Has the comeuppance of the low volatility ETF arrived?

Low-volatility ETFs have met their match in the stock market surge since mid-March.

Pitched as a way for people to focus on stocks that bounce around in price less than the broader market, low-volatility exchange-traded funds have been a revelation over the past five years. Through good and bad years for stocks, through periods of falling and rising interest rates, they delivered better returns than ETFs tracking the S&P/TSX Composite Index. Until the mid-March market bottom, that is.

Consider this ETF pairing: The BMO S&P/TSX Capped Composite Index ETF (ZCN-T) and the BMO Low Volatility Canadian Equity ETF (ZLB-T). Globeinvestor.com charts show a 12-month share price decline of 6.6 per cent for ZCN through June 18 and an 8.6-per-cent decline for ZLB. In the worst market conditions we’ve seen since the global financial crisis, a basic Canadian market ETF beat a low-volatility fund.

Other low-vol ETFs have lagged as well. Shares of the Invesco S&P/TSX Composite Low Volatility Index ETF (TLV-T) lost 13 per cent in the past 12 months, while the iShares Edge MSCI Min Vol Canada Index ETF (XMV-T) fell 7.3 per cent.

The explanation can be found in the market surge over the past three months. The broader market, with its exposure to growth-oriented stocks as well as the stable companies found in low-volatility funds, has vastly outperformed. The three-month gain for ZCN was 27 per cent, compared with 14.6 per cent for ZLB.

We knew this was coming, even if ZLB’s share price outperformed ZCN by a cumulative 16 per cent to 5.6 per cent over the past five years. Stocks chosen for their lack of volatility take away some of the downside in a bear market, but they will also miss some of the upside when stocks rally.

Even if they’ve been disappointing lately, this is no time to give up on low-vol ETFs. The market surge since late March is unsustainable unless the pandemic quickly fades and economic growth springs back to where it was in early 2020, or better. If we head into a difficult period of economic uncertainty where interest rates remain low, the conservative dividend stocks that populate low-vol funds could do comparatively well.

Low-vol funds had the comeuppance that was inevitable after five years of beating mainstream equity ETFs. Their next period of outperformance may not be far away.