In times of uncertainty, investors who want low risk along with capital preservation may turn to low-volatility investments. Securities considered to be low-volatility do not fluctuate in value as much as other investments.
“If you think about why someone would buy a low-volatility investment, they [have] a desire for risk reduction,” says Sam Febbraro, executive vice-president at Investment Planning Counsel. But there’s a trade-off. “It’s hard to have risk reduction and have the performance shoot to the moon. As a result, these investments may sometimes underperform in a rising market. But in theory they should be less volatile on the downside.”
A low-volatility investing strategy focuses on reducing volatility or risk compared to the stock market index, says Jeet Dhillon, vice-president and senior portfolio manager at TD Wealth Private Investment Counsel. “Low-volatility strategies use risk as the primary measure to determine if particular stocks will be included or excluded, and what the optimal weighting of the included stocks will be in a portfolio.”
Types of low-volatility investments
Many people think of cash, GICs and bonds when they think of low-volatility investments, but stocks and ETFs can also fall into this category.
Dhillon adds that utilities and consumer staples are examples of low-risk stocks because the demand for the goods and services from these companies is less cyclical. These stocks therefore provide some stability from swings in the economy.
Cash and GICs are low-volatility because there is no risk of losing the amount originally invested (known as the principal).
Bond agreements, also known as covenants, also promise that the principal will be paid back when the bond matures. Bondholders also typically receive interest payments, known as coupons, at regular intervals.
During periods of high volatility, bond values don’t fluctuate as much as the value of equities. That’s because fixed-income returns are affected by longer-term trends such as interest rate changes.
You can also invest in a low-volatility ETF. Such ETFs may comprise companies that are considered to be low-volatility, such as consumer staples, real estate income trusts (REITs) and utility companies, says Craig Basinger, chief investment officer at Richardson GMP.
Risks of low-volatility investments
Dhillon warns that low-volatility equities don’t always outperform the stock market. They tend to underperform during strong bull markets and outperform during severe bear markets. “In other words, the lower level of volatility dampens both the highs and lows of returns,” Dhillon says.
Low-volatility ETFs may be risky during periods with rising bond yields, warns Basinger—particularly ETFs that favour REITs and utilities. REITs and utilities tend to hold a lot of debt and are therefore sensitive to increases in interest rates: rising rates make servicing debt more expensive, so returns are dampened. More importantly, explains Basinger, if government bond yields rise, then the dividend yields of these REITs and utility stocks (called “quasi-bond proxies”) look less attractive and fall in price. “The government bonds are a competing asset class to the bond proxies,” he says. (Note that Basinger’s warnings also apply to the underlying REITs and utilities if they were purchased directly or in a mutual fund.)
Bonds have an inverse relationship with interest rates, tending to fall when rates rise. Investors could then lose money if they sell a bond for less than what they paid for it.
Inflation also poses a risk to bondholders. Investors who hold bonds to maturity get their principal back, but if inflation has increased since purchase, the principal would be worth less in present-day dollars.
Buying bonds from unstable governments or companies is another risk, known as credit risk or default risk. Such issuers may not be able to pay the interest payments or the principal of the bond at maturity.
Since GICs are guaranteed, they tend to pay lower interest rates than riskier instruments. Most GICs also fix their rates for the entire term. This is a risk because the interest rate may not keep up with inflation.
Other ways to reduce volatility
Creating a balanced portfolio with stocks and bonds is a good way to reduce volatility, says Basinger. Diversifying a portfolio geographically and across asset classes will also help.
Basinger’s firm also uses what’s called a risk on, risk off investment strategy. This strategy tilts the asset allocation toward equities when the stock market goes up. Conversely, the strategy will favour bonds when the market falls.
“It’s not designed to be a full portfolio, but designed to complement a portfolio and provide a tactical component,” he says.