Are low-volatility equity ETFs performing as planned?

Low-volatility equity ETFs have become increasingly popular over the past several years. There are now 44 in Canada (including U.S. dollar and currency hedge funds) with total assets of $8.2 billion — a modest slice of the $200-billion ETF market.

Although the first low-volatility ETF was launched in 2011, it’s only recently that a significant number of securities have accumulated substantial historical data, allowing us to analyze the strategy. Did the products deliver attractive returns? Were they really less volatile than the market? Are they well diversified? And how tax efficient are they?

Low-volatility ETFs are costlier than basic ETFs, with an average management expense ratio (MER) of 0.46% compared with around 0.15% for core ETFs. Are they worth the extra cost?

Before we analyze fund performance, let’s take a look at the various methods for building low-volatility equity portfolios.

Three strategic approaches

Low-volatility portfolios are built in three stages. First, the universe of eligible securities is determined. This universe most often consists of members of a well-known stock index, such as the S&P/TSX Capped Composite.

Next, the portfolio securities are selected using predetermined criteria. Lastly, the weights assigned to each security are calculated using a formula specified by the methodology. The selection criteria and weighting methods are what differentiate one strategy from another.

All of these methodologies are based on historical data. As a result, they assume that a group of securities with low volatility in the past will exhibit the same behaviour in the future.

The first strategy — proposed by BMO Global Asset Management, which has a 59% share of the Canadian low-vol ETF market — is to classify eligible securities by their beta index, which measures their sensitivity to general market fluctuations. Those with the lowest beta — i.e., lowest risk — are selected and also given higher weights.

The second strategy is similar to the first, but it measures the risk of each security based on its volatility, measured by the standard deviation of returns over a period of up to three years. Again, the lower the standard deviation, the heavier the weight. Volatility-based strategies are used by Invesco and CI First Asset ETFs.

The third strategy is more complex. It uses an optimization algorithm to select and assign a weight to shares from the universe of eligible securities while factoring in their correlations. In accordance with a number of diversification constraints, the algorithm proposes securities and weights that collectively produce the lowest volatility. This strategy is implemented by iShares ETFs.

Our methodology

To answer our questions, we analyzed ETFs with five years of data, focusing on Canadian-dollar and non-currency-hedged ETF classes. We also excluded ETFs that incorporate other factors in addition to low volatility. Lastly, we limited our selection specifically to Canadian, U.S., international and emerging market equity ETFs (excluding global equity low-vol products).

This left 11 ETFs with similar characteristics to analyze. We compared these 11 low-volatility ETFs to benchmark ETFs using the following criteria:

• Management expense ratio
• Trading expense ratio
• Total return over five years
• Standard deviation over five years
• Number of holdings in the portfolio
• Concentration of top 10 stocks
• Average portfolio turnover
• Capital gains distribution (for more on their significance, see “Phantom distributions” below)

Canadian equity

For Canadian equities (see Table 1, below), the low-vol ETFs were all much costlier than their benchmarks, with the CI First Asset MSCI Canada Low Risk Weighted ETF (RWC) the most expensive. As expected, all the products we analyzed exhibited significantly lower volatility than the benchmarks between 2015 and 2019, and the returns of three out of the four securities outperformed the benchmarks.

From a diversification standpoint, the number of holdings in low-vol ETF portfolios was much lower than their benchmarks. Nonetheless, the concentration among the top 10 stocks was generally lower.

Lastly, all the funds had a much higher portfolio turnover than the benchmark ETF, which could raise concerns about high capital gain distributions. However, this risk materialized — in moderation — for only one low-vol fund (the BMO Low-Volatility Canadian Equity ETF distributed an average of 1.5% of net asset value during the 2015 to 2018 period). As a result, the tax effectiveness of Canadian equity ETFs has been somewhat favourable.

Table 1: Low-volatility Canadian equity ETFs as at Dec. 31, 2019

		Expenses (%)		Return and risk (%)		Diversification		Tax efficiency
Title	Ticker	MER	Trading expense ratio	Total return 5 yr	Standard deviation 5 yr	Number of holdings	Top 10 stocks	Average turnover 2015–2018	Capital gains distribution 2015–2018
BMO Low Volatility Canadian Equity	ZLB	0.39	0.00	8.84	7.31	47	29%	34%	1.5%
CI First Asset MSCI CAD Low Risk Weighted	RWC	0.67	0.12	5.72	7.74	90	24%	43%	0.2%
Invesco S&P/TSX Composite Low Volatility	TLV	0.32	0.04	7.79	7.01	50	24%	62%	0.5%
iShares Edge MSCI Min Vol Canada	XMV	0.33	0.01	6.78	7.34	67	30%	55%	0.5%
Benchmark: BMO S&P/TSX Capped Composite	ZCN	0.06	0.00	6.26	8.80	237	36%	18%	0.4%

Source: PWL Capital

U.S. equity

Low-vol U.S. equity ETFs (Table 2) also had higher management fees than their benchmarks. Two out of the three products we studied showed significantly lower volatility than their benchmarks and had five-year returns that outperformed (the third underperformed by a narrow margin).

With respect to diversification, the number of holdings in the three portfolios was much lower than their benchmarks and, once again, the concentration among the top 10 stocks was generally lower.

Lastly, all the low-vol ETFs had a much higher portfolio turnover than the benchmark funds and, this time, two out of the three had higher capital gains distributions, which translates into lower tax efficiency when held in an unregistered account.

