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The markets are calm – for now.

More market swings are just over the horizon. How do you protect your assets?

Gordon Pape's advice on the calm before the stormBy Gordon Pape, Editor and Publisher

Good news! The VIX is down!

Okay, good news is always nice to hear, you may be thinking. But what the heck is the VIX and why should I care?

VIX is short for the Chicago Board Options Exchange (CBOE) Volatility Index. It measures the expected degree of volatility in the S&P 500 index over the next 30 days, based on options trading.

Fear index

It’s simpler just to think of it as the “fear index”. When it is up, investors are expecting share prices to fluctuate dramatically. The higher it is, the closer we are to panic. When it is low, people are more sanguine and expect calm markets going forward.

As I write, the VIX sits at 14.82. That’s less than half the level of December 24, when it hit a 52-week high of 36.07. That was the day the S&P 500 dropped to its lowest level since May 2017 as U.S. markets experienced their worst December since the Great Depression.

The index hit an all-time high of 80.86 in November 2008, when stock markets around the world were tumbling and there was widespread fear that the global financial system would unravel. Everyone was frightened about the future – and the VIX reflected that.

Right now, things are different. There is still a lot to worry about – trade wars, interest rates, Brexit, to name a few. But, if the VIX is to be believed, investors aren’t overly concerned, which suggests no dramatic moves in the stock market for a while.

That’s encouraging, especially in the context of what by some measures is the longest bull market the U.S. has ever experienced. A benign VIX indicates that run will continue for at least a little longer, although a Presidential tweet or an unexpected corporate collapse could change things overnight.

Calm before the storm

But wise investors know that the VIX won’t stay low forever and that more big market swings are out there just over the horizon. How do you protect your assets from that?

One answer that’s being offered by some mutual fund and ETF providers is a relatively new product called low-volatility funds. These invest in stocks that have a low beta. That’s a measure of how a stock’s performance varies from the movement of the market as a whole.

For example, a stock with a beta of one would be expected to go up or down in direct relation to the general market. A higher beta indicates a stock will fluctuate more than the market – a 1.5 beta suggests its price will move up or down 50 per cent more than the average for its benchmark index.

Conversely, a beta of less than one indicates lower volatility. A beta of 0.5 signifies a stock will gain or lose only half of the movement of the overall index.

This may seem to be a lot of investing jargon, but the bottom line is that low-volatility funds are designed to cushion the blow if the bottom falls out of the stock market. That doesn’t mean they can’t lose money, but the losses should be less than the market as a whole.

The other side of the coin is that when stocks rise, low-volatility issues will trail the pack.

Low-volatility funds

A growing number of companies offer low-volatility products (also called minimum-volatility and low-risk). They include Fidelity, Vanguard, RBC, TD, First Asset, and Investors Group, among others.

BMO Asset Management offers a suite of low-volatility exchange-traded funds (ETFs) that covers Canada, the U.S., emerging markets, and international stocks.

Do they work? So far, the answer is yes in most cases I’ve looked at. Their unhedged version of BMO’s U.S. low volatility fund (TSX: ZLU) gained 8.46 per cent in 2018 while the S&P 500 Index lost 6.24 per cent. In fact, this fund has not had a losing year since it was launched in 2013. The hedged version of this fund (which strips out the currency gains and losses) lost 1.34 per cent but that was still better than the S&P 500.

BMO’s Canadian low-volatility fund (TSX: ZLB) was down 2.83 per cent last year while the S&P/TSX Composite lost 11.6 per cent.

iShares also offers several of these funds – they call them minimum volatility. The Canadian version (TSX: XMV) also beat the Composite with a 2018 loss of 7.13 per cent. The U.S. unhedged version (TSX: XMU) was up 9.98 per cent while its hedged sibling was down 1.05 per cent.

The performance numbers I’ve looked at suggest that these low-volatility funds are meeting the objective of reducing risk, although we have not seen how they will perform in a severe market plunge such as we experienced in 2008.

As far as costs go, the low-volatility ETFs I’ve mentioned fall in the mid-level, with management expense ratios in the range of 0.33 to 0.51 per cent. That’s a lot more expensive than a core product – the iShares Core S&P/TSX Capped Composite ETF (TSX: XIC) has a management expense ratio of only 0.06 per cent. But sector funds – those that focus on specific areas of the economy – are much costlier with MERs running upwards from 0.60 per cent.

Bottom line

Investors who are risk-averse but still want to participate in the stock market should take a close look at low-volatility funds. If you have a financial advisor, ask him or her to help you identify which is the best for your account.


This article originally appeared in The Toronto Star.