5 Questions Your Clients May Ask About Volatility

The end of an era

We’ve been on quite the growth ride over the past decade. Markets shot up after the 2008 Financial Crisis, enjoying a wild “hockey stick” ride where growth stocks appreciated rapidly. It was a great time to play offense in your client portfolios. But, as they say, all good things must eventually come to an end.

We’re now entering a more challenging environment, and it’s in these difficult markets that investors seek greater peace of mind. They may already be reaching out to express anxiety about their investments. And while you’ve probably told them to remain calm and focus on their long-term financial plan, the conversation can be tough without a clear strategy in place to weather the storm.

Clients want to know if, under these new conditions, you can protect their capital as well as you helped it grow in bull markets. I often use hockey as an example. The best teams are always those that play extremely well on offense and defense. Great defensive teams can succeed to an extent, but they likely won’t win any championships if they can’t score goals. And vice versa—the best offensive line in the world cannot help you win if the other team keeps pace on points. You have to win on both ends, and the same is true for investing.

Two valuable tools to play defense are the BMO Low Volatility Canadian Equity ETF Fund and BMO Low Volatility U.S. Equity ETF Fund. These Low Volatility strategies have benefits beyond portfolio construction—they are critical for your client conversations. To illustrate how they can be used to manage client expectations, we’ve scripted a few questions that Advisors often receive when the markets hit a rough patch. The answers, while not as exciting as the growth story of the 2010s, do help investors appreciate that action is being taken to protect their capital. For example…

Client Question #1: Will I be alright?

When clients get nervous, the first step is often to refer clients back to the financial plan. This can be used to remind them that while markets have faltered before, their retirement future is still on track. More than that, however, it’s important to show clients the long-term resilience of equity markets. As you can see from the charts below, broad indexes like the S&P 500 and S&P/TSX Composite tend to rise steadily when the investment horizon is stretched out, and our low vol funds can deliver comparable growth on the upside—or better. The BMO Low Volatility Canadian Equity ETF Fund, for example, beat the benchmark handily in a ten-year span that included seven significant market sell-offs. So, looking at the big picture, you can argue that the odds of a recovery are strong.

100% Canadian Fund Outperforming in Up & Down Markets

BMO Low Volatility Canadian Equity ETF (ZLB) vs. S&P/TSX Composite TR Index

Source: Morningstar as of April 29, 2022. Inception of ZLB is October 2011. Inception of BMO Low Volatility Canadian Equity ETF fund is May 2019. The chart shows the performance of ZLB – BMO Low Volatility Canadian Equity ETF and does not show the performance of the Mutual fund version. The Mutual fund version is a fund of fund and holds only ZLB. Index performance is provided as a benchmark but is not illustrative of any particular investment. You cannot invest directly in an index.

BMO Low Volatility US Equity ETF (ZLU) vs. S&P 500 TR Index

Source: Morningstar as of April 29, 2022. Inception of ZLU is March 2013. The chart shows the performance of ZLU – BMO Low Volatility US Equity ETF and does not show the performance of the Mutual fund version. The Mutual fund version is a fund of fund and holds only ZLU. Index performance is provided as a benchmark but is not illustrative of any particular investment. You cannot invest directly in an index.

Client Question #2: How often should we change or adjust my portfolio?

Investors often ask this question when experiencing “statement shock.” They open their investment statement hoping to see good news and instead get an unpleasant jolt when the numbers are lower than expected. It’s a common reaction. If they aren’t seeing positive returns, they want to see activity instead. What’s important to tell clients at this time is that they don’t want to “catch a falling knife”—which is to pick up assets that are declining only to see them drop further still. They should appreciate that timing the market is virtually impossible. No one truly knows where the bottom is, and it’s better to have a set-it-and-forget-it portfolio that’s invested in high quality holdings.

Client Question #3: Am I owning low vol funds only because markets are down?

Some investors think lower volatility assets are only relevant when markets are down or choppy. In reality, they help to lower risk while still providing upside potential, and hence are worthwhile in all market conditions. As seen below in Table 1, both the US and Canadian funds provide considerable downside protection (32.68% and 56.50%, respectively), while delivering close to full participation (83.94% and 78.13%) on the upside. Looking at the Sharpe ratios shown in the performance table below, you can see the risk levels relative to their benchmarks are noticeably lower. This balance of risk and return provides a compelling story for client conversations regardless of whether markets are up or down.

Table 1: Capture Upside, Limit Downside

Source: Morningstar data as of April 30, 2022. ZLB is compared to the S&P/TSX Composite TR Index; ZLU is compared to the S&P 500 TR Index CAD. The chart shows the performance of ZLB – BMO Low Volatility Canadian Equity ETF and ZLU – BMO Low Volatility US Equity ETF, and does not show the performance of the Mutual fund versions. The Mutual fund versions are funds of funds and hold only ZLB and ZLU, respectively. Index performance is provided as a benchmark, but is not illustrative of any particular investment. You cannot invest directly in an index.

Source: Morningstar data as of April 30, 2022. ZLB is compared to the S&P/TSX Composite TR Index; ZLU is compared to the S&P 500 TR Index CAD. The chart shows the performance of ZLB – BMO Low Volatility Canadian Equity ETF and ZLU – BMO Low Volatility US Equity ETF, and does not show the performance of the Mutual fund versions. The Mutual fund versions are funds of funds and hold only ZLB and ZLU, respectively. Index performance is provided as a benchmark, but is not illustrative of any particular investment. You cannot invest directly in an index.

Client Question #4: Who are low volatility funds intended for?

It’s worth noting that low volatility strategies have been employed by many large pension plans for years. However, misperceptions about their risk-return profiles have persisted among Advisors and, by extension, Canadian investors. We believe these funds can be an excellent holding for some investors, in particular for:

• Long-term investors looking to mitigate risk while generating appreciable returns
• Retirees or those nearing retirement who will need to drawdown on their investments
• Low to medium risk investors who still want growth

Ultimately, market downturns will happen sooner or later. The cycle eventually turns and growth equities fall from grace. What do you do then? For example, you may remember that in 2018 central banks were threatening to raise interest rates and end the growth run created by quantitative easing. There was a huge selloff in high-growth names. Assets rotated away from higher beta sectors, and low volatility turned the tables to outperform. Sound familiar? The same process has begun to unfold in the past few months because, as they say, history may not repeat but it sure does rhyme.

Client Question #5: Why did you choose this low volatility fund?

Coming back to the idea statement shock—and playing good defense—it’s important to be transparent about the price of funds. Our low volatility solutions are low-cost, relative to the industry average,¹ yet they still perform well against the benchmark. And while other asset managers may focus on standard deviation, our filter is focused on beta values. We rank companies in our selection universe by beta, and choose only the largest and most liquid securities to ensure the portfolio is holding solid, high-quality companies. This is because lower beta equities are, by definition, less correlated with their benchmark and the broader market. They tend to exhibit smaller price swings on both the upside and downside, providing a sense of stability that’s attractive to many investors. The smaller moves also create a powerful compounding effect over the long term, leading to what’s known as the “low volatility anomaly”—a curious phenomenon where lower risk stocks outperform higher risk stocks simply by preserving their principal value more efficiently.

So don’t be fooled by our diversified basket of lower beta stocks—they can not only play great defense, but can also outperform across a full market cycle.

For other investment strategies to enhance your practice and support your clients, contact your BMO Global Asset Management Regional Sales Representative.

¹ Simfund, BMO Global Asset Management, as of October 2021.