Inside the BMO and PowerShares Low-Vol ETFs

In the last 14 months or so, Canada’s ETF providers have launched several funds based on low-volatility strategies. As we saw in my last post, the research suggests it may be possible to build a portfolio of stocks with lower volatility than the broad market without sacrificing expected returns. But exactly how do you select [...]

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In the last 14 months or so, Canada’s ETF providers have launched several funds based on low-volatility strategies. As we saw in my last post, the research suggests it may be possible to build a portfolio of stocks with lower volatility than the broad market without sacrificing expected returns. But exactly how do you select those stocks?

There are several ways to implement a low-volatility strategy, so before you consider any of the new ETFs, make sure you understand how they differ. Today we’ll take a look at the methodologies used by BMO and PowerShares. Next week we’ll look at the iShares strategy.

BMO looks at beta

Rather than tracking an index, the BMO Low Volatility Canadian Equity (ZLB) simply uses a transparent set of rules. You start with the 100 largest stocks in Canada and rank them according to their beta over the previous 12 months. You then select the 40 with the lowest beta: the lower the beta, the greater the company’s weight in the fund. No stock can make up more than 10%, sectors are capped at 35%, and the fund is rebalanced just once a year.

Beta can be a confusing concept. It’s important to understand it has two components: the stock’s volatility (how much its returns vary) and how closely it is correlated with the market as a whole. That means it’s entirely possible for a low-beta company to be highly volatile—as long as its wild price swings are uncorrelated with the market, the stock could still have low beta.

ZLB Top 10 Holdings

Fairfax Financial 5.0%
Metro 4.5%
Bell Aliant 4.0%
Shoppers Drug Mart 3.9%
Weston (George) Ltd. 3.6%
Saputo 3.4%
Emera 3.4%
Loblaw Companies 3.1%
Inter Pipeline Fund 3.1%
BCE 3.0%

One of the attractive features of ZLB is its diversification across sectors—its holdings are considerably more balanced than the broad Canadian market. As such, it would make a reasonable core Canadian equity holding.

ZLB Sector Breakdown

Consumer staples 21.8%
Financials 18.0%
Energy 12.8%
Utilities 12.1%
Telecom services 11.6%
Consumer discretionary 11.0%
Information technology 4.8%
Health care 4.7%
Materials 1.8%
Industrials 1.5%

PowerShares looks at standard deviation

The PowerShares S&P/TSX Composite Low Volatility Index (TLV) uses a different strategy. Remember we said beta measures both volatility and correlation with the overall market? Well, TLV ignores that second factor and looks only at standard deviation, or the degree to which a stock’s daily price movements vary around its average. This means the fund may include companies that are highly correlated with the market (that is, stocks with relatively high beta).

The ETF’s index includes the 50 stocks in the S&P/TSX Composite Index whose price movements had the lowest standard deviation over the past 252 trading days, or 12 calendar months. Again, the companies are weighted according to their volatility, not market cap: the most stable get the largest share of the index. It’s rebalanced every quarter.

TLV Top 10 Holdings

Bell Aliant 2.8%
BCE 2.6%
Telus 2.4%
RioCan REIT 2.4%
Primaris Retail REIT 2.3%
First Capital Realty 2.3%
Dundee REIT 2.2%
Fortis 2.2%
CIBC 2.2%
National Bank of Canada 2.2%

It turns out 23 of the 50 companies in TLV are also in BMO’s low-volatility fund, but the sector breakdowns of the two ETFs are very different. TLV’s holdings are dominated by real estate companies (which are classified as financials): I counted 15 of them, which is one more than you’ll find in the iShares ETF devoted to REITs. There’s no sector cap in the S&P index, and the results are pretty dramatic.

TLV Sector Breakdown

Financials 52.9%
Telecom services 11.5%
Consumer staples 11.3%
Utilities 11.2%
Energy 5.9%
Consumer discretionary 5.4%
Industrials 1.9%

If you were planning to use a low-vol ETF for your core Canadian equity holding and you also have an allocation to REITs, using TLV will result in huge overlap. As always, you need to consider how any ETF in your portfolio complements the others.

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