Low-risk exposure to U.S. large-cap stocks

BMO Low Volatility U.S. Equity ETF should offer better downside protection than most of its peers.

Alex Bryan 31 October, 2017 | 5:00PM
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 BMO Low Volatility U.S. Equity ETF (CAD) (ZLU) should provide lower-risk exposure to U.S. large-cap stocks than the S&P 500 and most of its peers, giving it a good chance to post strong risk-adjusted performance over the long term. The fund applies a sensible rules-based approach to target the 100 members of the S&P 500 with the lowest sensitivity to market fluctuations during the past five years, placing the greatest emphasis on the most-recent data.

Stocks that make the cut are weighted by the inverse of their market betas, pulling the portfolio toward the less-risky names. However, there is a 5% cap on individual stock weightings and a 25% cap on sector weightings. The managers rebalance the portfolio to these weightings twice a year. To mitigate unnecessary turnover, the managers allow stocks to stay in the portfolio as long as their market risk ranks in the lowest 120 of the selection universe. While this is a rules-based approach, the managers have discretion to deviate from them if they think a stock's past market sensitivity isn't representative of what they expect going forward.

BMO's focus on market risk is meant to capture risk that investors can't diversify and is not a measure of a stock's total risk. For example, a pharmaceutical company awaiting approval for a new drug may have high volatility that is not correlated with the broader market's performance, but low sensitivity to market fluctuations. This approach by BMO is reasonable since, in a diversified portfolio, the uncorrelated risk should wash out. It chose this approach because it believes that each stock's level of common risk is more likely to persist than its relative volatility.

Stocks that make the cut are weighted by the inverse of their market sensitivity, so that the least-risky stocks get the largest weightings in the portfolio. This gives the fund a small value tilt relative to the S&P 500. The portfolio also tends to have some lopsided sector weightings, favouring utilities and consumer defensive stocks, though it caps them at 25%.

So far, the fund has not produced the volatility reduction expected. From its inception in March 2013 through September 2017, it exhibited slightly greater volatility than the S&P 500 while lagging the index by 74 basis points annually. But it did offer better downside protection than the index and was much less sensitive to market fluctuations. This came at the expense of underperformance during market rallies.

The fund's 0.33% management-expense ratio is reasonable for this strategy and lower than most funds in the U.S. Equity category.

Fundamental view

Investors can always reduce risk by allocating a greater portion of their portfolios to less risky assets like cash or bonds. But this strategy will likely offer better returns than a market-cap-weighted stock/bond portfolio of comparable volatility, albeit with smaller diversification benefits.

Historically, less risky stocks (as defined by volatility or market sensitivity--beta) have offered better risk-adjusted returns than their riskier counterparts. This effect was documented in 1972 by Fischer Black, Michael Jensen, and Myron Scholes. They found that stocks with low sensitivity to market fluctuations (low betas) generated higher returns relative to their amount of market risk than stocks with high sensitivity to the market. Several other researchers found a similar pattern for stocks sorted on volatility.

Robert Novy-Marx, a professor at the University of Rochester, attributes low-volatility stocks' attractive performance from 1968 to 2013 to their low average valuations and high profitability in his paper, "Understanding Defensive Equity." He argues that investors would be better off targeting stocks with value and profitability characteristics directly because there is no guarantee that low-volatility stocks will always have these characteristics.

While low valuations and high profitability likely contributed to low-volatility stocks' attractive historical performance, there is probably more to the story. Many investors care about benchmark-relative returns, which may cause them to favour riskier stocks that have higher expected returns in bull markets, reducing their expected returns relative to their risk. Similarly, neglected lower-risk stocks can become undervalued relative to their risk. This is not necessarily the same as the traditional value effect, as many of these stocks often trade at valuations comparable to or slightly higher than the market.

The fund favours defensive stocks, but its long lookback period and infrequent reconstitution can make it slow to detect shifts in relative risk and may reduce its efficacy. BMO attempts to address this issue by giving greater weighting to more-recent data, though this doesn’t entirely solve the problem as the portfolio reconstitutes only once a year. While this is a rules-based approach, the managers have some discretion in implementation. For example, if a stock's sensitivity to market risk changes significantly during the lookback period, the managers may work with the fundamental research team to assess whether that stock will likely be low-risk going forward.

Sector weighting here can look very different from the S&P 500. The fund has greater exposure to the utilities, consumer defensive and real estate sectors than the benchmark and less exposure to energy, technology and financial stocks. While the fund often takes large sector bets, it has limited exposure to individual names.

The fund's holdings tend to have more stable cash flows than most, but that stability can also make them more sensitive to interest rates. Interest rates don't change in a vacuum. They tend to rise as the economy strengthens and fall as it weakens. The fund's holdings may have less cash flow growth than most companies in strong economic environments to offset the negative impact of higher rates.

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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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