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Some Canadians aim to reduce their portfolio risk by investing in low-volatility exchange-traded funds. GAUDILAB/ISTOCKPHOTO / GETTY IMAGES

Why you might want to have low-volatility ETFs in your portfolio

Investors are understandably concerned about recent market volatility. Stocks have been knocked around by the economic fallout from Russia’s invasion of Ukraine and uncertainty caused by rising inflation and the expectation of rising interest rates.

Some Canadians aim to reduce their portfolio risk by investing in low-volatility exchange-traded funds (ETFs), which are designed to minimize losses in a market downturn. The ETFs aim to do this by investing in stocks that tend to have less fluctuation in value, and with weightings in sectors considered to be less risky when the economy falters. The only drawback, experts say, is the funds tend to underperform when markets bounce back.

Mark Yamada, chief executive of PUR Investing, is a fan of low-volatility ETFs to protect long-term returns.

“Research shows that better-returning stocks are not necessarily associated with more risk, as many believe,” he says. “So why take the added risk?”

Mr. Yamada says volatility can erode returns, known as ‘volatility drag.’ The higher the volatility in a portfolio, the worse the long-term compound rate of growth.

“Any volatility leads to lower returns,” Mr. Yamada says, “but reducing volatility helps.”

Tiffany Zhang, equity research analyst, ETFs and financial products, at National Bank Financial, says low-volatility ETFs are suited to the more risk-averse investor but warns they can provide less growth as markets rise.

“Investors could sleep at night knowing there’s some volatility reduction when they invest in these ETFs, with the trade-off coming from missing out on strong bull market recoveries,” she says.

In 2021, for example, she says many low volatility ETFs underperformed because investors were turning to growth stocks in sectors like technology and health care. Laggards last year included funds such as Fidelity’s International High-Quality Index ETF (FCIQ-T +1.16%increase) and its U.S. Low Volatility Index ETF (FCUL-T +0.60%increase), as well as the iShares MSCI USA Minimum Volatility ETF (XMS-T +0.66%increase).

But with market swings back so far this year, Ms. Zhang says many low volatility ETFs have been outperforming their broader market benchmarks. Top performers year-to-date include the AGFiQ U.S. Market Neutral Anti-Beta CAD-Hedged ETF (QBTL-T unchno change), the Invesco S&P Emerging Markets Low Vol ETF (ELV-T unchno change) and the Fidelity Canadian Low Volatility ETF (FCCL-T +9.00%increase).

Morningstar data shows that the total assets under management (AUM) of Canadian low-volatility ETFs totaled about $3.7-billion in January. The sector’s AUM topped $4.4-billion in December 2019, then dropped early in 2020 as investors dumped funds of all kinds as financial markets tumbled at the start of the pandemic. Since then, the sector’s AUM has fluctuated between $3.6-billion and $3.9-billion, according to Morningstar.

Ian Tam, Morningstar Canada’s director of investment research, says assets in this space have yet to recover to pre-pandemic levels, as rules-based investment vehicles (such as low-volatility ETFs) found it difficult to adjust quickly enough to account for the market shock and investor interest in this set of ETFs waned.

According to Morningstar’s data, there are 39 low volatility ETFs currently offered in Canada; 35 of which have been around for 10 years. Most providers offer funds based on specific regions and offer both hedged and unhedged versions.

Mr. Tam notes four of those funds have outperformed their peers over the 10-year period: the CI MSCI Canada Low-Risk Weighted ETF (RWC-T +0.48%increase), the CI MSCI Europe Low-Risk Weighted ETF (RWE-T +2.31%increase), the Fidelity International High-Quality Index ETF (FCIQ-T +1.16%increase), and the iShares MSCI Minimum Volatility Canada ETF (XMV-T +0.79%increase).

XMV’s top holding is Barrick Gold Corp. and includes grocers Loblaw Cos Ltd. and Metro Inc. and pipelines such as Enbridge Inc. and TC Energy Corp.

RWE also holds grocers (Metro is its top holding), along with telecoms BCE Inc. and Telus Corp. and utilities Fortis Inc. and Emera Inc. RWC is betting on consumers having a consistent sweet tooth, with top holdings such as chocolate-makers Nestle Sa and Lindt & Sprungli Ag. and cocoa producer Barry Callebaut Ag. (Nestle sells a range of products including bottled water, coffee, creamer, food seasoning and pet food).

Fidelity’s FICQ has large positions in international semiconductor, real estate, mining and video game companies.

Ms. Zhang of National Bank notes that XMV has one of the lowest management expense ratios in the sector, at 0.33 per cent, and likes that it uses a mathematical model to select securities that show the least variation in their stock price over time. The objective is to minimize portfolio volatility with constraints on constituent weights, sector weights, country weights, risk exposures and index turnover, she says.

While these constraints can dampen the optimization of results, the merit of having such constraints is to avoid unwanted portfolio concentrations and avoid tracking too close to broad stock market indexes.

Low-volatility ETFs also have their share of critics.

John Hood, president and portfolio manager at J.C. Hood Investment Counsel, says they’re for “‘nervous Nellies’ who don’t understand why volatility is an opportunity to buy good assets ‘on sale’.”

Adds Mr. Hood: “If an investor is worried about volatility, they should reduce their equity exposure instead,” he says.

David Burrows, president and chief investment strategist at Barometer Capital Management says “there is a time and a place for low volatility ETFs” but his firm isn’t bullish on them currently, despite market uncertainty.

With inflation rising and interest rates set to go up, he feels the holdings in many low-volatility funds may not perform well. He believes more economically sensitive companies will perform better than stable defensive companies. As a result, his firm prefers to focus on dividend growth ETFs as a good choice for most investors.

Source: The Globe and Mail