Recent results from low-volatility exchange-traded funds are a reminder of an immutable investing rule that people keeping hoping to outsmart.
You can’t successfully invest in stocks without risk. Low-volatility ETFs seemed to refute this for a while, but they’re coming back down to earth. A recent note from investment dealer Richardson GMP explains why: Basically, it comes down to something called interest-rate sensitivity risk. As bond yields increase, the price of bonds and stocks in dividend-heavy sectors such as utilities, telecom, pipelines and real estate decline. These are exactly the sectors that dominate low-vol ETFs.
“Dividend focused strategies, which have historically experienced lower equity market risk, have a higher interest rate sensitivity risk,” the GMP note says. “Should yields continue to rise, this risk [would become] more impactful on performance. “
The popular BMO Low Volatility Canadian Equity ETF (ZLB) produced a total return of just 0.5 per cent for the 12 months to April 30, and a great five-year annualized return of 11.8 per cent. By comparison, the broad market BMO S&P/TSX Capped Composite Index ETF (ZCN) produced a one-year total return of 3.1 per cent and a five-year gain of 7.7 per cent.
Rate sensitivity has undoubtedly played a role in the slowing momentum for ZLB compared to ZCN. About 45 per cent of ZLB’s portfolio is in sectors that are sensitive to rising rates or that tend to underperform in the warming economic conditions that produce higher rates. “The advent of some ‘low volatility’ strategies that focus on equity investments with historically lower equity market risk have actually traded this risk for interest rate sensitivity risk,” the GMP note says.
Low-volatility ETFs continue to make sense for investors who want to own stocks that fluctuate less than others in price and are thus a little more comfortable to own. But you’ll outperform the market over some periods of time, and underperform in others.
Expect weaker returns from low-vol ETFs if rates continue to rise, and a resurgence when economic growth stalls and rates stabilize or edge lower. You’re not outsmarting the market with low volatility funds – you’re just exchanging one type of risk for another.