What are we looking for?
Low-volatility exchange-traded funds (ETFs) for the jittery stock investor.
The screen
Since the U.S. election, the media and seasoned commentators continue to opine on the potential effects of a disruption in trade policy that will send ripples through the global economy and public companies that we invest in. With this in mind, today we look to the world of low-volatility ETFs to potentially reduce market volatility in stocks through systematic investment approaches.
Low-volatility ETFs are a subsegment of “strategic beta” products (also known as “smart” beta), which straddle the line between active and passive investing. These investment funds typically follow a set of index rules, but instead of the traditional market-cap weighting scheme, these specialized indexes weigh stocks based on fundamental factors. For example, value-tilted indexes might put a higher weighting on companies with lower valuation metrics such as the price-to- earnings (P/E) ratio. Although some might consider these investments passive (in that there is little discretion from a human on portfolio picks), they clearly have active tilts to investment factors, often at a lower cost than through an actively managed product.
One such factor that Morningstar has flagged in our taxonomy for strategic beta funds is volatility. Broadly speaking, low-volatility products tend to overweight stocks that have a history of steadier market movements and predictable earnings, while still granting broad market exposure. This all might sound promising, but investors must remember that the factor weighting is based on history. During large market shocks, the predictability of earnings can go out the window.
Moreover, investors must remember that across the asset allocation, stocks remain a riskier asset class (superseded by the likes of cryptocurrencies and derivative exposure that leads to leverage) and are not immune to broad market shocks. This might have caught some off-guard during the pandemic, where many of these low-volatility strategies dropped in line with traditional market indexes. All this said, perhaps there is still some merit in considering a stock’s historical volatility over merely considering its size (which some might argue is a proxy for volatility).
For those that have this mindset, I used Morningstar Direct to screen for low-volatility ETFs that have either outperformed their peers, or that Morningstar believes will do so in the future. The screen includes two factors:
- The Morningstar Rating for Funds (the “Star” Rating) – which is the objective look back at risk-adjusted returns on an after-fee basis. Though this rating is backward looking, our data show that on aggregate, five-star funds end up outperforming four-star funds, which outperform three-star funds etc. in periods after receiving the rating.
- The Morningstar Medalist Rating – which is Morningstar’s qualitative assessment of whether a fund can outperform its peers in the future via our assessment of parent (the stewardship qualities of the firm), process (the validity and robustness of the investment process and risk-mitigation techniques) and people (the experience and tenure of the portfolio management team). For passive strategies, less emphasis is put on the people and parent pillars of the analysis and more is put on the process pillar.
Only Canadian-listed ETFs disclosing that they follow a systematic investment process targeting low volatility were considered in the search (often made evident in the fund name as well).
What we found
The funds that met the above requirements are listed in the table inclusive of their management expense ratios (MERs), the Morningstar ratings, inception dates and trailing performance. It is worthwhile noting that some of these ETFs are available in hedge and unhedged versions – only the unhedged versions were included in this list. Finally, investors are urged to first consider the category to which each ETF belongs, as it provides a good idea of what the ETFs’ regional exposures are, an important consideration when diversifying geographically.
This article does not constitute financial advice, it is always recommended to conduct one’s own independent research before buying or selling any of the funds mentioned in this article.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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