Low volatility funds are anything but

Over the past two years, we have seen large sums of investment money flowing into low volatility exchange traded funds (ETFs) and other mutual funds.

After several years of increased stock market volatility, investors seemed all too eager to jump on this latest investment fad in an effort to reduce their risk and volatility exposure. But what have these investors really bought? And are these funds actually living up to their names?

Back in May of last year, a report showed that $10 billion had flowed into low volatility ETFs in the first four months of the year, which took the total assets in this category from $25 to 35 billion USD in a very short time. Here in Canada, we’ve seen very similar inflows to this relatively new category as well. So let’s look at how things have performed since then.

For simplicity’s sake, I decided to look at the returns of various assets during the past six months, ending Feb. 7, since the period before this had the largest inflows to the low volatility space.

The Canadian stock market (TSX index) has gained 5.76 per cent during this period. The U.S. stock market (S&P500) has gained 5 per cent.

Standard deviation is a measurement that sheds light on historical volatility by calculating how far an investment deviates from the expected normal returns. The lower the number, the less volatile an investment is. The TSX’s standard deviation over the past three years was 8.32 and the S&P 500’s was 10.4.

Now to look at some of the larger low volatility funds to compare:

• BMO’s Low Volatility Canada ETF lost 1.46 per cent over the past 6 months with a 7.0 standard deviation. Over the past year, it has under-performed the TSX index by 10.31 per cent! That’s a lot of lost return for only slightly less volatility. • RBC’s QUBE Low-Vol US Equity fund lost 0.54 per cent over the past six months with a 10.83 standard deviation. Slightly more volatility than the S&P index with no growth to show for it.

• Investors Group’s Low Volatility U.S. Equity fund lost a full 3.4 per cent over the past six months with a 9.8% standard deviation.

This poor performance is made worse when you consider the 2.74 per cent annual embedded management fees that it incurs. What is the point of all this? I am certainly not trying to identify specific funds to buy or not to buy, but instead illustrate that you really shouldn’t blindly buy into the hype and assume an investment will perform a certain way based on its name. The stocks that are held in these funds are supposed to be high quality and low risk, but as valuations get stretched, they can be the exact opposite.

This is really troubling because the very investors who bought into these low volatility funds were doing so because they believed these investments to be low risk.

Yes, you should be concerned about the higher volatility that exists in today’s investment world but understand that these low volatility ETFs and funds are not necessarily the simple solution that they make out to be. It is not the name of an investment product that determines the risk, but instead what it actually invests in. An actively managed portfolio that can select stocks based on their overall merits, and not just by the set formula built into a passively managed ETF, can provide significant risk reduction and return improvement during these periods of heightened volatility.