Even the most optimistic portfolio managers counsel the need for downside protection. That’s particularly so now, given high valuations after nine years of bullish markets, the growth-stifling effect of rising interest rates and the prospect of a market slowdown. ETFs, with their liquidity, ease of use and sheer variety, can play key roles in supplying that downside protection.

“What’s appealing [about ETFs] is their simplicity,” says Mark Raes, vice president, product, at Toronto-based BMO Asset Management Inc. (BMOAM). “There is transparent exposure; you’re owning stocks; it’s not a derivative product; and you understand exactly what you’re attempting to accomplish, which is to just buy lower-risk stocks.”

A major stumbling block for financial advisors can be the difficulty of persuading clients in love with years of strong gains to invest in less flashy securities that perform better in bad times. Investor behaviour and lack of awareness about the long-term consequences of avoidable losses makes that challenge even greater, says Mark Stacey, senior vice president, portfolio management, and co-chief investment officer at Toronto-based Highstreet Asset Management Inc., a wholly owned subsidiary of AGF Management Inc.

“Most investors tend to believe that they can time the market before it goes down,” he says. “They sell at the wrong time, and then find it difficult to get back in.”

AGF’s strategy is to deploy broad diversification to avoid those unnecessary losses, Stacey says. Client portfolios should have exposure to a wide swath of geographical regions, sectors and “fundamental factors” such as growth, quality, value and risk. Putting these elements together, he says, gives investors “broad exposure to factors that have been proven to provide long-term outperformance.”

Adds Stacey: “You’re getting the benefit of the long-term performance of the factors, you’re diversifying by factor and you’re getting better downside protection and lower volatility because the factors aren’t completely correlated.”

Jaime Purvis, executive vice president, institutional sales, at Toronto-based Horizons ETFs Management (Canada) Inc., suggests a few approachs for dealing with volatility: “The easiest one, and the most fundamental if you think there is a crisis coming, is that you want to have non-correlated assets together. That is why people own stocks and bonds and why people have [recently] added gold and cash [to their portfolios].”

For investors who may be looking for something beyond this traditional approach, Horizons offers Horizons Morningstar Hedge Fund Index ETF (TSX: HHF), which provides access to complex hedge fund strategies without the cumbersome paperwork that hedge funds can require – at a much lower cost and with greater liquidity.

This ETF tracks the combined returns of a portfolio of 600 to 700 hedge funds developed by Morningstar Canada. Says Purvis: “It offers all the benefits of hedge funds in terms of good, risk-adjusted and reasonable returns with a different risk than what you [already] have in your equity portfolio.”

At BMOAM, managing risk while keeping clients invested in equities is emphasized, says Raes: “Most investors would tell you they’re saving for retirement, but they need their money to work for them. As such, they need to find vehicles within their risk tolerance that keeps their money growing.”

BMOAM’s collection of low-volatility ETFs, which have been offered since October 2011, have resonated with advisors and clients, Raes says. These ETFs often focus on staid but steady sectors, such as telecommunications and utilities, that tend not to gain strongly when the Canadian market is rising because of a spike in the price of oil. However, they tend to ride out the lows better. “So, with that smoother path, you get compounding benefits,” Raes says.

Although ETF firms have different approaches to downside protection, they’re on the same page about communicating the need for the strategy to clients. Therefore, advisors need to ask themselves which discussion will be the more difficult, Stacey says: “For most people, if they only got 25% when the market was up 30%, they feel OK about that. But when they [experience a 35% loss] and the market went down 30%, that’s a different discussion.”

Purvis says that countering client resistance on this point is “a thoughtful advisor’s biggest challenge,” which involves a consistent, ongoing discussion about the benefits of diversification.