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Experts say low-volatility ETF run has led many investors to mistakenly believe they’re intended to beat the market.Frank Harms/iStockPhoto / Getty Images

Many investors have the wrong idea about low-volatility ETFs, a product pitched to prevent investor whiplash.

Having consistently outperformed the broader market over the past several years, experts say the low-vol ETF run has led many investors to mistakenly believe they’re intended to beat the market. However, many have lagged the latest market rebound, which some money managers argue is exactly how those products are intended to perform.

“Over long periods of time, low-vol has proven to outperform on a risk-adjusted basis relative to the broad market and I think over the last few years it has, perhaps, distorted people’s view of what low-vol is supposed to be,” says Vivian Hsu, director of ETFs for Fidelity Investments Canada.

Low-vol ETFs have had “the best of both worlds for the last few years,” adds Chris McHaney, ETF portfolio manager at BMO Global Asset Management, “so I think some investors have potentially started to think these strategies are designed to outperform, which isn’t necessarily the case.”

Low-volatility ETFs are composed of individual equities that tend to bounce around less, which provides downside protection but also limits the potential for big returns when markets spike. Utilities, railways, grocery chains, insurance companies, telecoms, banks and real estate holding companies usually account for most of the holdings in low-vol ETFs as their business models tend to enjoy more long-term stability than those of other sectors.

“I think this recent COVID-19 drawdown has been sort of the outlier relative to historical events,” Ms. Hsu says. “Over all, low-vol has held its own. But at the same time, I think investors need to be aware and prepared for what they are investing in when they invest in low-vol ETFs, because when the market starts ramping up, you’re not going to get the same kind of torque on the upward side. That is something that people need to be aware of before going in, that there is no free lunch here.

Funds such as the BMO Low Volatility Canadian Equity ETF (ZLB-T), the Invesco S&P/TSX Composite Low Vol ETF (TLV-T), the Fidelity Canadian Low Vol Index ETF (FCCL-T) and the iShares Edge MSCI Min Vol Canada ETF (XMV-T) are all still struggling to recover their early 2020 losses; most remain down or relatively flat on a year-to-date basis while the S&P 500 was up by about 12 per cent this year as of Nov. 25. That is part of the reason Mr. McHaney argues, “now is actually a good time to start looking at low-vol.”

“There is still a lot of risk with the rollout of a vaccine [and] the valuation of the tech sector alone implies that, over the next few years, you just aren’t going to get huge returns out of that sector,” Mr. McHaney says. “Those sectors that have done well recently we don’t think will necessarily be the ones leading going forward [and] that creates a great opportunity for low-vol investors.”

Pat Dunwoody, executive director of the Canadian ETF Association, says the key to getting the most out of a low-vol ETF is to take the long view.

“They are really specifically suited for buy and hold strategies,” Ms. Dunwoody says. “I don’t know whether the kind of people that would be investing in low-vol products worry as much about ‘oh, I didn’t make as much as if I had invested in X product’, they are more likely to say, ‘I was able to sleep every night because I knew my investments were very secure.”

Though low-vol ETFs tend to be more expensive than funds that track the broader market – with management expense ratios roughly 20 to 30 basis points higher than S&P 500-tracking ETFs – Ms. Dunwoody says “there are multiple ways of building them” with different providers using unique methods of measuring volatility. (One basis point is a hundredth of a percentage point.)

“You can’t necessarily paint all low-vol with one brush because there are so many different approaches to building those portfolios,” BMO’s Mr. McHaney says. “Some of the other strategies out there perform optimizations around the broad market index, so it is a little more of a tilting of the broad market, whereas we are building a portfolio from scratch without concern as to what the broader market is doing.”

BMO is by far the largest player in the Canadian low-vol ETF space, with ZLB having more than $2.5-billion in assets under management. That fund uses ‘beta’, a mathematical determination of how responsive an individual stock is to changes in the overall stock market, as its primary metric.

“We think that isolates a truer exposure to low-vol and has tended to work well for us,” Mr. McHaney says, adding the use of a single metric versus more complex strategies is “where a lot of our success comes as well because it is a simple story.”

“The portfolio construction, we can outline it and it is fairly straightforward for investors to grasp and to understand what is going on within the portfolio,” Mr. McHaney says. “I think that provides another level of comfort as well.”

Cost is another critical factor in addition to comfort when choosing the right low-vol ETF. Although many low-vol ETFs tend to trade in line with one another, Ms. Dunwoody cautions against simply picking the most affordable option.

“The lowest-cost product may not be the right fit for the existing portfolio that the investor has,” she says. “It is part of the whole concept of diversification.”