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Lottery Tickets and Volatility: Strategies to Protect Your Client Portfolios

Flight to cash? Portfolio Manager Chris Heakes highlights how a low volatility strategy can work to protect your clients’ capital—and keep them invested.

June 2022

Photo of Chris Heakes

Chris Heakes

CFA, M.Fin., Head of Disciplined Equity, Portfolio Manager, Global Structured Investments, BMO Asset Management Inc.

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Key Takeaways

  • Low volatility funds offer “defensive growth” to fight inflation and shaky markets
  • Investors underestimate the long-term growth potential of lower beta stocks
  • Low volatility funds exploit the “lottery ticket” bias in behavioral investing

After years out of favour, Low Volatility seems to be making a return. What’s driving the resurgence?

CH Well, you have to go further back in the story to understand what’s happening. Why did low volatility fall out of favour in the first place? It’s because the last couple of years have been an extremely bullish period for markets, with the economic re-openings making it worthwhile for investors to take on more and more risk. There was great excitement about the potential “return to normalcy.” Growth stocks lifted off, led by the technology sector—but then we entered a period of reckoning. Inflation proved not to be as transitory as the U.S. Federal Reserve believed, prompting central banks to begin rate hikes, and we saw geopolitical crises flare up in Ukraine. The result was a noticeable up-tick in volatility—that’s what drove the shift back to low vol assets. Investors understood that with interest rates on the rise and greater uncertainty in the world, growth would be more expensive than before.

How does a low volatility strategy balance between downside and upside protection?

CH The downside protection story is pretty straightforward: by investing in lower beta stocks, we can reduce risk and ultimately decrease potential losses in investors’ portfolios. That’s the primary objective of these funds. But don’t underestimate the upside potential—research shows that low volatility punches above its weight class when measured across the full market cycle. As you can see below, our U.S. and Canadian Low Volatility exposures have produced capital appreciation that’s comparable to the broad market, or better. How does the strategy do both? The secret lies in behavioral investing. People generally equate risk and reward, thinking the more risk in their portfolio the better their potential returns will be. This causes them to overvalue higher-risk assets and underestimate lower-risk stocks. Some call it the “lottery ticket” phenomenon—investors see growth as a shot at huge upside, so they end up paying disproportionately more for it. By contrast, low volatility stocks go unnoticed.

100% Canadian Fund Outperforming in Up & Down Markets

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


Performance

Fund 1-Year 3-Year 5-Year 10-Year
BMO Low Volatility Canadian Equity ETF (ZLB) 7.96% 9.72% 8.99% 12.56%

Source: Morningstar as of May 31, 2022. Inception of ZLB is Oct 2011. Inception of BMO Low Volatility Canadian Equity ETF fund is May 2019. The chart shows the performance of ZLBBMO 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. The chart illustrates the impact to an initial investment of $10,000 dollars from October 2011 to May 2022 in the BMO Low Volatility Canadian Equity ETF. It is not intended to reflect future returns on investments in the Fund.

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

Performance

Fund 1-Year 3-Year 5-Year Since Inception
BMO Low Volatility U.S. Equity ETF (ZLU) 17.44% 11.61% 9.76% 15.11%

Source: Morningstar as of May 31, 2022. Inception of ZLU is March 2013. Index performance is provided as a benchmark but is not illustrative of any particular investment. You cannot invest directly in an index. The chart illustrates the impact to an initial investment of $10,000 dollars from March 2013 to May 2022 in the BMO Low Volatility Canadian Equity ETF. It is not intended to reflect future returns on investments in the Fund.

Low volatility has been called a “defensive growth” strategy. What exactly does that mean?

CH When speaking with Advisors, I often say that low volatility is about “winning by not losing”—which means that rather than aiming for the highest possible returns, you can preserve capital and keep it growing at a steady, albeit slower, pace. By protecting value during negative equity markets, the strategy is ultimately set up better for future success. Our bias is toward strong, stable businesses that perform well regardless of economic growth, high inflation and market volatility. The goal is to focus more on defensive sectors, known for “slow and steady”-type returns, and away from higher risk sectors. For instance, on the Canadian side, we have names like Metro, Hydro One and Dollarama, while for the US we have Dollar Tree, Waste Management and McDonalds. All of these equities are in a strong position today despite inflationary pressures, and benefit from consistent consumer demand, as their businesses are key to the economy.

Not all low volatility solutions are created equal. How does your investment methodology differ from other low vol funds?

CH Well, we were the first low volatility ETF provider in Canada. At the time, we completed rigorous data testing to determine whether the fund should select assets based on beta or standard deviation. We assessed the results over different timeframes, in different scenarios, with different stipulations. Ultimately, we determined that using beta over a five-year period made the most sense. We also employ a very pure construction methodology, one that isn’t concerned about market cap. Instead, we’re simply focused on the securities that offer the lowest betas. We even use a disciplined framework whereby a stock is removed from the portfolio once it falls outside our risk parameters. Finally, we avoid sector overweights by capping them at 35% for the Canadian fund and 25% for US. Our process is disciplined, rules-based and free of individual bias.

As we look ahead to more normalized times, with rates stabilizing and inflation subsiding to below its traditional 2% range, should Advisors continue to employ a low volatility strategy?

CH In a word—yes. As noted earlier, low vol can be considered a core holding for clients, with the specific weighting based on their risk tolerance and market conditions. History has shown, time and again, that it is a fool’s errand to try and time the market. No one can predict when volatility will strike. So, for investors interested in some measure of safety, having defensive growth in the portfolio can add valuable protection against a market downturn, particularly for clients who are in or nearing retirement.

Chris, we typically like to ask for a book recommendation. But we know you’re an avid podcast listener. Can you recommend one that our audience of Advisors may enjoy?

CH One of my regular listens is Trillions, from Bloomberg, which is focused on ETFs. It’s produced bi-weekly and provides a lot of valuable industry information. On a personal note, I’m also a fan of The Peter Attia Drive podcast. He’s a physician who is an expert on longevity and healthy living, and I’ve been trying to incorporate many of the concepts he discusses into my everyday life. I’m also a big proponent of tapping into the informed opinions of experts in their field, and being able to learn and grow from them.

Disclosures:

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