The Science of Stability: Secrets of Low Vol Investing

Key Takeaways

• The goal of BMO’s low volatility strategies is slow and steady growth
• A disciplined, rules-based process is employed to identify lower-beta companies
• Low vol is a good way to hedge against growth risk and has an impressive long-term track record

Thanks for speaking with us, Chris. Volatility has been a major story in markets over the past year-plus. Do you expect this choppiness to continue for the rest of 2023?

CH When it comes to volatility, there are a few factors at play. We’re still seeing some stickiness with inflation, particularly in the U.S.—it isn’t coming down as fast as either the Fed or investors had hoped, which has led to higher interest rates. And now, the Silicon Valley Bank situation has led to some volatility in the financial sector and potential credit exposure in U.S. Financials and a couple other regions. Those concerns are now bringing down interest rate expectations for the year. So, in a way, we’re seeing a substitution of potential interest rate volatility for stock-specific and credit volatility. To return to your original question—the short answer is that on top of existing volatility, new sources of volatility are popping up as well, and that’s not going to go away overnight. The other thing on the horizon this year that maybe wasn’t as much of a concern last year is the potential for a ‘hard landing’ scenario in which central banks overshoot and cause job losses and a worse economic slowdown. With that still a possibility, I expect volatility to remain on the radar.

Can you speak a bit about the methodology behind BMO GAM’s low volatility strategies, like the BMO Low Volatility Canadian Equity ETF Fund and BMO Low Volatility U.S. Equity ETF Fund? How are the Funds’ holdings selected?

CH The goal of our low volatility strategies is slow and steady growth—winning by not losing, as we like to say. For the BMO Low Volatility Canadian Equity ETF Fund and BMO Low Volatility U.S. Equity ETF Fund, we employ an active, disciplined, rules-based process, and the screening metric we use to identify companies is beta. As Advisors know, beta is a measure of volatility relative to broad markets. By definition, the market itself has a beta of 1. Stocks with higher beta (meaning a beta of greater than 1) have higher risk, and stocks with lower beta (a beta of less than 1) have lower risk. Specifically, we use five-year beta as our measure. The idea there is that by taking a timeline that is a bit longer, we get a better sense of a company’s true risk level—because in any given year, companies’ risk can fluctuate, seeming high-risk one year but low-risk another. A five-year window represents something closer to a complete market cycle, and we can see how companies perform in different environments. A side benefit of a five-year metric is that there’s a little less turnover—names don’t enter or drop off the list as often. For the BMO Low Volatility Canadian Equity ETF Fund, we have a target portfolio of 45 low-beta stocks that we’re looking to own, while for the BMO Low Volatility U.S. Equity ETF Fund, it’s 100 names. The portfolios are actually weighted by beta: the lower the beta of a stock, the higher the allocation of that stock within the portfolio.

Overall, I like to characterize it as a pure-play approach to the low-volatility factor. We’re not just starting with a benchmark and doing a bit of tilting around the edges. What we’re doing is diving deeper, identifying the lowest-risk stocks, weighting our portfolio based on beta, and then implementing sector caps to mitigate against sector-specific risk. We also have an interest-rate sensitivity cap, which we implemented about seven years ago. It makes sure we aren’t over-invested in interest rate-sensitive sectors like real estate, utilities and consumer staples. Those caps help maintain balance in the portfolio. As a portfolio management team, we’re always monitoring and adjusting the methodology as necessary.

What are some examples of stocks that are held by the Funds, and what is it about them that makes them particularly suited for a low-volatility strategy?

CH In Canada, a good example is Waste Connections, which is a garbage and recycling collection and disposal company. It provides a service that’s always needed regardless of the present economic environment, it’s very well-run, and it’s been one of the biggest contributors to the fund over its lifetime. Another company we’ve had a lot of success with is Dollarama. Consumers obviously want to save money whenever they can, and that’s especially true in a high-inflation environment. Dollarama fills that niche.

On the U.S. side, General Mills has been a perfect fit for the fund. It’s a company known for cereal and other food products, which consumers need even in a downturn. It may not be a sexy pick, but over the last five years, it’s provided 12% annualized compounded return. And perhaps more importantly, it’s been defensive, providing steady growth as markets have gyrated. Health Care is a sector that we also tend to overweight in the BMO Low Volatility U.S. Equity ETF Fund. There’s always a demand for heath care services, and demographic shifts like the aging of the ‘baby boomer’ generation has caused this demand to grow. Technology is at the forefront of health care, with new advances in medicine helping the sector to grow further. Take Merck, for example—its five-year compounded return is 19% with a beta of 0.55, meaning that it’s been less volatile and lower-risk than broad markets.

Taking a step back—so far, the Bank of Canada has followed through on its announced rate-hiking pause. If we have reached a plateau, what might this mean for the BMO Low Volatility Canadian Equity ETF Fund?

CH It’s a good question because there are a lot of moving parts. If we get a ‘soft landing’ scenario, with inflation coming down and interest rates normalizing, that’s great for markets overall. The way I think of low volatility is that it’s designed to participate in returns, but its really going to benefit if markets go down. Periods of interest rate increases tend to be followed by an inverted yield curve which is followed, in turn, by a recession. We’re in the second part of that scenario right now—yield curves are significantly inverted, so using history as our playbook, we can expect some difficulty ahead. It’s in that kind of slowdown or recession-type environment where low vol would really shine: it keeps its owner invested, it helps protect capital, and it sets the client up for future success. As we navigate a lot of volatility, low vol strategies are prudent ways to invest.

With inflation proving stickier in the U.S., what is your outlook for the BMO Low Volatility U.S. Equity ETF Fund?

CH In general, the fund will do what it’s designed to do, which is to protect capital while participating in some upside. The U.S. broad market is interesting in that it’s almost 40% Technology. Some of those tech companies have been re-categorized in other sectors over the years—for instance, Amazon moved to consumer discretionary, and Google has moved to communications services. But in reality, it’s a technology-heavy, higher-risk index. As a result, we could see a bit of a feast-or-famine dynamic with respect to growth. A soft landing could set things up well for growth, in which case low vol should do okay. But if we get continuing pressure from inflation and interest rates, or if there is significant volatility in a sub-segment of the market like Financials, then that environment would likely play into a defensive strategy like low vol. Overall, I think that low vol is still a nice place to be in order to hedge against Growth risk. It’s worth considering balancing our low vol funds with growth-oriented funds like the BMO Nasdaq 100 Equity ETF Fund or the BMO U.S. Equity ETF Fund. In the long run, low vol has an impressive track record.

S&P 500 Low Volatility Index vs. the S&P 500 Total Return Index
In the long run, low-vol strategies have outperformed

Source: Morningstar. Data as of January 31, 2023 – for illustrative purposes only. Index returns do not reflect transactions costs, or the deduction of other fees and expenses and it is not possible to invest directly in an Index. Past performance is not indicative of future results.

One last question for you. We like to end by asking for book recommendations that have shaped the way you think, and we know you’re also an avid podcast listener. What would you suggest for our Advisor audience?

CH I’m currently reading Crime and Punishment by Fyodor Dostoyevsky. It’s obviously not typical fare for a financial professional, but I think part of being an insightful thinker is learning from other thinkers, even if their work is not directly applicable to your field. There’s a lot you can learn about human nature from Dostoyevsky.