Low volatility funds and ETFs have become rather popular with investors lately, and it’s not hard to see why. Who doesn’t love the idea of getting returns that will come pretty close to the broader market, but with a lot less downside? It sounds too good to be true, and while the track records are still relatively short, the early results are very encouraging.
This was the best performing Canadian ETF on the Focus List over the period, falling 1.3%, compared with a drop of 4.8% for the S&P/TSX Composite Index. The longer term numbers are also rather impressive. For the three years ending January 31, it gained 16.4%, compared with 3.4% for the index. More impressive however, is this was done with a level of volatility that was about three quarters of the market, and it posted a downside capture ratio that was negative, which means that on average, when the broader market was down, this ETF was positive.
As impressive as this level of outperformance has been, it is not sustainable. One key reason is the ETF has very little exposure to the hard hit energy sector, and no exposure to materials, which has been the biggest drags on the S&P/TSX Composite. Once we see energy stabilize and start to rebound, this ETF is likely to lag the broader Canadian market.
Another worry I have relates to the valuation levels of the underlying portfolio. According to Morningstar, the price to earnings ratio of ZLB is 19.4 times. In comparison, the S&P/TSX Composite is trading at a more modest 15.5 times earnings. It is a similar story for other key valuation metrics, with ZCS exceeding the market on a price to book, and price to cash flow basis. Turning to earnings, the historic earnings growth rate of ZCS lags the index, and the forecasted earnings growth is significantly lower than the market. In other words, investors have significantly bid up the price of these lower beta names, and they now trade at levels that are not justified by both the current and expected level of earnings.
That is not to say a significant selloff is imminent. On the contrary. Instead, looking at the sector makeup, I would expect it to continue to hold up well in periods of higher than normal volatility. However, when the markets turn positive, this ETF would be expected to lag, in some cases significantly, while earnings catch up with valuations. If you have held this ETF for any period of time, I would strongly encourage you to take some money off the table, by rebalancing your portfolio and taking some profits.