Low volatility ETFs aim to use betas to reduce portfolio volatility. We don’t think they are good for investors.

Recently, a member of my Inner Circle inquired about a low volatility ETF, aimed at decreasing overall portfolio volatility and exposure to market swings.

The BMO Low Volatility Canadian Equity ETF, symbol ZLB on Toronto, provides exposure to a portfolio of Canadian stocks with an overall low beta weighting (more on beta below).

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The ETF selects 40 or so (currently 48) of the lowest beta stocks from the 100 largest and most-liquid stocks in Canada. The stocks in the portfolio are rebalanced in June and reconstituted in December. That’s when any stocks are dropped and new ones added. The BMO Low Volatility Canadian Equity ETF has an MER of 0.39%. It currently yields 2.7%.

The fund’s current top holdings are Loblaw Cos., 4.0%; Metro Inc., 3.8%; Hydro One, 3.5%; Empire Company, 3.3%; Waste Connections, 3.2%; Thomson Reuters, 3.1%; Fortis Inc., 3.0%; Emera, 2.7%; Intact Financial, 2.7%; and TMX Group, 2.7%.

This ETF relies on beta scoring, a commonly used but sometimes misleading measure of volatility. To calculate a stock’s beta, an index like the S&P/TSX Composite or the S&P 500 is assigned a beta of 1.0. The historical volatility of different stocks relative to the index are then analyzed using their performance over the past 36 or 60 months.

If a stock has a beta of 1.0, that suggests the market and the stock move up or down together at the same rate. Specifically, a 10% up or down move in the stock market index should theoretically result in a 10% move in the same direction for the stock. A beta of 2.0 implies the stock tends to move twice as much as the market. That is, if the market moves up 10%, the stock should move up 20%. A beta of 0.5 indicates the stock will move one-half as much as the market.

A negative beta indicates the stock tends to move in the opposite direction from the general market. That is, the stock price declines when the overall market is rising, or it rises when the overall market is declining.

As a measure of risk, beta has a number of limitations. It is based on past data, so its use in predicting the future assumes that the underlying company being charted remains unchanged. For example, it assumes that no major acquisitions or divestitures, or other company-changing events have taken place. In reality, a stock’s beta can rise or fall over a period of years, or it can change abruptly.

Beta scoring can mislead you in other ways. Gold stocks have an average beta of 0.42 when you use the S&P 500 Index as their benchmark index. Such a low beta indicates that gold funds are relatively stable investments, like utilities. But, of course, they are not, and that’s because their performance and returns have relatively little to do with the performance and returns of the S&P 500 Index. They rise and fall with gold prices.

Institutional investors are always looking for so-called “quantitative” measures like beta that can be calculated automatically by a computer program. Beta makes a broad statement about a stock’s history of volatility, but it doesn’t say much, if anything, about prospects for that stock or its appeal as an investment.

To assess a company’s suitability for your portfolio, you are better off using other, more reliable measures of safety. Those include such safety measures as steady earnings, dividends and cash flow, low debt, and the outlook for the company’s specific markets.

Have you fallen into the beta trap? How did it turn out?