Taming market volatility

When securities markets turn volatile — as they have been since the fourth quarter of 2018 — ETF investors tend to flock toward products that can mitigate that volatility and reduce equities’ risk. These products may include low-volatility ETFs, hedge fund ETFs and buffer ETFs.

Low-volatility ETFs, which employ investment strategies designed to reduce downside risk during periods of market volatility, are the traditional choice.

“The key promise of these ETFs is to protect [portfolio] value when the markets are going down,” says Chris Heakes, director and portfolio manager, ETFs, with BMO Asset Management Inc. in Toronto. “Investors still get upside exposure to equities, but also get downside protection when the markets turn negative.”

Adds David Kletz, vice president and portfolio manager with Forstrong Global Asset Management Inc. in Toronto: “[Low-volatility] ETFs should suffer less extreme losses than the broad market during a downturn.”

But you and your clients should learn about the benefits and limitations of low-volatility ETFs before including them in portfolios.

“The biggest risk with these [ETFs] is that investors do not understand how they work and what they are meant to do, especially when it comes to return expectations,” says Mark Noble, senior vice president, ETF strategy, with Horizons ETFs Management (Canada) Inc.

Typically, low-volatility ETFs use an index- mirroring methodology in which the chosen stocks that have exhibited lower volatility have higher weights in the mirror index, says Noble. Other solutions include “actively managed ETFs that have a lower volatility than the broader equities market; that incorporate strategies that have a heavy focus on risk management.”

Pure strategies, which incorporate active risk-management metrics, tend to offer a higher degree of protection than index-based strategies, Heakes says. “We use low beta as a metric to determine which stocks should be held in a portfolio,” he says. “We do not start with the index and decide to look like the index.”

There aren’t any constraints on the selection of low-beta stocks across sectors, Heakes adds, with the exception that concentration risk in any given sector is avoided.

Comparatively, index-based strategies tend to replicate the sector weights in the pertinent index. The ETF’s portfolio manager may choose to hold, for example, plus or minus 5% of a sector weighting as part of a low-volatility strategy — consequently, the ETF would end up looking a lot like the index.

Paul Vendrinsky, portfolio manager with SIA Wealth Management Inc. in Calgary, says his firm’s approach to mitigating volatility involves “implementing unconstrained and tactical investment strategies based on relative strength analysis. These strategies are designed to mitigate long-term downside volatility, especially during negative equities markets.”

Regardless of the tactics used, lower-volatility strategies generated better returns overall than the broader equities market did during recent periods of heightened volatility, Noble says, beginning late in 2018 and through most of the first six months of 2019.

“From the beginning of the fourth quarter of 2018 [and] up to the end of June 2019, the S&P 500 [composite] index had a total return of about 1.52%, whereas one of the most widely followed low-volatility equity ETFs, iShares Edge Minimum Volatility USA ETF [TSX: USMV], was up by 7.61%,” Noble says. “In Canada, we see a similar pattern with the S&P/TSX composite index, which was up by 1.69% [over the same period], whereas BMO Low Volatility Canadian Equity ETF [TSX: ZLB] was up by 11.2%.”

The biggest issue with low-volatility ETFs is that they do well during periods of relatively high volatility, but can underperform in a growth market or a rising interest rate market, Noble says. For example, in 2016, the Canadian equities market was up by 15.4% for the year, while ZLB was up by only 9.97%.

Hedge fund ETFs, such as Horizons Seasonal Rotation ETF (TSX: HAC) and Purpose Multi-Strategy Market Neutral ETF (TSX: PMM) also focus on providing absolute returns, regardless of whether the markets rise or drop. “HAC has the ability to invest in cash or defensive assets, such as gold,” Noble says, “and can generate excess returns in a market pullback.” HAC has delivered a five-year annualized return of 8.51% as of Aug. 23, 2019.

Buffer ETFs represent a new risk-mitigating strategy. These ETFs, offered by Wheaton, Ill.-based Innovator Capital Management LLC and Toronto-based FT Portfolios Canada Co., use options strategies to limit losses. At Innovator, the buffer is based on the level of the S&P 500 on the day the ETF launched, so if you buy a buffer fund when stocks have dipped below the starting level, you will enjoy less downside protection. However, you would not see any gains until stocks rebound to above the starting threshold.

Hedge fund and buffer ETFs funds have higher fees than regular ETFs, Noble says: “Most plain-vanilla market cap-weighted [ETFs] have management fees of less than 20 basis points (bps), whereas most factor or alternative ETFs have management fees of roughly 35 bps to almost 1%.”

Noble attributes the higher cost to the greater complexity in structuring these ETFs. Costs may also include higher trading fees, the cost of derivative contracts and, in some cases, performance fees.

“Alternative investment strategies that employ shorting or leverage would be expected to have a higher risk associated with them,” Noble adds.

Using low-volatility ETFs makes sense toward the end of the business cycle, Kletz says, as the risk/return profile of the broad equities market begins to skew to the downside. “Conversely,” he says, “a higher-beta approach is warranted as the business cycle begins to stabilize following a recession because the early phase of an economic recovery typically produces a sharp rally for stock markets, with more volatile companies being the primary beneficiaries.”

Vendrinsky cautions that low-volatility ETFs were introduced after the global financial crisis and, therefore, haven’t experienced a severe downturn yet: “One concern is that the low-volatility names could become highly volatile [during] a global market panic when investors rush for the exits.”