Low volatility funds are the newer kids on the block, garnering attention as investors grow weary of wild market swings.
In the past five years, the Canadian investment industry has launched mutual funds and exchanged-traded funds [ETFs] designed to help investors sleep better at night. They hold low-volatility stocks and provide a smoother ride than most of their equity peers. While returns have been impressive – particularly in market downturns – the strategies of these funds are not all alike, and some have drawbacks.
"These sorts of funds sell easily now" because markets have been so rocky, says Christopher Davis, director of fund analysis at Morningstar Canada. "One could make a good case for these funds in a portfolio, but I think people may buy them for the wrong reasons."
So far, these offerings have delivered on their promise to be less volatile than the market, Mr. Davis said. But many of their stocks, including dividend-payers, have seen their prices climb higher in recent years and are now more expensive, he said. "They may not necessarily deliver the same strong returns in the future."
Often, these investments take a backward-looking approach, owning stocks that have low-volatility histories. Among mutual funds, Mr. Davis prefers the RBC QUBE low volatility offerings because they have a more "forward-looking" strategy with exposure to high-quality companies.
"Low volatility and quality don't necessarily go hand in hand," he noted.
Daniel Straus, an ETF strategist with National Bank Financial, agrees that investors need to look under the hood. For instance, some ETFs follow the broad market closely, while others have no restrictions on industry sectors and will rotate into the least volatile stocks in an index.
"If you know what is in the portfolio, how it behaves and why, then investors will face fewer surprises," he said.
In the Canadian equity space, the iShares MSCI Canada Minimum Volatility ETF is designed so that it cannot avoid stocks in any one sector in its index, or be drastically overweight in those sectors, either. Recently, it had a 16-per-cent weighting in the energy sector, which has been hit hard by falling crude oil prices.
On the other hand, the BMO Low Volatility Canadian Equity ETF and the PowerShares S&P/TSX Composite Low Volatility ETF rotate into the more stable sectors.
"Both naturally have high weightings in utilities and real estate investment trusts [REITS], which historically have shown very low volatility," said Mr. Straus. "But they are very [interest] rate-sensitive. If a rate hike happens very suddenly, it will be these portfolios that suffer."
Still, Mr. Straus does recommend the BMO Low Volatility Canadian Equity ETF, which has seen strong inflows of money this year and has assets of just below $600-million. It is the largest low volatility Canadian-listed ETF, and was also the best-performing broad-based Canadian equity ETF in the 12 months ending Sept. 30.
Its strong performance has been helped by a low weighting in energy stocks, he noted.
For U.S. exposure, Mr. Straus likes the PowerShares S&P 500 Low Volatility ETF. He is also a fan of the iShares MSCI EAFE Minimum Volatility ETF, which invests in developed markets in Europe, Australasia and the Far East.
For very risk-averse investors, low volatility ETFs could be a core portfolio holding or an entry point into equity investing in order to get a less bumpy ride, he said. These kinds of ETFs will "avoid the extremely high-risk stocks which could be driven by speculation or sentiment," he said.
Dave Paterson, a mutual fund and ETF analyst with D.A. Paterson & Associates Inc., was "pleasantly surprised" by how low-volatility funds performed during this past summer's sharp market tumble, but he is not ready to embrace them wholeheartedly. He is concerned about the higher valuations of the stocks in their portfolios, and a lack of a long-term history.
"I am not sure I would recommend any of them right now in the mutual fund space because of the [short] track record," he said. He would still prefer other mutual funds run by managers who are very defensive, and invest in high-quality names that are "less likely to bear the full brunt of any market selloff," he said.
Among these funds are the Fidelity Canadian Large Cap, Cambridge Canadian Equity, Mackenzie Ivy Foreign Equity and Franklin U.S. Rising Dividends.
Among ETFs, however, he is comfortable with recommending the BMO Low Volatility Canadian ETF, and iShares MSCI EAFE Minimum Volatility ETF. Still, he would not jump into low volatility ETFs with both feet.
"There have been a lot of back-test data to show it [the strategy] works, but we only have a relatively limited real-time record," Mr. Paterson said. "In the context of a portfolio, I would be looking to use these as a portion of my equity allocation. I would not use it as a core, though."
With low volatility funds in the limelight, it's easy to forget about the old-fashioned ways to reduce volatility, such as holding cash or government bonds.
"Stocks and bonds don't behave the same way, so that too can reduce volatility," said Morningstar's Mr. Davis. "Keep in mind that low volatility funds hold stocks, so, while they lower your volatility, they are not immune to losses."
FOUR LOW-VOLATILITY FUNDS
Low-volatility Canadian equity ETFs that outperformed the 8.38-per-cent loss for the S&P/TSX composite total return index in the year ending Sept. 30:
BMO Low Volatility Canadian Equity ETF (ZLB-TSX)
- MER: 0.40 per cent
- Top five holdings: Dollarama Inc.; Alimentation Couche-Tard Inc.; Fairfax Financial Holdings Ltd.; Constellation Software Inc.; Intact Financial Corp.
- Return for the year ended Sept. 30: 15.25 per cent
First Asset MSCI Canada Low Risk Weighted ETF (RWC-TSX)
- MER: 0.67 per cent
- Top five holdings: BCE Inc.; Intact Financial Corp.; Fortis Inc.; First Capital Realty Inc.; Canadian Imperial Bank of Commerce
- Return for year ended Sept. 30: -4.37 per cent
iShares MSCI Canada Minimum Volatility ETF (XMV-TSX)
- MER: 0.32 per cent
- Top five holdings: BCE Inc.; Intact Financial Corp.; Canadian Imperial Bank of Commerce; Thomson Reuters Corp.; Bank of Montreal
- Return for year ended Sept. 30: 0.29 per cent
PowerShares S&P/TSX Composite Low Volatility ETF (TLV-TSX)
- MER: 0.33 per cent
- Top five holdings: Cominar REIT; Crombie REIT; Bank of Montreal; BCE Inc.; Royal Bank of Canada
- Return for year ended Sept. 30: 3.14 per cent
Source: National Bank Financial/Bloomberg; company data for holdings as of Oct. 8, 2015