Low volatility ETFs an inflation-protection option

As investors look for safe havens and inflation protection, many are turning to low volatility exchange traded funds (ETFs).

These ETFs aim to provide more stable returns by focusing on companies whose share prices have smaller fluctuations than the broader market, pay dividends, and provide market-like returns. They tend to be large, mature, and dominant in their businesses. While their share price performance may lag in strong bull markets, they perform better in downturns.

Among the sectors favoured by these funds are utilities which provide essential services like electricity, water, and gas. Consumer staple stocks are another focus since they sell everyday necessities such as food and household products. Healthcare holdings include drug firms, medical device manufacturers, and health insurers. Telecom stocks offering internet, phone plans, and cable services are another area of interest. Specialty real estate investment trusts (REITs) also have a place in some funds.

Chris Heakes, a senior portfolio manager at Harvest ETFs in Oakville, Ontario, says low-vol funds provide peace of mind in choppy, uncertain markets. Harvest recently launched two funds in the space, the Harvest Low Volatility Canadian Equity ETF (TSX: HVOL) and the Harvest Low Volatility Canadian Equity Income ETF (TSX:  HVOI). The latter uses a covered call strategy to increase the income stream.

“These funds offer growth over time, but take some of the risk off the table,” he says

There are plenty of TSX-listed low volatility funds with a Canadian-only focus. They tend to draw from a similar basket of stocks but differ in the number of holdings, how they weight the companies, and which sub-sectors they prefer. So, it pays to take a close look at the funds and their strategies.

One of the oldest and largest Canadian-only ETFs in this category is the BMO Low Volatility Canadian Equity ETF (TSX: ZLB). It was launched in 2011 and has assets under management (AUM) of $4.9 billion. It has been on the IWB recommended list since 2019.

Another large ETF with a long track record is the iShares MSCI Min Vol Canada Index ETF (TSX: XMV) with $319 million AUM. It was launched in 2013 and is passively managed, as is ZLB.

Mr. Heakes says the disruption caused by the Trump tariffs and trade war includes the risk of stagflation, which would be the worst of both worlds. It combines inflation which raises prices and a slowing economy which reduces demand.

“That type of situation is very negative for equities,” he says. “It will hit the cyclicals such as financials, industrials, and consumer discretionary. Staples, utilities, and healthcare are likely to perform better because people always need them.”

HVOL is actively managed by Mr. Heakes and invests in 40 large and mid-cap Canadian companies weighted by their risk score and size. No single holding is bigger than 4%. Dividends are paid quarterly and can be taken as cash or DRIPs. The fund has a 0.35% management fee. The second fund, HVOI has the same holdings but uses a covered call strategy to increase income.

The largest sectors are financials, including the Big Six banks (36%), industrials (15%) including Canadian Pacific Kansas City and CN railroads, and energy (11%) including Enbridge and TC Energy. The top four holdings are CIBC, TD Bank, RBC, and Scotiabank. They account for 17% of the fund.

“The strategy is blue chip and higher quality which is proven to work well over time.” he says. “It provides solid dividend yields with good dividend streams. HVOI increases that income a little bit more with the covered call option overlay.”

The BMO low volatility fund, ZLB, has been a strong performer over a long period, with an average annual return since inception of 12.4%. Year-to-date it is up 12.5%. It holds 51 stocks has an expense ratio of 0.39% and an annual distribution yield of 2.12%.

Its biggest sector is also financials (21%) but thereafter it goes with consumer staples (19%) and utilities (15%) rather than industrials and energy. The top holdings are Canada’s grocers, Loblaw, Metro, and Empire, which make up 12% of the fund. Utilities including Hydro One, Fortis, and Emera are all in the top 10.

The iShares MSCI Min Vol Canada Index ETF (TSX: XMV) has been nearly as good with an average annual return since inception of 10.3%. Year-to-date it is 10% higher. It has the highest number of holdings at 68 and lowest expense ratio at 0.3%. It has an annual distribution yield of 2.37%. Its weightings are similar to the Harvest funds with the highest going to financials (32%) followed by industrials (13%) and energy (11%). TD Bank, Scotiabank, and Enbridge are its top three holdings.

Mr. Heakes says low volatility funds have pros and cons. On the plus side they act as a cushion in down markets, mitigating sell-offs while delivering returns that will likely be market-like, or better than market. But there will be times when the strategy is not in favour. In very strong markets, these funds tend to lag as higher growth, riskier stocks outperform.

Over the long term, he points out, “Blue chip, higher quality stocks are proven to work well. It is the Warren Buffett approach. It’s always a good style of investing, but particularly applicable in a market with higher risks.”

This article appeared in a recent issue of the Internet Wealth Builder.  For information on how to reprint this article please view this page.