The Canadian ETF industry has experienced strong growth over recent years, and much of this can be attributed to the inherent flexibility of the ETF structure.
In particular, this adaptability has paved the way for a surge in rules-based ETFs that transcend the confines of traditional indexing. Enter "smart beta" ETFs.
These are not your typical index ETFs; they utilize advanced screening tools and methodologies to zoom in on empirically proven drivers of investment returns. Factors such as size, value, quality, and momentum might already be on your radar.
Yet, there's one theme that might be flying under the radar: low volatility. Despite its less flashy reputation, there is a body of evidence suggesting that historically, stocks exhibiting lower volatility have, in fact, outperformed their more turbulent counterparts over extended periods.
Conventional wisdom usually implies that greater risks are typically associated with potentially greater returns. However, the persistence of the low volatility anomaly, or paradox appears to challenge this traditional notion.
So, what is behind the low volatility factor, and how can investors capitalize on it? Let's go over its mechanics, and review three Cboe Canada listed ETFs from CIBC (TSX:CM) that allow investors to target this unique factor.
What is the low volatility factor?
The low volatility anomaly suggests that stocks that have historically exhibited lower price volatility tend to outperform those with higher volatility over extended periods.
But how do we measure this? Two commonly used metrics are beta and standard deviation:
- Beta: This metric measures a stock's volatility in relation to a broad market index. A beta of 1 means the stock generally moves with the market. A beta less than 1 indicates that the stock is historically less volatile than the market, while a beta greater than 1 suggests higher volatility.
- Standard Deviation: In the context of stocks, this metric assesses the extent to which a stock's price varies from its average price over a specific period. A lower standard deviation indicates that the stock price is historically more stable and doesn't fluctuate widely, while a higher value means greater price volatility.
Imagine two stocks: Stock A and Stock B. Over the past year, Stock A has had relatively minor price fluctuations, moving within a tight range. On the other hand, Stock B's price has swung dramatically, rising and falling with significant amplitude.
If Stock A consistently provides steady, albeit modest returns, while Stock B fluctuates widely but ends up with similar or even lower returns than Stock A by year's end, then Stock A is said to exhibit the low volatility factor.
Why does it exist?
Now, before you dive deep into a sea of academic papers trying to unearth the reasoning behind this phenomenon, let me save you some time. The consensus?
There isn't one – at least not definitively. While there have been numerous hypotheses, no single rationale has emerged as the definitive explanation for the low volatility factor. Some of the proposed rationales for the existence of the low volatility factor include, but are not limited to:
- Behavioral Biases: Investors might chase "lottery-like" stocks, inadvertently elevating the prices of high-volatility stocks and thereby reducing their future returns.
- Leverage Constraints: Retail investors may lean towards high-volatility stocks to achieve desired returns due to an inability to deploy cheap leverage, even if these stocks present heightened risks.
- Risk Perception: A potential undervaluing of low-volatility stocks might occur if investors perceive them as less attractive due to misconceived risk-and-return relationships.
- Geometric Mean Effects: The mathematics of compounding returns play a role. Higher losses require larger subsequent gains to break even. For example, a 50% loss requires a 100% gain to recover the original position.
- Value Factor Overlap: There's a possibility that low volatility is, in part, capturing elements of the value factor. Low volatility stocks often tend to be undervalued, and thus, the performance of such stocks could be attributed to their undervalued nature as much as their lower volatility.
- Interest Rate Environment: Over the past few decades, the global economy has witnessed a trend of falling interest rates. Lower interest rates can lead to increased borrowing and spending, which can benefit stable, dividend-paying stocks typically found within low volatility sectors like utilities.
Low volatility versus minimum volatility
However, before wrapping up, it's crucial to differentiate between two terms: low volatility and minimum volatility. The two might sound synonymous, but they're distinct concepts in the investing realm.
While "low volatility" focuses on selecting individual stocks that have historically shown less price fluctuation, "minimum volatility" pertains to the construction of a portfolio where the combined assets aim to minimize overall volatility.
Some individual components of a minimum volatility portfolio might be volatile, but when combined with other assets, they result in a balance that curtails overall portfolio risk.
To simplify with a food analogy: think of "low volatility" as choosing the blandest ingredients for a dish, while "minimum volatility" is like curating ingredients that, when mixed, result in a dish that isn't spicy, even if some individual ingredients pack some heat.
CIBC's low volatility ETFs
For investors intrigued by the low volatility factor, attempting to identify individual stocks that align with this approach can be challenging.
Screening for stocks based on historical standard deviation and beta requires time, dedication, and expertise. Moreover, once you've compiled your list, managing that portfolio and ensuring it's appropriately balanced can add another layer of complexity.
However, there's an efficient alternative that can bypass much of this labor-intensive process: entrust this strategy to a professionally managed ETF.
Enter CIBC's suite of three low volatility ETFs. These funds offer a streamlined approach to harnessing the low volatility factor, and they're all conveniently listed on Cboe Canada.
- CIBC Qx U.S. Low Volatility Dividend ETF (CQLU): 0.34% expense ratio.
- CIBC Qx Canadian Low Volatility Dividend ETF (CQLC): 0.34% expense ratio.
- CIBC Qx International Low Volatility Dividend ETF (CQLI): 0.46% expense ratio.
By blending these three ETFs in varying ratios, investors can create a globally diversified equity portfolio with a pronounced low volatility factor tilt. Such an approach can offer the potential benefits of the low volatility factor while also spreading risk across multiple geographical markets.
This content was originally published by our partners at the Canadian ETF Marketplace.