BMO Canadian ETF Dashboard

— as of August 31, 2018 —

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Chris Heakes

Combining Low Volatility and Value – Smart Beta Use Study

Summary of Trade Ideas

Low-Volatility ETFs: BMO Low Volatility Canadian Equity ETF (Ticker: ZLB) BMO Low Volatility US Equity ETF (Ticker: ZLU) BMO Low Volatility International Equity Hedged to CAD ETF (Ticker: ZLD) Value ETFs: BMO MSCI Canada Value Index ETF (Ticker: ZVC) BMO MSCI USA Value Index ETF (Ticker: ZVU) BMO MSCI EAFE Value Index ETF (Ticker: ZVI)

Trade Opportunity:

The rise of smart beta Exchange Traded Funds (ETFs) has created more possibilities for investors to customize portfolios to deliver specific return and risk outcomes that better align with their objectives. Well-constructed smart beta ETFs aim to improve upon the return or risk level (or both), relative to the broad index. BMO Global Asset Management is the market leader and largest provider of smart beta ETFs in Canada. This month we introduce an attractive smart beta pairing to consider when implementing systematic equity exposure, with the objective of improving risk-adjusted results relative to broad market indexes.

Pairing Low Volatility and Value creates a compelling mix, capitalizing on the advantages of each, while also taking into account their weaknesses. Value is a higher risk/alpha strategy that tends to perform well in periods of economic expansion. Low Volatility, on the other hand, is a lower risk/defensive strategy that tends to outperform the index in periods of equity contraction.

Why Value Now?

Value tends to perform best in expansionary economies. While the current market is now 10 years into the recovery cycle (the longest on record), global economic trends remain robust. A continuation of growth would be beneficial for Value strategies. BMO’s suite of Value ETFs has an average beta of 1.1 and is positioned for good performance should the late-cycle rally continue. In 2016 and 2017, an example of a recent strong equity market, the Enhanced Value indexes returned an average 3% better than the broad index on an annual basis (12.4% annual performance, versus 9.2% for the MSCI World). In 2008, an example of a bear market, the maximum drawdown was the same for Enhanced Value and the broad index, at -37%. Value stocks are historically cheap, while broad market index valuations are becoming stretched. Value strategies are poised to perform well should the economic backdrop remain robust, or improve further. The underlying index (MSCI) also utilizes 3 different metrics, offering a diversified and efficient way to deliver this exposure.

Why Low Volatility Now?

Low Volatility is the most defensive factor offered, and tends to outperform the broad index in periods of equity contraction. In 2008, Low Volatility outperformed broad indexes by an average of 11%. Conversely, in 2016 and 2017, Low Volatility underperformed, partially due to rising interest rates as well as investors’ preference for growth stocks, particularly IT. Low Volatility performance has bounced back over the past 6 months, signalling an adjustment to higher interest rates. Most importantly though, should market volatility increase in future months, Low Volatility will be poised to outperform once again.

Sep-2018-Heakes-Combining-Low-Volatility.jpg#asset:1558

In combination, Value and Low Volatility have the lowest correlations of all smart beta ETFs offered, varying from 0.50 to 0.65.  Using MSCI data, a 50% Value/50% Minimum Volatility strategy achieves an annualized average return 2.3% higher than the broad index, while reducing risk by 10% relative to the broad benchmark. Diversifying using these 2 factors provides a smoother return experience, while potentially adding significant alpha over the longer timeframe.

Sep-2018-Heakes-Correlation-Benefits.jpg#asset:1555

The average correlations between factors are the lowest between Low Volatility and Value. Combining these factors will potentially enhance portfolio diversification and improve upon broad beta index ETFs.

