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portfolio strategy

Traders work on the floor of the New York Stock Exchange (NYSE) on June 27, 2016 in New York City.Spencer Platt/Getty Images

Never waste a stock market plunge, investors.

Episodes like the two-day market sell-off that happened after the Brexit vote last week are a quick and dirty stress test for various investing strategies. Observe the results and use them to evaluate an aspect of investing that we don't often talk about – the ownership experience.

The suitability of investments depends on things such as your age, your preference for growth versus income and your willingness to accept risk to make returns higher than bonds and cash. You also have to consider things such as fees and the consistency of returns.

But the experience of owning an investment is worth consideration as well. If declines are too much for you, there's a chance you'll make an ill-timed decision to sell based on emotion rather than rational thinking. Remember what the science of behavioural investing tells us: While we all enjoy having our portfolios rise in value, we feel the pain of losses more intensely.

We'll look at what it felt like to use three different investing options through the brief but sharp Brexit sell-off – plain old balanced mutual funds, index-tracking exchange-traded funds and an increasingly popular type of ETF called a low or minimum volatility fund. These latter ETFs are designed to track markets by focusing on stocks that move up and down in price less sharply than others.

Also in our mix are some bond funds – ETFs and mutual funds. They're included to remind investors why the basic diversification principle of mixing stocks and bonds remains essential, even with bond yields at today's low levels.

The star products in the brief Brexit decline were low volatility funds. In our comparison, they went three for three in head-to-head comparisons with conventional index-tracking Canadian, U.S. and international (everywhere but North America) ETFs.

Most striking was the comparison of the iShares Edge MSCI Min. Vol. USA Index ETF (XMU) against the iShares Core S&P 500 Index ETF (XUS), which is your basic cheap and cheerful way to put the U.S. stock market in a portfolio. The low vol fund eked out a 0.4 per cent gain in the two-day Brexit drop, while the S&P 500 fund dipped 2.7 per cent.

More typical results from low vol funds were found in the Canadian and international categories. As you can see in the chart, low vol funds simply lost less than their conventional index-tracking counterparts. This should be the typical experience with low vol funds – lose less on the down side, make less on the up. But in the past few years, low vol funds have outdone themselves.

The BMO S&P/TSX Capped Composite Index ETF (ZCN) made an annualized 6.7 per cent for the three years to May 31, while the BMO Low Volatility Canadian Equity ETF (ZLB) made 15.7 per cent. Gun-shy ever since the 2008-09 stock market crash, investors have been gravitating to low volatility stocks and funds as a way of adding a modest safety margin to their stock market exposure.

Demand for low vol ETFs is such that even Vanguard, a company with a huge ETF franchise based on tracking bedrock stock indexes, has just introduced a product in this category for Canadian investors. It's called the Vanguard Global Minimum Volatility ETF (VVO) and it includes stocks in developed and emerging markets.

Certainly, the surprise vote in Britain to leave the EU highlights the value of a low vol emphasis in stock market exposure. When bad stuff happens, you can be pretty sure you won't get the worst of it. But there is zero chance of a low vol fund providing perpetual outperformance. There will be a period where investors are ready for more risk and low volatility stocks are out of favour.

In the chart, you'll see a currency hedged version of XMU that lost 2.5 per cent in the two-day market drop. There's a lesson here on the desirability of currency hedging in portfolios. Nervous investors flock to the U.S. dollar, which means our Canadian dollar will suffer. In that environment, unhedged funds will perform better than hedged funds. Hedging, by the way, means using financial instruments called derivatives to block out the effects of currency fluctuations on the value of foreign stocks and bonds.

Balanced funds are a broad category that includes sub-groups with different missions. In our comparison, we have a fund that tilts toward Canadian stocks in Fidelity Canadian Asset Allocation; a fund with a global tilt and a neutral stock-bond emphasis in Mawer Balanced; and a Canadian neutral balanced fund in RBC Balanced.

To properly assess what these balanced funds did in the Brexit sell-off, let's compare them to a mix of ETFs that a do-it-yourself investor or adviser using ETFs for clients might assemble. With a mix of 20 per cent each in funds that track the S&P/TSX composite, S&P 500 and MSCI EAFE (Europe Australasia Far East) indexes and 40 per cent in a broad bond ETF, you'd have a two-day drop of 2.6 per cent (unhedged ETFs used here). All the balanced funds did better than that.

Now, let's compare balanced funds to a portfolio where exposure to the Canadian, U.S. and international markets is split evenly between conventional index-tracking ETFs and low volatility funds. Using the ETFs in the chart to build this portfolio, we get a two-day decline of 1.6 per cent.

Among the conclusions to be drawn from these comparisons is that balanced funds offer value in the form of automatic diversification through a mix of stocks and bonds. However much the major stock indexes are falling in a pullback, you can expect your balanced fund to be down less.

The experience of owning traditional index-tracking ETFs in the Brexit decline was more uncomfortable than the balanced funds, though adding low volatility ETFs to the mix took the edge off. ETF investing makes great sense because of the low fees, but it may not be the most comfortable ride at times.

Using the Brexit sell-off as an investing stress test makes sense given how intensely we feel the pain of losses. But performance in strong markets is important, too. We'll look into this when a sharp rise in stocks offers an opportunity. Stay tuned.