Friday, 7 September 2012

Choosing Between US and International Equity Low Volatility vs Cap-Weight ETFs

The low volatility ETFs holding Canadian stocks that we wrote about last week are not the only ones available. There are a number of others covering equities around the world - US-only, developed economy (aka EAFE) countries, emerging markets (like China and India) and all-world. Let's see how they compare to the basic building block ETF for most investors, the traditional cap-weighted index ETF.

The ETFs
Unfortunately, there is not a single comprehensive source that lists all the ETFs available to Canadian investors - those traded in Canada on the TSX can be found through ETF Insight's screener by doing a search under Strategy for "Low Volatility" giving this result,

and US-traded ETFs through ETFdb's screener under Investment Style for "Low Volatility" and also "Low Beta", giving this,
We'll focus on the US equity ETFs since the comparisons and issues for consideration there also apply to the other international equity ETFs. Russell recently announced that it was soon to close down all its low beta and low volatility ETFs due to poor up-take by investors so the selection is much reduced.

Below is our detailed comparison table. Red highlighted text in the table shows the largest differences between the low volatility ETFs and our benchmark the cap-weight iShares S&P 500 Index Fund (NYSE: IVV).
What does the table reveal?

1) Very large differences in holdings ...
  • Sector weights dramatically divergent between PowerShares S&P 500 Low Volatility (CAD Hedged) Index ETF (TSX: ULV) and its US-traded equivalent the unhedged SPLV, which also happens to be the runaway most popular low volatility ETF of all. Utilities are a huge part of ULV/SPLV but a tiny part of IVV.
  • Low degree of overlap in holdings. Of the 50 largest holdings in IVV, only 22% and 32% show up in the top 50, respectively, of XMU or its US equivalent USMV, and of ULV/SPLV. The most dramatic example of low overlap, just as we discovered for the Canadian equity ETFs, is that the largest holding of all in IVV, in this case Apple Computer which represents almost 5% of IVV, does not show at all in either pair of low volatility ETFs!
  • Lower concentration in the low volatility ETFs. The highest weighted stock in each low volatility ETFs is much lower than in IVV and the top ten make up much less of the overall ETF. This is despite the fact that IVV has five times the total number of stocks.
  • Smaller companies, as shown by the lower average market cap, are in the low volatility ETFs. 
  • Higher priced companies in terms of predicted earnings and book value, are in the low volatility ETFs.
  • Companies with appreciably higher dividend yields are in the low volatility ETFs. It is worth noting that dividend yield is not a selection or weighting factor in low volatility ETFs.
Our conclusion is thus the same as for the Canadian equity ETFs - the returns and volatility of the low volatility ETFs will differ from the cap-weight benchmark.

2) Performance pattern as advertized - same trend but lower volatility
A quick look at the Google Finance chart image below confirms that in the short time since their launch, both SPLV and USMV have indeed been bumping down, and up, less than IVV while generally following the same direction. The ETF that differs the most from IVV is SPLV and its performance has also diverged the most. A fact sheet from SPLV provider Powershares calculates that there has been a 95% correlation (moving in the same direction at the same time) between the index SPLV follows and the S&P 500 index IVV mimics. In our view, that is a reassuring feature that we would expect to see continue.
3) Higher MER trade-off vs foreign exchange conversion costs
The Canadian-traded ETFs have 0.10% (UMV) or 0.15% (XMU) higher MERs than their identical US-traded versions. That's an annual performance drag. Against that the investor must weigh the cost of converting Canadian dollars to US dollars in order to buy (or the reverse, to sell) ETFs on US markets. Different brokerages charge different amounts (see MillionDollarJourney's discount broker comparison and see also Finiki's Norbet's Gambit method of reducing those costs). In the case of ULV and XMV, the currency conversion costs are embedded in the fund's MER. The less often that an investor buys/sells and the lower the currency conversion cost, the more attractive the lower MER of the US fund becomes.

4) Higher MER on low volatility ETFs
The cap-weight benchmark IVV has appreciably lower overhead costs than any of the low volatility funds, though USMV gets pretty close with its 0.15% MER. Why the ETF fees should be as high as 0.35% for funds that use the same kind of process as an index fund - an automatic procedure to select, weight and rebalance holdings - is not clear.

5) CAD hedged vs un-hedged ETF
In addition, ULV introduces the option for the investor to hold US stocks in a fund that includes protection against US vs Canadian dollar currency swings. There is an often significant cost to this hedging but it shows up less in the higher MER than in the large under-performance of the ETF relative to its index, as Canadian Capitalist wrote about here and Rob Carrick of the Globe and Mail here.

6) Foreign withholding taxes will undermine returns in tricky ways that vary per type of account
We have previously written about how different types of ETFs in TFSA, RRSP, RESP or taxable accounts incur US and/or international withholding taxes on dividends in Pros and Cons of Cross-Border Shopping in the USA for ETFs and in ETF Asset Allocation across, RRSP, TFSA and Taxable Accounts. The bottom line with respect to our present ETFs is that XMU and ULV irretrievably lose 15% US withholding tax on distributions compared to their counterparts USMV and SPLV in a RRSP or other registered account. All suffer in a TFSA or RESP and none suffer in a taxable account.

Similarly with the all-world, developed country and emerging market ETFs, the Canadian-traded ETFs lose US withholding tax in RRSPs and like accounts compared to the US-based versions - XMW vs ACWV, XMI vs EFAV and XMM vs EEMV. What's worse all the ETFs suffer the irretrievable loss of foreign non-US withholding tax no matter what account they are held in.

The same caveat applies that we have expressed before - the future may not be like the past that showed low volatility to be a viable stock selection strategy. It is also worth noting that low volatility does not mean the ETF cannot go down, even considerably (see the provider websites where the backtesting showed big declines in 2008/2009), it just means it will go down a lot less than the cap-weight ETF.

In whose portfolio and in what place
Investors who cannot afford the volatility, such as many retired investors who will be drawing down from their accounts on a regular basis, will find low volatility ETFs worthwhile as a substitute for the mainstream equity allocation.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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