Investors are often looking to insulate themselves against the vagaries of the bond and stock markets. Many exchange-traded funds (ETFs) have emerged to do just that.
“There’s no bad time to be looking at a low-volatility strategy. But with the risks we’re seeing, investors are definitely more interested right now,” says Mike Machel, wealth adviser and portfolio manager at Machel De Leeuw Wealth Advisory Group in Winnipeg, part of National Bank Financial.
“Although you’re hampering some of the upside if the markets take off, at least you’re doing what these strategies are intended to do, which is reduce the overall risk of the portfolio.”
Mr. Machel uses bond and low-beta ETFs, as well as ETFs that have more of a dividend focus. “Low beta” describes stocks that experience shallower market swings in either direction compared with the broader index. These are typically large, established and well-capitalized businesses that have historically demonstrated relative price stability.
Canadian investors can choose from several low-beta ETF options, such as the BMO Low Volatility U.S. Equity ETF, which provides exposure to just over 100 blue-chip stocks, led by names such as Eli Lilly & Co., and Johnson & Johnson.
The fund has delivered an annualized performance of 8.24 per cent over the past five years, compared with 13.6 per cent for the S&P 500 for the same period. An investor in the latter would have had to stomach a 19.4-per-cent decline through 2022, as well as this year’s volatility, to gain that return premium. In contrast, the one-year performance of the BMO low-vol ETF is a relatively staid 0.8 per cent.
Stock volatility is “off the charts these days,” says Cole Kachur, an adviser and portfolio manager at Kachur Wealth Management Group in Saskatoon, part of Wellington-Altus Private Wealth Inc.
Over the past few years, beginning with the turmoil caused by COVID-19, he has moved his book into primarily an ETF-based approach. “At least for my clientele, they’re tired of the swings of the individual names. These once-in-a-lifetime events seem to be happening a lot more frequently than once in a lifetime.”
Mr. Kachur uses broad-based funds to de-risk client portfolios through diversification into multiple geographies and asset classes. Once a risk-appropriate foundation is set, the discretionary manager uses ETFs to tactically achieve client goals.
“If there’s a means to manage that volatility, while still maintaining exposure to the areas that you want, that’s where ETFs hit a sweet spot,” he says.
Fixed-income ETFs are another option for investors to reduce portfolio unpredictability.
“It doesn’t matter if it’s dividends or interest; income coming into a portfolio will reduce volatility,” says Jeanette Power, wealth adviser at the Power Investment Team in Mississauga, part of CIBC Wood Gundy.
Bonds have served as an inherent stabilizer in an overall portfolio. Yet 2022 and now 2023 have upended that thinking, given that many investors are on the cusp of back-to-back years of negative fixed-income returns.
With yields on short and ultra-short-term bonds hitting multi-decade highs, many investors are turning to fixed-income ETFs. They’re a way to park cash, stay relatively liquid and often earn more than 5 per cent, while experiencing little volatility compared with equity or longer-dated bond investments.
“We are definitely using those type of instruments more than we typically would. You’re looking at a 5-per-cent return that carries very little risk,” Ms. Power says.
She also suggests looking at floating-rate and real-return funds as other bond exposures. “Those are good options to reduce volatility and protect the fixed-income portion of the portfolio.”
Many alternative ETF strategies are designed to boost income while dampening volatility, including the rising number of covered-call funds. These use call-option premiums to generate elevated returns. “They can provide a higher yield, typically. But that comes with a certain amount of risk as well,” Ms. Power says.
Investors in covered-call funds are giving up potential capital gains in exchange for the income generated by options writing. That may be suitable for some investors, such as retirees in need of monthly cash flow, but not others.
Ms. Power says that for investors seeking to reduce volatility, the most practical tool available has little to do with options writing, timing the rate cycle or looking for low-beta stocks. Diversification is what’s critical. “If I’m looking to build out a portfolio in terms of diversification, it is an ETF that I’ll often go to.”