Tacticals

ETFs: Reap the Benefits of Diversification

This week’s article will be the first on the topic of ETF and mutual fund alternatives inside the Canadian equity universe. If you would like us to make a similar analysis , please send us an email. One of our clients requested us to compare the BMO Low Volatility Canadian Equity ETF (ZLB)  with the Horizons Inovestor Canadian Equity ETF (INOC) to decide which of the two to hold for his small accounts.

To compare both ETFs, the first step is start both time series in 2011, the inception date of ZLB. Since we do not have a historical track record with INOC, we will have to use the Nasdaq Inovestor Canadian Equity Index (NQICA) as a proxy. Furthermore, because the index does not consider management fees, we include 0.65% MER so the comparison can be made as accurately as possible. See our findings below:

 

NQICA is generating a higher alpha de 6.35%, 0.58% more than ZLB. Nevertheless, it is not surprising for ZLB to have a lower standard deviation of 6.5% vs 7.3% for NQICA considering that low volatility is the main factor driving this ETF. This creates a Sharpe ratio slightly higher than NQICA, in other words, it performs slightly better on a risk-adjusted basis. Moreover, its beta is only 0.41 vs. 0.66 for NQICA.

As for fundamental characteristics, ZLB’s median market cap is higher than INOC. These larger companies are more mature and exhibit persistent lower volatility. This is indirectly reflected in the dividend yield of 2.7%, 0.7% higher than that of NQICA. On the flip side, NQICA tends to pick stocks that are high quality and trading at a reasonable price. NQICA’s P/E is much lower at 14.1 vs 20.6 for ZLB and if there was a Return on Capital comparison (data is unavailable for ZLB), NQICA would be higher.

The sector allocations are different between both ETFs. It is not surprising to find an overweight in high-dividend defensive sectors (Utilities and Staples) for ZLB and an overweight to non-cyclicals (Discretionary and Industrials) for NQICA. However, both are significantly underweighting commodity related sectors such as Materials and Energy, making them very different from the S&P/TSX.

Based on our analysis, both financial products are very attractive given their unique characteristics: ZLB invests in low volatility while INOC invests in quality at reasonable price. Since factors tend to outperform at different times of the business cycle, it is worth combining both ETFs in a portfolio. By doing so, you improve the Sharpe ratio and benefit from additional diversification.