Low volatility approaches to investing have developed as a means to address investors’ concerns about the long-term impact of negative market swings on their portfolios. Low volatility investing puts less focus on stock selection and more of a focus on building portfolios with less total risk than their benchmarks.

This low volatility approach is well suited for today’s investor. After several years, many investors still have the precipitous market declines of 2008-2009 on their minds. They cannot forget the uncertainty they felt, and may do whatever it takes to avoid feeling that way again. For many of these people, avoiding the markets altogether is not a practical investment strategy. Canadians want to enjoy a comfortable retirement and will need to invest in equity markets to capture their upside potential. Said another way, Canadians must accept some level of risk in order to build sufficient funds for their retirement.

The growth of low volatility investing

“There is a demographic shift,” says Chris McHaney, Vice President and Portfolio Manager, BMO Asset Management Inc., “as the general population is aging as a whole. Since more investors are moving towards the later stages of their investment lifecycle, managing volatility becomes more of a factor than chasing frothy markets. The goal is to achieve attractive, steadier risk-adjusted returns.”

Interestingly, there appears to be a correlation between consistent earnings growth and reduced volatility, according to Greg Gipson, Senior Vice President, Head of Portfolio Management – Systematic Investments, BMO Asset Management Inc. Gipson believes that investors are more willing to pay a premium, via higher price-earnings ratios, for stocks with consistent earnings growth. This higher valuation helps curb the downside movement of these stocks and has actually helped lower volatility investments outperform the broader market over the long term.

Low volatility investing is suitable for any investor who seeks lower total expected volatility in their portfolio. The low volatility strategy works especially well for investors who want upside participation and downside protection, with some income potential. This approach is also well suited for cautious and conservative investors who can use low volatility solutions to gain equity exposure within an acceptable risk framework. Through low volatility solutions, long-term investors have more opportunities to better match their investments to their investor profile than they would with a broad-based benchmark.

Managing volatility with ETFs

Canadian investors are fortunate to have access to a wide range of low volatility exchange-traded funds (ETFs), from passive ETFs to actively managed funds-of-ETFs. “When looking at passive low volatility ETFs, transparency and low cost are two key benefits,” says McHaney. Beyond these core benefits, the ETF should still have portfolio-level risk controls. That is, the ETF should offer sufficient diversification by sector and market capitalization. Even if the ETF takes a passive, rules-based approach, it’s critical to avoid unintended biases in the portfolio (e.g., if the financials sector has been outperforming, it may lead to overweight exposure if no rebalancing takes place).

Generally speaking, a fund-of-ETFs provides investors with a balanced exposure to markets, with the added benefit of a tactical overlay. While the underlying components are passive ETFs, the overall portfolio is actively managed. “Tactical overlays capitalize on those times when markets are buying risk or when having some exposure to risk is attractive,” says Gipson. “If the risk-reward balance is attractive, the fund-of-ETFs manager can use a tactical overlay to adjust weightings between low volatility ETFs and more traditional ETFs that provide beta exposure.”

Managing currency during volatile times

Passive low volatility ETFs come in hedged and unhedged versions. Over the long term, McHaney believes that U.S. dollar exposure tends to reduce volatility for a Canadian investor, since the U.S. dollar generally increases in value when the U.S. market declines. While it seems reasonable for long-term investors to forego currency hedging, investors who want to remove short-term currency risk may choose to consider hedged versions of foreign ETFs.

An active fund-of-ETFs may use currency management to capitalize on short-term dislocations in foreign exchange markets to potentially boost returns and further reduce volatility. Gipson cites Japan as a telling example: “Look at Japan’s Nikkei 225 Index. From approximately mid-2012 to mid-2015, the total local return in yen terms was about 196%. If you had hedged against the Japanese yen, you would have made that return. If you did not hedge, you only would have made roughly 52%.” Gipson estimates that 20% of the volatility in foreign securities is attributable to currency fluctuations. Since short-term market dislocations are becoming more frequent, tactically hedging the active, unwanted currency exposure is a viable strategy to manage volatility.

Know what’s under the hood

With the proliferation of low volatility solutions, McHaney believes that it is important for advisors to understand the methodology of a portfolio and how it was constructed. Even though there are many different low volatility ETFs and mutual funds in the marketplace, they are not all built the same way, so they will provide different exposures and generate different results.

Advisors who want to appeal to risk-averse investors should view risk-mitigating approaches, such as low volatility ETFs, ETF-based mutual funds and funds-of-ETFs, as a way to encourage clients to stay invested in all market conditions so they can better meet their long-term financial objectives.

BMO Global Asset Management comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp. and BMO’s specialized investment management firms. BMO ETFs are managed and administered by BMO Asset Management Inc., an investment fund manager and portfolio manager and a separate legal entity from Bank of Montreal. BMO Mutual Funds refers to certain mutual funds and/or series of mutual funds offered by BMO Investments Inc., a financial services firm and separate legal entity from Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in mutual funds and exchange traded funds. Please read the prospectus before investing. Mutual Funds and exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.

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