How Can ETFs Help Mitigate Portfolio Volatility?
Using an Exchange-Traded Fund (ETF) over a single stock is one way to manage overall portfolio volatility. An ETF holds a basket of stocks, so it’s broadly diversified which typically provides less volatile returns relative to a single stock. To illustrate this point, the table below shows the January 2022 returns for some of the largest companies in Canada vs a broad market Canadian ETF. Many stocks saw drastic moves, some to the upside and some to the downside, while the broad market ETF was relatively flat (less volatile) during the same time.
| Stock/ETF | One Month Return January 2022 |
|---|---|
| Royal Bank | 8.9% |
| Toronto Dominion Bank | 5.5% |
| Bank of Nova Scotia | 2.3% |
| Shopify | -29.3% |
| Enbridge | 8.8% |
| Brookfield Asset Mgmt | -8.4% |
| Broad Canadian Market ETF* | -0.4% |
*Based on an S&P/TSX Composite Index ETF which holds the 240 largest publicly listed companies in Canada. Source:
Are There Specific ETF Strategies That Are Less Volatile Than Others?
There are also specific ETF strategies that offer a basket of low volatility stocks to investors who prefer to invest in less volatile stocks than the broad market. These are called Low Volatility ETFs. Like the name suggests, these ETFs apply a set of rules to a portfolio of stocks to achieve a certain outcome: a lower volatility profile than the broad market. Low Volatility strategies have become popular choices for investors who are looking for ways to invest in equity markets while managing portfolio risk.
In Canada, our broad market is about 33% in Financials, 15% in Energy and 11% in Materials. The overweight to Energy and Materials makes this more volatile and more cyclical than many investors’ risk appetites can handle 1. By applying a low volatility screen to the broad Canadian market, an investor would end up with an ETF which a lower beta (lower risk) than the broad market and overweighted to more defensive sectors such as Utilities and Consumer stocks.
What to Look for When Choosing A Low Volatility Strategy
ETFs are a great tool to add a low volatility strategy to a portfolio easily and cost effectively. There are several low volatility options for investors, so below are some considerations to make when sorting out which strategy might best suit them 2.
- How is the ETF screening for low volatility stocks? What criteria is being selected? Risk metrics such as beta and standard deviation are two common stock characteristics that can be analyzed to determine how risky a stock is.
- What is beta? Beta is a risk metric that measures a stock’s sensitivity to fluctuations in the broad market (market sensitivity). The broad market has a beta of 1.0 therefore a stock with a beta less than 1.0 indicates it is less risky relative to the broad market. Low beta investments are less volatile than the broad market and can be considered more prudent investments. Over the long-term, low beta stocks may benefit from smaller declines during market corrections and still increase during advancing markets. Low beta stocks tend to be more mature and provide higher dividend yield than the broad market.
- What is standard deviation? All else equal, the lower the standard deviation of a stock or ETF, the less volatile it is. The standard deviation of a stock is calculated not only by looking at how extreme its downturns have been, but also considers the up swings as well. The risk rating of an ETF can give you an idea how volatile it has been over the long-term.
- How long has the stock been analyzed? A one-year standard deviation provides less insight than a 3 or 5-year standard deviation. Typically, data points which capture longer periods of time create a better understanding of the stock’s true long-term volatility and create a more sustainable low volatility strategy.
- Is the ETF tracking an index or is it active? You can learn more about how the ETF is achieving its low volatility structure by reading about the index it tracks, or about the methodology the managers are employing if the strategy is active.
In times of high volatility, investors need to know their risk
profile and tolerance. Low volatility ETFs can provide exposure to the
markets without exceeding your risk tolerance. Having a conservative
approach can still provide returns.
Find a low volatility ETF now in our platform with our ETF Centre tool.
1Bloomberg, February 5, 2022.
2Most ETF providers include the below information on their websites so investors can learn more about the ETF and its strategy before investing.
About the author: Danielle Neziol, Vice President, BMO ETFs
Danielle Neziol has spent the last five years helping to drive the ETF product development and strategy at BMO ETFs by engaging stock exchanges, capital markets desks, index providers, and portfolio managers to bring new ETFs to market. More recently, Ms. Neziol is focusing her time with both investors and professionals to provide ETF insights and education. She has also been a guest speaker and panelist for both public and industry events, hosts the weekly webinar ETF Market Insights, and has a podcast which delivers ETF education to DIY investors. Ms. Neziol has an honours degree from Western University.