BMO ETFs offers a wide range of smart beta ETFs that feature both Value and Low Volatility: Smart Beta Exposure Geography Offered Tickers
Low Volatility Canada, US, EAFE, Emerging Markets ZLB, ZLU/ZLH, ZLI/ZLD, ZLE
Quality US, Europe, Global ZUQ, ZEQ, ZGQ
Value Canada, US, EAFE ZVC, ZVU, ZVI
Dividend Canada, US, EAFE ZDV, ZDY/ZUD, ZDI/ZDH
Equal Weight Select Canadian and US Sectors Find in ETF Roadmap
Chris Heakes

Combining Low Volatility and Value – Smart Beta Use Study

Summary of Trade Ideas

Low-Volatility ETFs: BMO Low Volatility Canadian Equity ETF (Ticker: ZLB) BMO Low Volatility US Equity ETF (Ticker: ZLU) BMO Low Volatility International Equity Hedged to CAD ETF (Ticker: ZLD) Value ETFs: BMO MSCI Canada Value Index ETF (Ticker: ZVC) BMO MSCI USA Value Index ETF (Ticker: ZVU) BMO MSCI EAFE Value Index ETF (Ticker: ZVI)

Trade Opportunity:

The rise of smart beta Exchange Traded Funds (ETFs) has created more possibilities for investors to customize portfolios to deliver specific return and risk outcomes that better align with their objectives. Well-constructed smart beta ETFs aim to improve upon the return or risk level (or both), relative to the broad index. BMO Global Asset Management is the market leader and largest provider of smart beta ETFs in Canada. This month we introduce an attractive smart beta pairing to consider when implementing systematic equity exposure, with the objective of improving risk-adjusted results relative to broad market indexes.

Pairing Low Volatility and Value creates a compelling mix, capitalizing on the advantages of each, while also taking into account their weaknesses. Value is a higher risk/alpha strategy that tends to perform well in periods of economic expansion. Low Volatility, on the other hand, is a lower risk/defensive strategy that tends to outperform the index in periods of equity contraction.

Why Value Now?

Value tends to perform best in expansionary economies. While the current market is now 10 years into the recovery cycle (the longest on record), global economic trends remain robust. A continuation of growth would be beneficial for Value strategies. BMO’s suite of Value ETFs has an average beta of 1.1 and is positioned for good performance should the late-cycle rally continue. In 2016 and 2017, an example of a recent strong equity market, the Enhanced Value indexes returned an average 3% better than the broad index on an annual basis (12.4% annual performance, versus 9.2% for the MSCI World). In 2008, an example of a bear market, the maximum drawdown was the same for Enhanced Value and the broad index, at -37%. Value stocks are historically cheap, while broad market index valuations are becoming stretched. Value strategies are poised to perform well should the economic backdrop remain robust, or improve further. The underlying index (MSCI) also utilizes 3 different metrics, offering a diversified and efficient way to deliver this exposure.

Why Low Volatility Now?

Low Volatility is the most defensive factor offered, and tends to outperform the broad index in periods of equity contraction. In 2008, Low Volatility outperformed broad indexes by an average of 11%. Conversely, in 2016 and 2017, Low Volatility underperformed, partially due to rising interest rates as well as investors’ preference for growth stocks, particularly IT. Low Volatility performance has bounced back over the past 6 months, signalling an adjustment to higher interest rates. Most importantly though, should market volatility increase in future months, Low Volatility will be poised to outperform once again.

Sep-2018-Heakes-Combining-Low-Volatility.jpg#asset:1558

In combination, Value and Low Volatility have the lowest correlations of all smart beta ETFs offered, varying from 0.50 to 0.65.  Using MSCI data, a 50% Value/50% Minimum Volatility strategy achieves an annualized average return 2.3% higher than the broad index, while reducing risk by 10% relative to the broad benchmark. Diversifying using these 2 factors provides a smoother return experience, while potentially adding significant alpha over the longer timeframe.

Sep-2018-Heakes-Correlation-Benefits.jpg#asset:1555

The average correlations between factors are the lowest between Low Volatility and Value. Combining these factors will potentially enhance portfolio diversification and improve upon broad beta index ETFs.

BMO ETFs offers a wide range of smart beta ETFs that feature both Value and Low Volatility: Smart Beta Exposure Geography Offered Tickers
Low Volatility Canada, US, EAFE, Emerging Markets ZLB, ZLU/ZLH, ZLI/ZLD, ZLE
Quality US, Europe, Global ZUQ, ZEQ, ZGQ
Value Canada, US, EAFE ZVC, ZVU, ZVI
Dividend Canada, US, EAFE ZDV, ZDY/ZUD, ZDI/ZDH
Equal Weight Select Canadian and US Sectors Find in ETF Roadmap
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Brian G. Belski

Ease the Tension with Quality

Summary of Trade Ideas

BMO MSCI USA High Quality Index ETF (Ticker: ZUQ)

A preference toward higher-quality stocks has been one of our overriding investment themes for many years. Our work suggests that these stocks perform very well over longer periods and are particularly well suited for the market environment we expect to unfold in the coming quarters. Indeed, our work shows that higher-quality stocks can help investors combat periods of increased volatility, while also allowing for participation in the upside during periods of market strength. 

