Pat McKeough recently replied to a member of the Inner Circle looking for an ETF that offers protection from down markets. The BMO Low Volatility Canadian Equity ETF selects stock holdings based on their beta score. That’s a commonly used, but often misleading, measure of future risk. There are better ways to assess an investment’s suitability, says Pat, who does not recommend this ETF.
Q: Dear Pat: I am looking for a “defensive” ETF that will be less volatile than the overall market. I’m thinking of the BMO Low Volatility Canadian Equity ETF. What do you think?
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A: The BMO Low Volatility Canadian Equity ETF, $38.56, symbol ZLB on Toronto (Units outstanding: 67.15 million; Market cap: $2.6 billion; www.etfs.bmo.com), provides exposure to a low beta weighted portfolio of Canadian stocks.
The BMO Low Volatility Canadian Equity ETF selects the lowest beta stocks from the 100 largest and most liquid securities in Canada. The underlying portfolio is rebalanced in June and reconstituted in December. The BMO Low Volatility Canadian Equity ETF has an MER of 0.39%. It currently yields 2.6%.
The BMO Low Volatility Canadian Equity ETF’s current top holdings are Franco-Nevada, Hydro One, Fairfax Financial, Empire Company, Fortis, Emera, Canadian Utilities, Intact Financial, Loblaw and Metro.
The BMO Low Volatility Canadian Equity ETF relies on beta scoring, a commonly used but sometimes misleading measure of volatility. To calculate a stock’s beta, an index like the S&P/TSX Composite or the S&P 500 is assigned a beta of 1.0. The historical volatility of different stocks relative to the index is then measured using either a 36-month or 60-month regression analysis.
If a stock has a beta of 1.0, then it means that the market and the stock move up or down together, at the same rate. That is, a 10% up or down move in the stock market index should theoretically result in a 10% up or down move in the stock. A beta of 2.0 implies the stock will tend to move twice as much as the market. That is, if the market moves up 10%, the stock should move up 20%. A beta of 0.5 indicates the stock will move one-half as much as the market, either up or down. The BMO Low Volatility Canadian Equity ETF relies on the scoring of individual stocks it holds to maintain the fund’s overall low volatility.
ETF: Beta scoring has a number of limitations
A negative beta indicates the stock tends to move in the opposite direction from the general market. That is, the stock price declines when the overall market is rising, or rises when the overall market is declining.
As a measure of risk, beta has a number of limitations. It is based on past data, so its use in predicting the future assumes that the underlying company being charted remains unchanged. For example, it assumes that no major acquisitions or divestitures, or other company-changing events take place. In reality, a stock’s beta can rise or fall over a period of years, or change abruptly.
Beta’s can mislead you in other ways. Gold stocks have an average beta of 0.70 when you use the S&P 500 Index as their benchmark index. Such a low beta indicates that gold funds are safe investments, like utilities. But they are not, of course, and that’s because their performance and returns have relatively little to do with the performance and returns of the S&P 500 Index. They rise and fall with gold prices.
Institutional investors are always looking for so-called “quantitative” measures like beta that can be calculated automatically by a computer program. Beta makes a broad statement about a stock’s history of volatility, but it doesn’t say much if anything about its prospects or its appeal as an investment. To assess a company’s suitability for your portfolio, you are better off using other, more reliable measures of safety, such as steady earnings and cash flow, low debt and a secure hold on a growing market.
We don’t recommend the BMO Low Volatility Canadian Equity ETF.
Inner Circle recommendation: SELL
How much importance do you place low volatility in picking stocks? Have you invested in the BMO Low Volatility Canadian Equity ETF?
Low-volatility stocks have their fans, but what appeal have they held for you over your investment career?
For our report on the key factors in making the right choices in ETFs, read When an ETF investment is the right choice.
For our view on two ETFs that represent the best way to hold bonds today, read These two bond ETFs offer low fees and stable income.
This article was originally published in 2016 and is regularly updated.