Look beyond low-volatility ETFs to ride out market uncertainty

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A new phase of market instability calls for a different approach to defending against investment losses, according to one of the pioneers of low-volatility investing.

While low-volatility funds have proven effective in their short lifespans to date, they are not designed to anticipate the emergence of future market disturbances.

"They are purely systematic, and they are backward looking," Bruno Taillardat, investment director for equities at Geneva-based money manager Unigestion, which has about $18-billion (U.S.) of assets under management, said in an interview. "It's much more important to be forward looking, to imagine what can go wrong tomorrow."

Low-volatility ETFs are some of the most popular products under the "smart-beta" umbrella, which includes funds built on alternative methods to the traditional market-capitalization-weighted benchmarking. The funds use performance data to weed out those stocks most sensitive to market movements.

In Canada, funds such as the BMO Low Volatility Canada Equity ETF have lived up to their billing by successfully reducing volatility, while actually outperforming the broader market. The BMO fund, for instance, has generated an annual return of more than 15 per cent since first being introduced in 2011.

Income-producing sectors tend to be well represented right now in low-volatility funds. BMO's Canadian low-volatility ETF, for example, has a 12-per-cent weighting in utilities stocks, compared with a 2-per-cent share of the S&P/TSX composite index.

A low-interest-rate environment, which has reigned through the entire trading history of these low-volatility ETFs, is good for dividend-yielding stocks and rate-sensitive sectors, like utilities.

But those are exactly the kinds of names vulnerable to a rise in interest rates.

"The problem is the inflection point," Mr. Taillardat said. "When the market is changing fast, this is where quantitative strategies tend to lag. The models need time to react."

The U.S. Federal Reserve may have again put off the first U.S. policy rate hike in a decade, but there's little doubt that the central bank is inching toward tightening as the domestic economy improves.

Confusion over U.S. rate policy, combined with the unknown extent of China's economic slowdown, have together brought about a sudden resurgence in market volatility after a period of stock market latency.

"I think investors are concerned that we're at the end of the game," Mr. Taillardat said. And until investors get clarity on either situation, markets are likely to be unstable, Mr. Taillardat said.

Navigating that short-term volatility is better served by adding a layer of qualitative analysis on top of low-volatility investing methods, he explained. "It's quite important to take into account macro risks," he said. "Only a human can analyze those changes so quickly."

Rate hikes, for example, will have an outsized negative effect on certain sectors, most of them defensive, he said. Many of those names are overpriced, anyway, as a result of the demand for safety and the hunt for yield.

Meanwhile, roiling commodity markets, in part a product of China's growth scare, has him avoiding most of the resource-heavy Canadian stock market.