Special Feature

ETF Guide 2015

This web-exclusive companion to Investment Executive's ETF Guide for Financial Advisors, 2015, offers insight on helping your clients understand their choices among exchange-traded funds (ETFs). In a video, Hugh Murphy, managing director of Credo Consulting, discusses the results of a recent survey of how advisors are using ETFs. Stay tuned for more web-exclusive content.

These ETFs are designed to smooth the ride for risk-adverse clients, but take the time to understand the strategy

By Dan Hallett | May 2015

I have heard many sales presentations and reviewed piles of marketing material from investment-management organizations over the past 20 years. The most common theme I've observed has been some variant of "We offer lower volatility and risk without sacrificing returns."

The exchange-traded fund (ETF) industry has launched dozens of low-volatility strategies in recent years on evidence that less volatile stocks outperform those with higher volatility. But as Forrest Gump's mother used to say, "You never know what you're going to get" - unless you take the time to develop a deep understanding of the strategies involved.

There are about 30 ETFs listed on the Toronto Stock Exchange (TSX) that aim to deliver index-like or index-beating returns with significantly lower volatility and downside risk than competitors. The five that focus on Canadian stocks sport a confusing array of labels, such as "managed risk," "risk-weighted," "low-volatility" and "minimum-volatility."

Three of the TSX-traded low-volatility Canadian equity-based ETFs sport sector concentrations that are very similar to the S&P/TSX composite index. One other ETF is more concentrated, while another boasts more diverse sectoral exposures.

With so few of these ETFs offering meaningful diversification against the market, their rationale is an improved risk/return profile. Although the body of research on low volatility dates more than 40 years, much of it is more recent. Researchers almost universally agree that less volatile stocks have outperformed those with higher volatility, but there is no consensus on the source of this excess return.

Some studies concluded that the higher performance of low-volatility stocks is compensation for higher risk not measured by volatility, such as liquidity risk. Other studies attributed the higher returns to stock mispricings because of investor attitudes and behaviour with respect to volatility. And other studies still said that the highest-volatility stocks perform horribly, and removing them leaves an outperforming group.

Here's a closer look at the five TSX-traded low-volatility Canadian equity-based ETFs:

- PowerShares S&P/TSX Composite Low Volatility Index ETF invests in the 50 least volatile stocks in the S&P/TSX composite index, as measured over the prior year.

- First Asset MSCI Canada Low Risk Weighted Index ETF adjusts the weights of the 95 stocks in the MSCI Canada index to overweight less volatile stocks and underweight more volatile names.

- iShares MSCI Canada Minimum Volatility Index ETF is subject to several constraints pertaining to sectors, style factors, stock concentration and turnover. MSCI applies computer optimization to minimize expected volatility.

- Horizons Canadian Equity Managed Risk ETF provides exposure to the S&P/TSX 60 index, but adds an "options overlay" program - mainly involving buying "put" options - to limit volatility and downside risk.

- BMO Low Volatility Canadian Equity ETF starts with the 100 biggest and most liquid stocks traded on the TSX and invests in the 40 stocks sporting the lowest "beta." (Beta is the product of the correlation of a stock's returns against that of its index and the stock's volatility relative to that of its index.)

Although these ETFs should give a slightly higher weighting to smaller companies - excluding the Horizons ETF - the BMO ETF is expected to be the most different from the S&P/TSX composite index because its measure of choice: beta.

By definition, stocks with the lowest correlation to the index will be those with smaller index weightings. Stocks with smaller weightings in a market-capitalization weighted index have smaller market caps. So, the BMO ETF should be the least similar to the broader market and offer the best diversification. The BMO ETF's portfolio has more emphasis on smaller firms than its peers, which exposes the BMO ETF to liquidity and other risks that haven't materialized during its existence.

Although there is limited "live" history for these five ETFs, a recent volatile six-month period served as a small test. From early September 2014 through late February 2015, the S&P/TSX composite index experienced double-digit losses and sharp rebounds that added up to a 1% total loss over this period.

All of these five ETFs delivered on their lower-volatility promise, and each lost less than the benchmark during the index's worst periods in September, October and December. And all except one of the five ETFs - the Horizons ETF - outperformed the index overall. However, it's a short time frame, from which you should not draw any firm conclusions.

Whatever low-volatility ETF you select, it's important to understand that these strategies really are nothing more than quantitative active strategies. So, make choices based on a deep understanding of the strategy and conditions that will cause your choices to excel or falter.

Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for institutions and affluent families.

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