Queasy about markets? Try a low-volatility ETF

Low volatility exchange-traded funds sound like a boring way to make a buck, but these ETFs are gaining traction among investors who can't stomach wild market swings.

"Fear and greed drive investor behaviour," said John Gabriel, an ETF strategist with Morningstar Inc. "These ETFs play to fear. …You get to participate in the equity market performance with about 20 to 30 per cent lower volatility."

This new breed of funds, which were pioneered last year in the U.S. market and carry the "low" or "minimum" volatility label, has the potential for solid returns as opposed to being a marketing ploy, ETF experts say. But they caution investors about doubling up on these funds because they might already own ETFs that can do the same job.

U.S.-listed low volatility ETFs have attracted $4-billion in assets among 13 funds since the PowerShares S&P 500 Low Volatility ETF (SPLV) was first launched in May, 2011. In Canada, there is about $53-million in assets in eight such ETFs. BMO Low Volatility Canadian ETF (ZLB) was the first to list last October followed more recently by offerings from PowerShares Canada and BlackRock Asset Management Canada Ltd.

These ETFs, which hold the least volatile or low-beta stocks in an index, "are more than a marketing gimmick," Mr. Gabriel said. Academic studies indicate that investors holding low-volatile stocks can get "the same types of returns as the market or even outperformance in some markets," he said.

"If you look at the past five years, these [low volatile] strategies have outperformed. But if there is a junk rally like we saw at the end of 2009, when the riskiest securities performed the best, there certainly could be a time period where that happens, too."

Low volatility ETFs, which also charge slightly higher fees than plain-vanilla market index funds, can use different criteria for its stocks. Most focus on the concept of beta, which measures a stock's sensitivity to the broad market. A stock with a beta of 1 indicates a security that gyrates with the market. A stock with a beta of less than 1 moves less than the market.

ETFs focused on dividend-paying stocks tend to have similar low-volatility or lower-risk performance so "I wouldn't buy a low-volatility ETF if you have dividend funds," he added.

Vikash Jain, a portfolio manager with archerETF Portfolio Management, agreed that investing in low-volatility branded ETFs is a "legitimate strategy," but suggested that they are more suited to portfolios with less than $100,000 in assets.

Mr. Jain, who does not use them, said he accomplishes the same goal for clients by holding lower-beta ETFs, such as those invested in sectors like utilities and real estate investment trusts, or dividend-paying stocks. For larger portfolios, investors can get lower volatility this way, but "you have to make sure that your portfolio is diversified," he said.

One dividend ETF that he likes is the iShares S&P/TSX Canadian Dividend Aristocrats ETF (CDZ), which focuses on companies growing their dividends. It gained an annualized 3.8 per cent for the five years ended July 31 versus a 0.56-per-cent loss for the S&P/TSX composite index.

Investors might be better off in this ETF than other dividend peers because it is more diversified with little financial exposure that could prove to be risky, Mr. Jain suggested. "Financials around the world have been tainted over the last several years [since the 2008 global credit crisis], and there is also regulatory uncertainty as well."

Pat Chiefalo, an ETF analyst with National Bank Financial, has begun recommending low-volatility branded ETFs to certain clients who request that kind of strategy. But he has not totally embraced them wholeheartedly because he wants to see longer-term performance.

"We would expect some level of return trade-off over a complete market cycle," he said. "To what extent remains to be seen as these new products develop their trading history."

ETF providers, meanwhile, are also marketing the flipside to low volatility ETFs for investors who want to bet on rising markets. PowerShares Canada, for instance, recently launched "high-beta" ETFs that hold stocks that will rise more than the market. These ETFs, invariably, will appeal to investors motivated by greed.

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BMO Low Volatility Canadian ETF (ZLB): Tracking the ups and downs

*S&P/TSX Total Return Index. Source: BMO