How have low-vol ETFs fared during the pandemic?

That ideal scenario fell apart in 2020. When stock markets crashed during the early days of the pandemic, low-volatility ETFs went along for most of the precipitous slide. And when markets made a U-turn and posted spectacular gains, Canadian low-vol ETFs lagged far behind the surging S&P/TSX composite index.

“What we saw in 2020 was obviously a huge drawdown in the market, and while low-volatility strategies did provide some benefit, it wasn’t as much as we’ve probably seen in other corrections previously,” said Chris McHaney, director and portfolio manager, BMO ETFs, with Toronto-based BMO Asset Management Inc. The $2.7-billion BMO Low Volatility Canadian Equity ETF is the largest of its kind in the Canadian category, and the oldest.

“Some investors might have been caught off guard as to the amount that low-volatility strategies also went down with the broad market,” McHaney said.

The subsequent 2020 turnaround was led by growth-oriented stocks, many from within the technology sector, which tends to be underrepresented in low-vol strategies. “That’s really what led the market back higher,” McHaney said. “So the low-volatility strategies didn’t participate as much on the upside.”

Last year, Ottawa-based Shopify Inc. — absent or at best severely underweight in low-vol portfolios — soared to become the largest Canadian company as measured by stock-market capitalization.

“Any strategy that did not hold a market weight to Shopify did not do well,” said Hussein Rashid, vice-president and ETF strategist with Toronto-based Invesco Canada Ltd., which manages the $323-million Invesco S&P/TSX Composite Low Volatility Index ETF.

“It really was a tale of two halves,” said Bob Hum, a director with the ETF and index investments group at New York–based BlackRock Inc. The Canadian subsidiary, Toronto-based BlackRock Asset Management Canada Ltd., manages the $123-million iShares MSCI Min Vol Canada Index ETF.

Hum said the ETF fared relatively well during the downturn, but not during the strong rebound. “In that type of environment, you would expect a lower-risk portfolio to underperform. It’s really built to do that.”

Over longer periods, the oldest Canadian low-volatility ETF has been an impressive performer. Since its inception in October 2011, the BMO ETF has an annualized return of 12.9% to April 30, far outpacing the S&P/TSX Composite’s 8.1% return, and with below-market volatility.

“Certainly the longer-term track record is very positive,” McHaney said, “not just from providing that lower-volatility exposure, but also on the return side.”

A key metric employed to evaluate risk is the extent to which an ETF participates in — or “captures” — the market’s gains and losses. Since the iShares ETF’s 2012 inception, its upside capture ratio has been 82.5%, and its downside capture ratio only 71%. “The strategy has performed in line with our expectation, delivering that similar market return with less risk,” Hum said.

The BMO, iShares and Invesco ETFs — the three with multi-year track records — all have five-year standard deviations that are well below the broad market. Despite this similarity, there are significant differences in how the competing ETFs build their portfolios.

The Invesco ETF holds roughly one out of every five constituents of the S&P/TSX Composite index and selects about 50 stocks with the lowest one-year standard deviations. The portfolio is reconstituted quarterly, and there are no sector constraints.

Rashid said the Invesco ETF’s low-vol strategy, which is also available as a mutual fund, is not intended to be a standalone holding in the Canadian equity category. It’s recommended as a complement to other strategies, such as a growth-style fund.

By contrast, the roughly 65-stock iShares ETF is designed to be a core holding, said Hum, who prefers to use the term “minimum” volatility. The MSCI index, on which the ETF is based, considers not only standard deviation but also correlations between stocks. “We will own some high-risk stocks in the portfolio that are diversifying to the rest of the strategy.”

Importantly, the sector exposure is constrained to within plus or minus five percentage points of the parent MSCI Canada Index. “We do think you need to have sector guardrails within the strategy — because if you don’t, then you might have some really big bets from a sector perspective,” Hum said. “We want to ensure this looks and feels like the broad market, but giving you lower volatility over the long term.”

The BMO ETF’s 45-stock portfolio is drawn from the 100 S&P/TSX stocks with the largest market capitalizations. Stock selection is based on beta — a measure of how a stock’s performance differs from the broad market — for which a composite score is based on multiple periods ranging from one to five years. The maximum weightings are 5% per stock and a fairly generous 35% per sector regardless of size. The portfolio is updated twice a year.

“Beta tends to be fairly stable over time. If there’s a low-beta stock today, chances are a year from now it’ll still be a low-beta stock,” McHaney said. “We have a fairly stable portfolio that has a few names coming in and out each year.”

Two other Canadian equity ETFs employ low-volatility strategies, for a total of five. The Fidelity Canadian Low Volatility Index ETF, launched in January 2019, screens for stocks with below-average price volatility and stable earnings. The TD Q Canadian Low Volatility ETF, launched in February 2020, employs a rules-based methodology that, like its iShares rival, is based on standard deviation of individual stocks and correlations between stocks.

The common theme among all low-vol strategies is to provide solutions for investors who need the potential returns that equity markets provide, but with less risk of severe losses in bear markets. “With fixed income markets having such low yields, even conservative investors have to look to the equity markets to get the return expectation that they’re hoping for,” McHaney said. “But not all investors want to take on the risk and volatility that’s associated with the broad market.”