In fact, our works shows: 

1.  Quality Can Help Guard Against Volatility, but Also Benefits During Periods of Market Strength 

Although we continue to be bullish on the outlook for U.S. stocks, we do believe that investors will be forced to contend with higher levels of volatility in the coming quarters. As such, we decided to highlight quality strategies, which tend to perform well during these types of periods, according to our work. 

Aug-2018-Belski-High-Quality-Can-Combat-lg.jpg#asset:1528


2.  
Quality Performs Well in Range-Bound Markets

Performance of High-Quality Screen for Range-Bound S&P 500 Periods Beginning 1990
S&P 500 Range-Bound Period as Identified by the High-Quality Screen 

Start End Duration (Days) Period Return
4/4/1991 12/11/1991 251 7.6%
1/2/1992 11/17/1992 320 4.2%
12/18/1992 7/6/1993 200 1.3%
7/16/1997 1/9/1998 177 11.6%
3/18/1999 10/8/1999 204 -7.6%
11/18/1999 10/5/2000 322 12.8%
10/11/2001 5/16/2002 217 26.5%
12/23/2003 10/25/2004 307 3.1%
11/12/2004 10/27/2005 349 -3.6%
11/25/2005 7/3/2006 220 7.3%
4/25/2007 12/26/2007 245 0.1%
1/18/2011 7/29/2011 192 4.6%
3/15/2012 12/28/2012 288 3.3%
2/18/2015 8/17/2015 180 -0.2%
11/3/2015 11/4/2016 367 2.0%
Average 4.9%

Source: BMO Capital Markets Investment Strategy Group, FactSet, IBES.


3.  High Quality Represents a Diverse Strategy

Despite common perceptions, high quality is not necessarily associated with defensive strategies. In fact, our current quality screen actually represents a pretty cyclically diverse strategy, as shown in the sector composition pie chart below. While Health Care certainly makes up a sizeable portion of high quality currently, the traditional defensive areas of the market have fairly low exposure, with Telecom, Real Estate, and Utilities entirely absent from the screen.

Sep-2018-Belski-Sector-Composition-lg.jpg#asset:1538


Fundamental Backdrop Favours Quality 

Given the type of market environment we expect to unfold, we believe our quality strategy will outperform the broader market over the next 12–18 months. This is especially true given the solid fundamental backdrop of these stocks.

Quality Exhibits Attractive Fundamentals

Metric High-Quality S&P 500
ROE 21.2 14.9
Cash as % of Market Cap 9.4 5.0
EPS Growth Volatility 8.6 15.1
NTM EPS Growth 14.4 14.3

Source: BMO Capital Markets Investment Strategy Group, FactSet, IBES.


4.  Trade Idea: BMO MSCI USA High Quality Index ETF (ZUQ)

  • Since ZUQ’s inception, it has had strong tracking with our U.S. High-Quality Screen, which we used in the analysis (see NOTE below)
  • Focus on blue-chip companies with high Return on Equity (ROE), low leverage (Debt/Equity) and stable earnings growth
  • Rebalanced semi-annually to ensure continued adherence to the quality exposure
  • An attractive way to obtain exposure to equity growth in the U.S. market, while maintaining a measure of defensiveness relative to the broad market by focusing on companies with higher profitability and stronger balance sheets


For more information, please see our most recent publication, “Ease the Tension with Quality.”.


NOTE: The above analysis is not based on ZUQ, but on our BMO Capital Markets Investment Strategy Groups High- Quality Screen: B+ or higher S&P stock rank; BBB- or higher S&P LT debt rating; 5-year EPS growth volatility lower than S&P 500 median value; ROE higher than S&P 500 median value; and cash as a percentage of market cap higher than S&P 500 median value.

