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There’s a shift in market sentiment and the rise of the Delta variant of COVID-19, and different views from the U.S. Federal Reserve Board on tapering, inflation, and the pace of the economic recovery have created a cloud of uncertainty. That’s led investors to think there may be a bumpier road ahead.

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After 14 months of outflows, low-volatility exchange-traded funds (ETFs) turned the tables on that trend in July and August and pulled in $191-million as the funds gained and investors became jittery about the market’s rise.

“The renewal in demand is due to the performance of these ETFs in recent months,” says Tiffany Zhang, equity research analyst, ETFs and financial products, at National Bank Financial Inc. (NBF), which tallies Canadian ETFs’ inflows and outflows. Investors have about $8.75-billion in low-volatility ETFs in Canada, according to NBF data.

These ETFs lagged when the market rebounded in March, 2020, following a sharp decline after COVID-19 was labelled a pandemic, she says.

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But year-to-date, Canadian low-volatility ETFs are outperforming the broader market, Ms. Zhang adds. “Investors are definitely taking notice.”

David Kletz, vice-president and portfolio manager with Forstrong Global Asset Management Inc., says the inflows into low-volatility ETFs over the past two months have to be put into context.

A recent report from Morningstar Inc. states that there were US$18-billion in net outflows from low-volatility funds in the United States between March, 2020 and May, 2021, “which is massive,” he says.

Morningstar data also show an outflow of $1.6-billion among the 37 low-volatility ETFs listed in Canada during the same time period.

The market surge after the March, 2020 decline caused many investors to bail on these funds. “It made sense that investors wanted to rotate out of these quasi-defensive equity holdings and into higher volatility or broader market type of exposures” as stock markets rose, Mr. Kletz says.

Ms. Zhang says part of the recent outperformance is that the sector makeup of low-volatility ETFs is different from the market and “they tend to overweight utilities, consumer staples, real estate, and underweight technology [and] health care, which are more volatile sectors.”

Last year they lagged, as those sectors were the market drivers, but now they’re catching up as those sectors slow down.

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Real estate and consumer staples are performing better as the economy opens up and that has given low-volatility ETFs a boost, she says. “What you’re seeing is the return of the low-volatility ETF.”

There’s also been a shift in market sentiment and “there’s a cloud of uncertainty” with the rise of the Delta variant of COVID-19, and different views from the U.S. Federal Reserve Board on tapering, inflation, and the pace of the economic recovery, Ms. Zhang says.

That’s led investors to think that “there may be a bumpier road ahead” and that low-volatility ETFs are a good product to invest in right now, she adds.

Mr. Kletz says this “vulnerability” in the short term “creates a really good setup for [investments] like min vol [minimum volatility] and low vol.”

These ETFs allow investors to get more defensive in their portfolios “without hitting the panic button and getting out of equities altogether. That’s a happy medium for a lot of investors,” he adds. “From a tactical perspective, min-vol and low-vol ETFs can definitely make a lot of sense in the current environment.”

One recommendation from Ms. Zhang is BMO Low Volatility Canadian Equity ETF ZLB-T, which she says is the largest low-volatility factor Canadian ETF.

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The ETF has $3-billion in assets under management (AUM), a management expense ratio (MER) of 0.39 per cent, and a “pretty solid” track record, with a five-year annualized return of 9.8 per cent and a year-to-date return of 21.07 per cent, according to Morningstar Canada data as of Sept. 3.

BMO Low Volatility Canadian Equity ETF is overweight on utilities, financial services, and consumer staples. It doesn’t have any energy or health care holdings, Ms. Zhang says.

The ETF aims to have a low beta weighted portfolio of Canadian stocks and uses a rules-based methodology to build its portfolio. It has a maximum weighting of 5 per cent per stock and a maximum of 35 per cent per sector “to ensure it doesn’t get out of whack,” she says.

Mr. Kletz says another option is iShares MSCI Minimum Volatility Canada Index ETF XMV-T, which has $136.6-million in AUM and an MER of 0.33 per cent. Its five-year annualized return is 8.6 per cent, and it’s up 21.9 per cent year to date. It tracks the MSCI Canada Minimum Volatility Index.

He adds that a U.S. option is iShares MSCI USA Minimum Volatility Factor ETF USMV-A , which has US$29-billion in AUM, an MER of 0.15 per cent, and a year-to-date return of 16.1 per cent. It looks to invest in U.S. equities that have lower volatility characteristics relative to the broader U.S. equity market.

These two iShares ETFs are large funds and offer good liquidity, Mr. Kletz says. “These are bellwether-type funds.”

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He adds that another option is Invesco S&P 500 Low Volatility ETF SPLV-A, which has US$8.3-billion in AUM, an MER of 0.25 per cent, and a year-to-date return of 16 per cent.

Mr. Kletz says there are some differences between low-volatility and minimum-volatility ETFs. Although both are based on a parent index, like the S&P/TSX Composite Index or the S&P 500, stocks with the lowest trailing volatility in the index are picked for a low-volatility ETF. In contrast, a minimum-volatility ETF will look at the portfolio as a whole versus individual stocks. So, it will consider the cross-correlation between stocks in an index and create a portfolio with minimum volatility, overall.

Low-volatility or minimum-volatility ETFs are “something to look into if you’re an investor who wants to steer clear of crazy market swings. The products do what they’re supposed to do,” says Ian Tam, director of investment research at Morningstar Canada.

As an example, Mr. Tam points to another low-volatility ETF, CI MSCI Europe Low Risk Weighted ETF RWE-T, which “has outperformed the category.” Its three-year annualized return is 8.4 per cent, its five-year return is 7.7 per cent and it’s up 14.8 per cent year to date. It has $19.8-million in AUM and an MER of 0.65 per cent.

The fundamental quality of these ETFs is they aim to have less volatility than the overall market. So, when the market is high, they will lag, but when the market sinks, they are designed to overperform, he adds.

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