The stock market thrill ride of the past 18 months or so seems to have frayed the nerves of some investors.
You can see this in the numbers documenting the flow of money into low-volatility exchange-traded funds, which hold stocks that are less volatile in price than the broader market. As noted by National Bank Financial, low-volatility ETFs posted net inflows of money last month after 14 months of outflows.
Investors buying such ETFs are making a call that the market euphoria of the past year and a half will abate and that there will be some bad days ahead, as well as good. In that environment, low-volatility ETFs offer the potential for a smoother ride than indexes such as the S&P/TSX Composite or S&P 500. Let’s see how things might play out using a pair of popular ETFs from BMO, the BMO Low Volatility Canadian Equity ETF (ZLB-T) and the BMO S&P/TSX Capped Composite Index ETF (ZCN-T).
To start, we’ll flash back to the crash of early 2020. ZLB lost 16.2 per cent over the first three months of the year on a total return basis, while ZCN lost 20.8 per cent. ZLB’s lower volatility holdings declined less, but not dramatically so. If you’re buying low-volatility ETFs now, keep this performance comparison in mind and temper your expectations for downside protection if stocks fall.
If stocks take off again, expect low-volatility ETFs to lag traditional index ETFs. ZLB’s two-year annualized total return to July 31 was 11.7 per cent, compared with ZCN’s 14.8 per cent. And what about calm, low-drama market conditions? In the comparatively placid markets before the pandemic began, low-volatility ETFs were very competitive.
Might now actually be a good time to pivot to such ETFs? Making portfolio changes such as these is a form of market timing, which is to say they’re tough to do in a consistently timely way. Still, we could be at a key juncture for low-volatility investing. After lagging traditional indexing for a while, this strategy has now pulled even. Year to date, ZCN and ZLB are both up about 18 per cent.
If stocks are decelerating, low-volatility ETFs could offer a mildly less bumpy ride in the months ahead and deliver better results. Don’t expect too much, though. In a fast-falling market, bonds are what save your portfolio.
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