A solid defensive equity ETF

This fund builds the least volatile portfolio possible with stocks from the MSCI Canada Index.

Alex Bryan 31 July, 2018 | 5:00PM
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 IShares Edge MSCI Minimum Volatility Canada ETF (XMV) offers a well-crafted approach to reduce volatility for a low fee. It should offer a smoother ride and better risk/reward profile than most of its peers, warranting a Morningstar Analyst Rating of Silver. That said, this strategy has not yet been tested in a major market downturn.

The fund attempts to construct the least volatile portfolio possible with stocks from the MSCI Canada Index, which includes large- and mid-cap names, under a set of constraints. These include limiting turnover, exposure to individual names and sector tilts relative to the index, helping to mitigate unintentional bets. This strategy doesn't just target the least-volatile stocks. It also takes into account each stock's exposure to common risk factors and how they interact with each other to affect the portfolio's overall volatility.

The portfolio includes nearly 70 holdings, such as  Toronto-Dominion Bank (TD),  Thomson Reuters (TRI) and  TransCanada (TRP). While many of these firms have lower volatility than average, more-volatile names can make the cut if they have low correlations with the other stocks in the portfolio, which may help reduce the overall portfolio's volatility.

As expected, the fund has exhibited lower risk than its parent index. From August 2012 through May 2018, the fund exhibited 16% less volatility and 13% less market risk sensitivity than its parent index. However, it lagged the benchmark by 24 basis points annually during that time, posting comparable risk-adjusted performance.

Performance will not always be strong. The fund will likely lag during bull markets and probably won't generate market-beating returns over the long-run. But it should hold up better than most of its peers during downturns and offer better risk-adjusted returns than the MSCI Canada Index over a full market cycle.

While there are cheaper market-cap-weighted index alternatives, the fund's 0.33% management-expense ratio gives it a considerable advantage over its actively managed rivals. The median MER in the Canadian Equity category is 1.09%.

Fundamental view

Low-volatility stocks have historically offered a more favourable risk/reward trade-off than the market and will likely continue to do so because of behaviourally induced mispricing and constraints asset managers face. Riskier stocks tend to have greater upside potential than defensive stocks, which makes them more appealing to investors who care about earning high returns, like mutual fund managers who are trying to beat a benchmark. These collective bets on risky stocks can cause them to become overvalued and offer less attractive compensation for their risk than their more defensive counterparts.

Past volatility isn't a strong predictor of returns for most large-cap stocks. However, it is a good predictor of future volatility and downside performance, at least in the short term. This risk reduction is the principal source of low-volatility stocks' attractive risk-adjusted performance.

This fund doesn't directly target stocks with low volatility, though it still heavily favours them. It considers both expected individual stock volatility and correlations across stocks, under a set of constraints, like limiting sector tilts. This holistic approach causes the fund to own some more-volatile stocks than it would if it simply targeted the least-volatile stocks in the market. However, it should lead to a better diversified portfolio that can translate into lower risk at the portfolio level. No measure of risk is perfect. Low volatility can mask risks that haven't yet been realized. Investing in stocks with low correlations with one another can help reduce the portfolio's exposure to sources of risk that past volatility may not capture.

Interest-rate risk is one of those risks that past volatility may not capture. Morningstar research suggests that low-volatility stocks tend to be more sensitive to interest-rate fluctuations than the market. Interest rates don't change in a vacuum. They tend to rise as the economy strengthens and fall as it weakens. Low-volatility stocks are less cyclical than most, so they have less cash flow growth to offset the negative impact of rising rates. That said, it isn't prudent to time exposure to defensive stocks. Despite this risk, low-volatility stocks should still offer attractive risk-adjusted performance over the long term. It is also worth noting that this fund is a bit less sensitive to interest-rate risk than its peers that directly target low-volatility stocks.

The fund's holdings are currently at comparable valuations to its parent index. It explicitly limits its tilt toward value or growth stocks, which helps mitigate unintended style bets, though it doesn't eliminate them entirely.

Not surprisingly, the fund has greater exposure to defensive sectors, such as telecom, consumer defensive and utilities, than the MSCI Canada Index. It also has less exposure to financial-services, basic-materials and energy stocks. But because the fund limits its sector tilts relative to this benchmark, financial-services stocks still soak up a sizable portion of the portfolio.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
TC Energy Corp52.95 CAD-0.56Rating
The Toronto-Dominion Bank77.95 CAD0.62Rating
Thomson Reuters Corp232.72 CAD-0.10Rating

About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.

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