Many investors feel as if they're walking in high heels on black ice. Based on the last dozen years, it's easy to see why. Sure-footed gains have been followed by spectacular crashes.
U.S. stocks enjoyed history's longest bull market through the 1990s then fell 34 per cent between July, 2001, and March, 2003. Canada's stock market doubled after 2003 only to see most of those gains wiped out between June, 2008 and March, 2009.
Whether we're really on black ice – especially with the U.S. market – is anyone's guess. The S&P 500 has easily doubled, including dividends, since its 2009 low. But lacklustre earnings growth, talk of Fed "tapering" and worries about a Chinese slowdown have all made investors wary in recent days.
If you believe we're in for another crash, you might be comforted by a portfolio of low-volatility index funds. These funds are designed to give you the upside of stocks but with less violent swings than you would encounter by simply buying the entire market index.
The quandary? There's no guarantee they will function as advertised during the next downturn. And there's no agreement about the best way to build a low-volatility fund.
Among the choices are five funds introduced late last year by iShares Canada. They're designed to cushion market falls by combining stocks that often swing in opposite directions. The goal is to increase stability without sacrificing returns.
The funds track Minimum Volatility MSCI indexes including ones for Canada (XMV), the U.S. (XMU), the EAFE index (XMI), the Emerging Markets (XMM) and the All World index (XMW). Expense ratios range from 0.3 per cent for the Canadian and U.S. indexes to 0.79 per cent for the Emerging Markets Index.
So do they actually deliver on the promise of high returns and low volatility? According to a "back test" – a hypothetical look at how a strategy would have performed in the past – the Canadian Minimum Volatility Index would have outperformed the S&P/TSX composite, with roughly 20 per cent less volatility, since May, 2001.
Back-tested results, however, should be taken with a large grain of salt. Since investing strategies are based on what has worked historically, it's no surprise they shine when tested on that same data. The unknowable thing is whether they will continue to work well in the future.
To complicate matters further, there are different approaches to building a stable portfolio of stocks. Consider the path taken by Bank of Montreal, which started offering low volatility ETFs a year before iShares released its products.
Instead of combining stocks that typically move in opposite directions, the bank's Canadian low volatility index strategy starts with the 100 largest and most liquid stocks on the market, then selects the 40 least volatile, as measured by their "beta." (A low beta stock tends to move less than the overall market while a high beta stock has a history of jumping around more than the market.)
While the top holdings of the iShares Canadian Minimum Volatility ETF feature the usual suspects (think Canadian banks), BMO's Low Volatility Canadian Equity ETF (ZLB) doesn't include a single bank in its top ten. Its five largest holdings include Fairfax Financial, Metro Inc., Shoppers Drug Mart, Weston (George) Ltd. and Bell Aliant Inc.
BMO released two low-volatility U.S. equity funds, (ZLU) and (ZLU-U), in March, 2013, each made up of 100 low beta stocks. And Powershares has its own S&P 500 Low Volatility ETF (ULV) hedged to the Canadian dollar. As with BMO and iShares, the ten-year back-tested results would have beaten a traditional index.
Despite the obvious appeal of these strategies, Canadians haven't warmed to low-volatility ETFs. Combined assets under management for the nine available products total less than $200-million.
If the market does crash, that may change quickly. But only if these funds deliver on their promises – and we won't know that until a crisis actually occurs.