largely flat during high inflation and rising interest rates in 2022 while the TSX was down about 6 per cent.
Yet the COVID-19 downturn offers a different picture. The BMO ETF experienced similar volatility to the broad index during the crash in March, 2020, but it underperformed during the recovery.
The S&P 500 and BMO Low Volatility U.S. Equity ETF also saw comparable drops in 2020, with the broad index substantially outperforming the low-vol ETF in the pandemic bull market.
Measuring risk
The different outcomes demonstrate the limits of low-volatility strategies to mitigate risk.
One challenge is that risk has many facets, Mr. Straus notes. “It’s really like an unknowable, spikey monster in the shadows,” and volatility is just one of those spikes.
What’s more, different low-vol ETFs often define volatility differently.
BMO’s ETFs, for example, largely hold stocks with low beta scores to provide a different makeup than broad indexes. Among the U.S. fund’s top holdings are General Mills Inc. GIS-N and International Business Machines Corp. IBM-M, while the S&P 500’s top stocks include Apple Inc. AAPL-Q and Nvidia Corp NVDA-Q.
Other ETFs use standard deviation as the key metric. That includes Invesco S&P 500 Low Volatility Index ETF ULV-F-T, launched in 2017. It selects the 100 stocks on the index with the lowest realized volatility.
Another choice is iShares MSCI USA Min Vol ETF XMU-T. It selects holdings using an optimal minimum variance approach.
Share price variance is one criterion, but the ETF also has a minimum number of securities and each stock has a maximum weighting. The ETF is also limited in how much it can deviate from any market sector, Mr. Straus adds.
Despite differing approaches, all three ETFs have underperformed the S&P 500 since 2013, underscoring the risk of clients missing out on growth.
That can lead to FOMO (fear of missing out) and the risk investors sell one strategy at a low point and buy another at its peak, says John De Goey, portfolio manager with Designed Securities Ltd. in Toronto.
“There’s that old saying that the best plan is one you can stick to,” he says. Low-volatility ETFs may help some clients stick to their investment plans, but they could also lead to the opposite outcome.
Advisors can also reduce volatility using asset allocation or other factor-based strategies such as value and dividend ETFs. “Those are like low-volatility’s first cousins,” Mr. De Goey says, and they all tend to hold lower-beta stocks.
Still, low-volatility ETFs may be a suitable core equity strategy for retirees and other conservative clients who still need equity exposure, or as a satellite allocation to smooth out overall volatility, which could be with us for a while, Mr. Rai says.
“Given the turbulence coming out of the U.S., a low-volatility approach makes a lot of sense.”