The problem I see with many of the low volatility mandates is that investors have bid up the valuation levels of many of the stocks held in these products to very high levels. For example, according to Morningstar, the P/E ratio of the BMO Low Volatility Canadian Equity ETF (TSX: ZLB) is 21.4 times forward earnings. In comparison, the S&P/TSX 60 Index trades at approximately 15 times forward earnings. While ZLB has significantly outperformed the other Canadian low vol ETFs, I don’t see how that is sustainable at these levels of valuation. In comparison, this PowerShares ETF trades at a valuation level that is more in line with the broader market. Further, if you consider the forward looking growth rates, TLV looks to have a more positive outlook than ZLB, making the valuation levels that much more compelling.
There are a couple of other reasons to favour TLV over ZLB. One is TLV is rebalanced on a quarterly basis, making it potentially more responsive to the market than other low vol ETFs. Another reason to like this is its lower cost.
A drawback to TLV lies in the sector constraints, or lack thereof. There are no maximum limits on the sector exposure. With no constraints, it has the potential to get pretty concentrated, as is the case now, running about 27% in financials, and 31% in real estate, more concentrated than its peers. A higher concentration portfolio can be a double edged sword, and can either help or hurt depending on what way the market moves.
The bottom line is I believe that TLV is better positioned to outpace its peers. While ZLB may continue to outperform in the shorter term based on momentum factors. Historically, valuations typically regress back to the mean, making it highly likely it will experience a sustained period of underperformance in time. Considering all factors, I believe that TLV is better positioned than other low vol ETFs currently.