In a choppy market, it pays to invest in low-volatility stocks

When the market outlook is bleak, low-volatility stocks can be an important part of a defensive portfolio

Dollarama storefront

Recessions barely affect discount retailer Dollarama, hence its low beta. (Mario Beauregard/CP)

This may sound like 20/20 hindsight, but 2015 has been a year to own defensive stocks. According to Morningstar, low-volatility exchange-traded funds in Canada have returned an average of 4% since January, compared to a nearly 10% decline in the broader Canadian market.

But if you think you’ve missed that trade, think again. First, the volatility on markets is showing no signs of abating, and things could yet get worse. Second, the assumption that accepting higher volatility leads to better returns over the long run just doesn’t hold up. According to Research Affiliates, between 1967 and 2012, low-volatility equities across all developed nations outperformed the cap-weighted benchmark by three percentage points, even though the benchmark was three percentage points more volatile.

That’s largely due to the magic of compounding, says Jean Masson, who oversees $12 billion in mostly low-volatility equities as a managing director at TD Asset Management. Since less volatile stocks tend not to drop as much as their peers during a market correction, they don’t need to climb as much to recover. That allows them to compound at a faster rate, he explains.

Over the past three years, numerous low-volatility products have come to market with the basic idea of protecting a portfolio on the downside, while getting decent (though not lights-out) returns on the upside. More so than other stock pickers, low-volatility fund managers focus on metrics like beta, standard deviation and Sharpe ratios.

It’s stocks with a low standard deviation and a low beta that interest Masson most. Standard deviation looks at a particular stock’s ups and downs over time; the smoother those bumps are, the better. Beta looks at how cyclical a stock is compared with the comparable index. A company with a beta above one is more cyclical; below one, less.

Not surprisingly, Masson’s portfolios mostly contain defensive names in the consumer staples, utilities and telecom sectors. Resource, technology, industrial and other sectors where stocks go through boom-and-bust cycles are underrepresented. It’s a similar story for low-volatility ETFs, such as BMO’s Low Volatility Canadian Equity ETF. The stock with the highest weighting in the fund is Dollarama (TSX: DOL), which has the lowest beta, at 0.35, of all its holdings.

Some people wonder whether now’s the time to own low-volatility equities, given that the market has fallen so much and could be due for an upswing. As well, there is some concern around how an interest rate rise will affect these stocks, most of which pay dividends and thus compete with bonds for investors’ money.

Mark Raes, head of product for BMO Global Asset Management, concedes that climbing rates will make some names fall, but that shouldn’t bother the kind of long-term investors that hold them. “You don’t trade in and out of these,” he says. “It’s meant to provide something that gives equity market participation, but with lower risk levels over time.”

These types of funds or stocks are “for people who are looking to lower the volatility of their allocation, while maintaining the same amount of equity exposure,” says Peter Kashanek, a portfolio manager with Lazard Asset Management. “You can get a very attractive risk-adjusted rate.”