Table 2: U.S. equity low-volatility ETFs as at Dec. 31, 2019

		Expenses (%)		Return and risk (%)		Diversification		Tax efficiency
Title	Ticker	MER	Trading expense ratio	Total return 5 yr	Standard deviation 5 yr	Number of holdings	Top 10 stocks	Average turnover 2015–2018	Capital gains distribution 2015–2018
BMO Low Volatility US Equity	ZLU	0.33	0.01	12.93	11.30	104	14%	50%	1.3%
CI First Asset MSCI USA Low Risk Weighted	RWU.B	0.65	0.04	13.77	10.64	150	10%	56%	0.2%
iShares Edge MSCI Min Vol USA	XMU	0.33	0.00	14.39	10.22	209	15%	50%	2.9%
Benchmark: Vanguard U.S. Total Market	VUN	0.16	0.00	13.22	11.61	3579	20%	6%	0.1%

Source: PWL Capital

Developed country international equity

The two international equity low-vol ETFs we studied (Table 3) again had higher MERs than their benchmarks, but less so than for the Canadian and U.S. equities. The products showed significantly lower volatility than their benchmarks, and one of the two posted a higher five-year return than the benchmark.

With respect to diversification, the number of holdings in the portfolios studied is much lower than their benchmarks. But this time, the concentration among the top 10 stocks was lower for only one of the products.

In terms of tax efficiency, both low-vol ETFs had lower portfolio turnover and lower capital gains distributions than their benchmarks, which is outstanding.

Table 3: Developed country international equity low-volatility ETFs as at Dec. 31, 2019

		Expenses (%)		Return and risk (%)		Diversification		Tax efficiency
Title	Ticker	MER	Trading expense ratio	Total return 5 yr	Standard deviation 5 yr	Number of holdings	Top 10 stocks	Average turnover 2015–2018	Capital gains distribution 2015–2018
Invesco S&P Intl Dev Low Vol	ILV	0.44	0.10	7.74	8.31	200	6%	15%	0.0%
iShares Edge MSCI Min Vol EAFE	XMI	0.36	0.01	8.99	10.29	279	14%	21%	0.1%
Benchmark: iShares Core MSCI EAFE IMI	XEF	0.22	0.00	8.46	11.16	2614	11%	34%	0.4%

Source: PWL Capital

Emerging market equity

The two emerging market equity ETFs we analyzed (Table 4) again had higher MERs than their benchmarks, but less so than for Canadian and U.S. equities. Both low-vol ETFs had significantly reduced volatility relative to their benchmarks, but they both posted five-year returns below the benchmarks.

From a diversification standpoint, the number of holdings and the concentration among the top 10 stocks in the low-vol portfolios was lower than their benchmarks. On the tax efficiency front, both funds had higher portfolio turnover than their benchmarks, but the capital gains distributions were practically zero, which is ideal.

Table 4: Emerging country equity low-volatility ETFs as at Dec. 31, 2019

		Expenses (%)		Return and risk (%)		Diversification		Tax efficiency
Title	Ticker	MER	Trading expense ratio	Total return 5 yr	Standard deviation 5 yr	Number of holdings	Top 10 stocks	Average turnover 2015–2018	Capital gains distribution 2015–2018
Invesco S&P Emerging Markets Low Vol	ELV	0.34	0.41	3.83	10.33	194	12%	27%	0.0%
iShares Edge MSCI Min Vol Emerg Mkts	XMM	0.42	0.05	5.04	10.22	350	14%	29%	0.1%
Benchmark: iShares Core MSCI Emerg Markets IMI	XEC	0.26	0.00	7.26	12.44	2484	22%	12%	0.1%

Source: PWL Capital

How to use low-volatility ETFs

Low-volatility strategies are not my favourite. I find total market index strategies to be more reliable and better suited to long-term financial well-being.

However, data from low-volatility ETFs available in Canada indicates that these products are off to a good start. They have all kept their promise of less volatility than the market. Six out of the 11 low-vol products we studied produced five-year total returns above their benchmarks. Their diversification is not ideal, but not dismal either. And their tax efficiency has been generally decent so far, with relatively few capital gains distributions.

I have three suggestions for those seeking to invest in low-volatility ETFs. First, it’s preferable to avoid securities with significantly higher management and trading expense ratios. I find none of the proposed methodologies significantly outperforms the others, so it’s counterproductive to pay more.

Next, be consistent in your choices. You should use the same ETF family across your portfolio (Canadian, U.S. equity, etc.) to apply a consistent methodology.

Lastly, ask yourself if you’ll be persistent enough to keep your low-volatility ETF after a long sequence — I mean several years — of sub-market returns, as this will probably happen at some point. I don’t think there’s a magic strategy that outperforms all the time, which is why investors have to prepare to persevere against adversity. A strategy you discard along the way is not a strategy.

Phantom distributions

Let’s take a moment to explain why an investor may fear capital gains distributions, a.k.a. phantom distributions.

Capital gains distributions are detrimental to investors who hold investment fund shares in an unregistered account. When a fund realizes gains on the resale of certain portfolio securities, these cumulative year-end gains are added to unitholders’ taxable income. This is referred to as a “capital gains distribution.”

In fact, distributions are not paid to investors, as the amount of the gain is automatically reinvested in new fund units. Ultimately, unitholders receive nothing and are forced to pay tax. This is why they are sometimes called “phantom distributions.”

Note, however, that investors who are “victims” of phantom distributions will pay less tax later when they resell their shares, as the net value of the shares will be written down following the distribution. Therefore, undergoing a phantom distribution is equivalent to paying tax ahead of time.

One of the best arguments in favour of passive funds is that they systematically have fewer phantom distributions given their lower portfolio activity compared with actively managed funds.

Raymond Kerzérho, CFA, is research director at PWL Capital Inc.