Tuesday, 4 September 2012

Canadian Equity Low Volatility vs Cap-Weight ETFs Reviewed

When we first wrote about Low Volatility Equity ETFs in January, the promise of returns as good as, and perhaps even better than, traditional cap-weight index ETFs, along with greater stability, seemed quite credible. Towards the end of July, iShares Canada launched a series of low volatility ETFs covering Canada, the USA, EAFE, Emerging Markets and All-World. It's a good time to look inside the ETFs, to compare the low volatility offerings against the traditional passive index ETFs selected and weighted by capitalization. Today we focus on the ETFs that contain Canadian equities.

There are now three low-volatility Canadian equity ETFs:
- BMO Low Volatility Canadian Equity ETF (TSX: ZLB),
- Powershares PowerShares S&P/TSX Composite Low Volatility Index ETF (TLV)
- iShares MSCI Canada Minimum Volatility Index Fund (XMV)
Our benchmark to compare with is the cap-weight ETF,
- iShares' S&P/TSX 60 Index (TSX: XIU)
It is the largest ETF in Canada and very closely represents the overall TSX.

Using our detailed comparison table below, here's how they stack up.

Holdings in low volatility ETFs differ tremendously
It is perhaps not surprising that ETFs which use very different methodologies to implement the concept of "low volatility" (i.e. either based on beta, which is relative to the market, or based on each stock's price stability taken by itself, or by co-movements amongst the stocks - see table for the method each ETF uses) should come up with different sets of holdings.
  • ZLB and TLV are quite different from XIU, and from each other! That's true both for sector weightings and for the actual stocks held in each.  Not one sector in either ZLB and TLV has even approximately the same weighting. TLV in particular does not have even a single stock in a number of sectors. In terms of stock holdings, only about a quarter of the holdings overlap with XIU. A dramatic illustration of the degree of difference is that the largest stock in Canada, the Royal Bank (RY), does not even appear in either ZLB or TLV. The largest holding in ZLB, Fairfax Financial (FFH), does not appear in XIU either. 
  • TLV has a very high concentration in the financial sector - about 45% of its holdings. That's a bit of a worry. Conversely, on the good side TLV is also the least concentrated on individual companies - the top 10 holdings make up a far smaller proportion of the portfolio than any other ETF.
  • TLV and ZLB contain much smaller companies (data is not yet available in our source Morningstar for XMV). Their average market cap is only a quarter to a third that of XIU's holdings.
  • Dividend yields are at least as high, in ZLB, or higher, in TLV, as in XIU.
  • XMV resembles XIU to a significant degree - a 50% stock overlap (e.g. it does have Royal Bank as its 5th largest holding) and the sector weights line up fairly closely. Of course, that means XMV is quite different from TLV and ZLB. We wonder if it is different enough to be worth bothering about.
We expect therefore that future performance of the various ETFs, both in terms of volatility and cumulative returns, is likely to diverge from each other and from XIU.

Performance - past back-tested and future likely results
The low volatility ETF marketing promise (see iShares' Oliver McMahon on BNN) to protect against downside while participating in upside, though not as much as through the cap-weight alternative, appears to be more than met in back-testing. Will slow and steady continue to win the race?

BMO's back-test chart of the ZLB index
Powershares' back-test for the TLV index

iShares' backtest for the XMV index
What might go wrong, or why the promise may not work out
  • The future may not be like the past. The testing period is short. Only one back-test goes as far back as even the Internet tech bubble. None cover the nasty period of the high inflation 1970s or the 1930s depression. When markets were in expansion during the 1990s how much would the low volatility ETFs have fallen short of XIU?
  • Fees and expenses are not included. The back-test results do not reflect the returns-lowering effect of the ETF MERs. Though the MERs are reasonably low, the 0.1% to 0.2% higher MERs compared to XIU do make a difference especially over a compounded long run.
Performance so far
ZLB is working as advertized in its short life so far. The Google Finance chart below shows that ZLB since its October 2011 start-up has indeed outperformed XIU and shown much greater stability.
In the past month since the launch of XMV, the beneficial side of XIU's greater volatility is apparent in XIU's gain of 3.69% on another Google Finance chart, easily besting all the low volatility contenders. The same chart shows the expected big differences between the low volatility ETFs themselves.

Low volatility ETFs' place in a portfolio
An investor could simply substitute one of the low volatility ETFs in place of XIU as the Canadian equity holding. These ETFs cover the broad market sectors and are reasonably diversified, though TLV is a bit less than the others. A retired person, for whom volatility is an especially important issue, could find them particularly attractive.

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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