Brian G. Belski

Ease the Tension with Quality

Summary of Trade Ideas

BMO MSCI USA High Quality Index ETF (Ticker: ZUQ)

A preference toward higher-quality stocks has been one of our overriding investment themes for many years. Our work suggests that these stocks perform very well over longer periods and are particularly well suited for the market environment we expect to unfold in the coming quarters. Indeed, our work shows that higher-quality stocks can help investors combat periods of increased volatility, while also allowing for participation in the upside during periods of market strength. 

In fact, our works shows: 

1.  Quality Can Help Guard Against Volatility, but Also Benefits During Periods of Market Strength 

Although we continue to be bullish on the outlook for U.S. stocks, we do believe that investors will be forced to contend with higher levels of volatility in the coming quarters. As such, we decided to highlight quality strategies, which tend to perform well during these types of periods, according to our work. 

Aug-2018-Belski-High-Quality-Can-Combat-lg.jpg#asset:1528


2.  
Quality Performs Well in Range-Bound Markets

Performance of High-Quality Screen for Range-Bound S&P 500 Periods Beginning 1990
S&P 500 Range-Bound Period as Identified by the High-Quality Screen 

Start End Duration (Days) Period Return
4/4/1991 12/11/1991 251 7.6%
1/2/1992 11/17/1992 320 4.2%
12/18/1992 7/6/1993 200 1.3%
7/16/1997 1/9/1998 177 11.6%
3/18/1999 10/8/1999 204 -7.6%
11/18/1999 10/5/2000 322 12.8%
10/11/2001 5/16/2002 217 26.5%
12/23/2003 10/25/2004 307 3.1%
11/12/2004 10/27/2005 349 -3.6%
11/25/2005 7/3/2006 220 7.3%
4/25/2007 12/26/2007 245 0.1%
1/18/2011 7/29/2011 192 4.6%
3/15/2012 12/28/2012 288 3.3%
2/18/2015 8/17/2015 180 -0.2%
11/3/2015 11/4/2016 367 2.0%
Average 4.9%

Source: BMO Capital Markets Investment Strategy Group, FactSet, IBES.


3.  High Quality Represents a Diverse Strategy

Despite common perceptions, high quality is not necessarily associated with defensive strategies. In fact, our current quality screen actually represents a pretty cyclically diverse strategy, as shown in the sector composition pie chart below. While Health Care certainly makes up a sizeable portion of high quality currently, the traditional defensive areas of the market have fairly low exposure, with Telecom, Real Estate, and Utilities entirely absent from the screen.

Sep-2018-Belski-Sector-Composition-lg.jpg#asset:1538


Fundamental Backdrop Favours Quality 

Given the type of market environment we expect to unfold, we believe our quality strategy will outperform the broader market over the next 12–18 months. This is especially true given the solid fundamental backdrop of these stocks.

Quality Exhibits Attractive Fundamentals

Metric High-Quality S&P 500
ROE 21.2 14.9
Cash as % of Market Cap 9.4 5.0
EPS Growth Volatility 8.6 15.1
NTM EPS Growth 14.4 14.3

Source: BMO Capital Markets Investment Strategy Group, FactSet, IBES.


4.  Trade Idea: BMO MSCI USA High Quality Index ETF (ZUQ)

  • Since ZUQ’s inception, it has had strong tracking with our U.S. High-Quality Screen, which we used in the analysis (see NOTE below)
  • Focus on blue-chip companies with high Return on Equity (ROE), low leverage (Debt/Equity) and stable earnings growth
  • Rebalanced semi-annually to ensure continued adherence to the quality exposure
  • An attractive way to obtain exposure to equity growth in the U.S. market, while maintaining a measure of defensiveness relative to the broad market by focusing on companies with higher profitability and stronger balance sheets


For more information, please see our most recent publication, “Ease the Tension with Quality.”.


NOTE: The above analysis is not based on ZUQ, but on our BMO Capital Markets Investment Strategy Groups High- Quality Screen: B+ or higher S&P stock rank; BBB- or higher S&P LT debt rating; 5-year EPS growth volatility lower than S&P 500 median value; ROE higher than S&P 500 median value; and cash as a percentage of market cap higher than S&P 500 median value.