Low-volatility investment products are turning out to be a double-barrelled advantage for clients. These products have offered a smoother ride and superior returns relative to their relevant benchmarks in the few years they’ve been available in Canada.

“So far, the low-volatility products are doing the job they’re intended to do,” says Dan Hallett, vice president and principal of HighView Financial Group of Oakville, Ont. “But what we haven’t seen yet is a painful and prolonged bear market, and that will be the real test.”

Global stock markets have turned more volatile in recent months. On Aug. 24, there was a 1,000-point intraday drop in the U.S.-based Dow Jones industrial average, and although the hysteria has calmed somewhat, there have been many other dramatic moves.

According to Hallett’s research, during the recent declining and unstable period from mid-April to Sept. 30, all of the low- volatility Canadian equity exchange-traded funds (ETFs) fell by less than the 15% drop in the S&P/TSX composite index, and the ETFs were less volatile as well.

Low-volatility products are relatively new to Canada’s investment scene, with TD Asset Management Inc. blazing the trail with its introduction of “low-vol” pooled funds for institutional clients in 2009. Toronto-based Bank of Montreal (BMO) was the first to take low volatility into the ETF realm, when it launched BMO Low Volatility Canadian Equity ETF in October 2011. BMO has been followed by a handful of other providers, including PowerShares Canada (a division of Invesco Canada Ltd.), the iShares division of BlackRock Asset Management Canada Ltd., and First Asset Management Inc. (all of Toronto).

In addition, low-volatility strategies are available through mutual funds offered by PowerShares and RBC Global Asset Management Inc. The PowerShares mutual funds essentially are a low-volatility ETF contained within a mutual fund structure, while RBC’s QUBE funds offer an active low-volatility strategy.

Horizons ETFs Management (Canada) Inc. offers a slightly different twist on low volatility with two ETFs that combine broad index-based investing, based on either the S&P 500 or the S&P/TSX 60 index, with bear market protection in the form of puts and call strategies.

One of the primary reasons for the impressive performance of low-volatility products is the effect of losing less than benchmark indices in falling markets. Smaller losses also mean low-volatility portfolios recover their value more quickly than portfolios suffering larger declines, even if low-volatility products don’t outperform on the upside. Simple mathematics show that a loss of 20% requires a 25% gain to get back to even, while a loss of 50% requires a 100% gain to get back.

“When you lose less, it’s a much shorter trip to get back above water and into the black,” Hallett says. “You don’t need to gain as much on a percentage basis on the way up to get back to where you were.”

In addition, a more stable portfolio is less nerve-racking for clients, and they are less likely to get scared out of their stocks. By staying put, the holders of low- volatility products are positioned to benefit from market recoveries, unlike clients who panic and sell at the bottom.

“If an advisor is dealing with clients in the retirement-risk zone, which is five years before or after retirement, a plunge in the value of [those clients’] portfolios could be so damaging that it may not recover sufficiently to support the necessary withdrawals,” says Scott Boniferro, product manager with PowerShares Canada in Toronto. “At the same time, clients may be looking at 30 years or more in retirement, and they need to maintain equities exposure. Low-volatility products allow clients to maintain exposure and reduce volatility – the holy grail of investing. More return with lower risk is a powerful combination.”

Assets under management in low-volatility ETFs stand at $1.7 billion, still a small fraction of the $84 billion in Canadian listed ETFs. However, growth is accelerating, with $768 million flowing into low-volatility ETFs during the nine months ended Sept. 30, up from $252 million in the corresponding period a year earlier. BMO Low Volatility Canadian Equity ETF had the most traction this past year, attracting $215 million in new investment.

“When markets are strong, low volatility doesn’t give you as much upside, and the products are less in vogue,” says Boniferro. “But during the past 12 months, low volatility has been our top-selling equity strategy.”

Low-volatility ETFs have different methods for screening the stocks in their underlying portfolios, which accounts for the differences in performance. For example, with energy stocks showing a lot of volatility, PowerShares S&P/TSX Composite Low Volatility ETF has had no exposure to that sector since last March.

“We’ve been able to get out of the way of falling energy stocks,” Boniferro says. “Stock prices often become more volatile before they fall, and we act on those signals. Otherwise, you may not be able to get out of the way of a train wreck.”

Although BMO Low Volatility Canadian Equity ETF has exposure of 10.6% to the energy sector, that weighting is less than the S&P/TSX composite index’s weighting of about 20%. This low exposure to energy will help the ETF’s overall performance if energy stocks continue to decline, but may result in the ETF lagging the market if energy stocks rebound quickly.

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