Lower risk, lower return. It’s a commonly accepted axiom of investing. But according to managers of rules-based equity ETFs that aim to deliver below-market volatility, the sacrifice in return is worthwhile because these strategies are likely to capture more of the broad market’s gains than its losses.
“Contrary to conventional belief that higher risk is associated with higher return, there’s been extensive empirical research that has shown the opposite actually happening,” said Nirujan Kanagasingam, vice-president and head of ETF strategy with Toronto-based CI Global Asset Management. “This phenomenon is dubbed the low-volatility anomaly.”
CI’s late-January launch of the CI U.S. Minimum Downside Volatility Index ETF and CI Global Minimum Downside Volatility Index ETF brought the latest of a growing number of low-volatility strategies available to ETF investors. At a time of high interest rates, slow economic growth or possible recession, they’re positioned as a less risky way to invest in major equity markets.
Other firms that offer globally diversified suites of low-volatility equity ETFs include BlackRock Asset Management Canada Ltd., BMO Asset Management Inc. (BMOAM), CIBC Asset Management Inc., Fidelity Investments Canada ULC and TD Asset Management Inc.
Chris Heakes, director and portfolio manager with Toronto-based BMOAM, cites what he calls the “lottery ticket effect” as the best theory to explain why low-volatility stocks tend to outperform over time. There’s a tendency among some investors to be willing to overpay for riskier stocks in the hope that they’ll earn quick money, Heakes said. Bidding up the prices of these stocks not only generally results in poor returns, he added, but also fewer dollars flowing into low-volatility stocks.
“So their prices are depressed,” Heakes said. “And over time, as this corrects, they can earn outsized returns.”
Though methodologies vary, most low-volatility ETFs employ stock selection processes based on either standard deviation or beta. Each of these factors
measures the extent to which the ups and downs of stock returns have varied historically.
CI’s new offerings, which are based on indexes developed by Germany-based Solactive AG, take a different approach by ignoring positive returns and considering only downside volatility. They’ve replaced CI’s previous low-risk weighted suite of ETFs, two of which were eliminated via mergers in April of last year. The remaining three were merged into the new global ETF on March 31.
“Investors don’t mind when the volatility is on the upside, and the price movement is on the upside. It’s really the return deviation on the downside that they’re concerned about mitigating,” Kanagasingam said. “We think this results in a more intuitive approach, and really sets itself apart from other low-volatility strategies.”
Though the Solactive methodology screens for stocks that have exhibited low downside volatility over the last six months of trading, the stocks selected — up to 125 for the U.S. strategy and 250 for the global — won’t necessarily be those with the best scores.
In part, that’s because an optimization process also takes into consideration how the stocks within a portfolio interact with each other. “We’re taking a portfolio approach as opposed to an individual stock approach,” Kanagasingam said.
The strategy also employs risk constraints at each semi-annual rebalancing so that the portfolios don’t deviate too much from their broad market benchmarks.
The maximum holding at rebalancing is 5% per stock, and sector weights are held to no more than plus or minus five percentage points compared to the broad market. For the international strategy, country weightings are also kept within plus or minus five percentage points of the broad market.
“Ultimately the goal is to provide exposure to the least volatile portfolio while trying to reduce or control for excessive tracking error” versus the broad market, Kanagasingam said.
The BMO ETFs employ beta — a measure of how risky a stock is compared with the broad market — as the basis for its stock selection process. Unlike the new CI offerings, this metric — calculated over a multi-period formula — considers both up and down movements.
“We used beta because often investors are looking at that broad benchmark and trying to protect themselves relative to the movements of the broad index,” Heakes said.
BMO’s target number of holdings — 45 for the Canadian ETF and 100 for the U.S. and international portfolios — is subject to a maximum 10% weighting per stock. Higher weightings go to the stocks with the lowest betas. There are also sector constraints and, for the overseas strategy, a limit of 25% per country. Rebalancing takes place semi-annually.
Since inception, BMO’s Canadian and U.S. ETFs have impressive track records for risk-adjusted returns based on how much they’ve “captured” the market gains and losses.
The BMO Low Volatility Canadian Equity ETF has captured 81% of the gains but only 36% of the losses, while the BMO Low Volatility US Equity ETF has an upside capture ratio of 76% and a downside capture of 50%. These ratios are calculated from inception in 2011 and 2013, respectively, to year-end 2022.
Over the same period, the Canadian ETF returned an annualized 11.9%, handily outperforming the S&P/TSX Composite Index’s 7.4% return, and with 34% less volatility as measured by standard deviation. The U.S. ETF’s return of 14.8% was slightly lower than the S&P 500 return of 15.1%, with 18% less volatility.
However, the BMO Low Volatility International Equity ETF essentially broke even on risk versus return, with an upside capture 75% and a slightly worse downside capture of 78% from its 2015 inception to December 2022.
The international ETF’s 2022 overweight in Germany, historically one of Europe’s more stable country markets, was largely responsible for the relatively weak results. Because of the impact of Russia’s invasion of Ukraine, a key energy supplier, Germany ended up being one of the worst-performing markets.
“Like any strategy, you can have good years and bad years,” Heakes said, adding that a lower-risk strategy often does well in Europe.
The iShares MSCI Min Vol funds, sponsored by BlackRock Canada, have the longest track record for a geographically diversified suite of low-vol equity ETFs in Canada. They’ve successfully employed an optimization process that factors in both low standard deviations and correlations between stocks.
BlackRock provided 10-year upside and capture data to Feb. 28 for all five strategies: Canada, U.S., international, emerging markets and global.
“Each ETF has reduced volatility compared to the broad market, providing a smoother investment experience for investors,” the company said via email, noting that all five strategies have outperformed during market declines.
BlackRock’s best risk-return combination was that of the iShares MSCI Min Vol Global Index ETF, with upside capture of 68% and downside capture of only 51%. The Canadian ETF had the highest upside capture at 85%, but its downside capture of 72% was also the highest. The narrowest difference was in emerging markets, where the 60% upside capture was barely higher than the 57% downside ratio.