Skip to content

Offset RIM with a Low Volatility Portfolio.


Readers of this Blog will recall an introduction to Low Volatility Portfolio’s (LVP’s).  At that time, the LVP was a strictly Institutional offering. The whisper today, however, is that an LVP will be available to the Individual Investor marketplace by the end of 2011. This is good news.

At the risk of oversimplifying, LVP’s focus on risk mitigation … without the usual return hit. LVPs take advantage of a well documented anomaly in finance literature that says, in theory, higher risk(s) should be rewarded with higher return(s). In practice, this is NOT the case with high volatility stocks. So, basically, an LVP reduces (or removes) the impact of the most volatile stocks … but returns don’t suffer from dialing down the risk as more stable portfolios compound faster.

RIM provides investors with a good example.

Since mid-2008, RIM has dropped from ~ $140 to under $30 with lots of ups and (mostly) downs in between. Because RIM was at one time 3% – 4% of the Canadian stock market (the TSX) but is now only 0.86% of the index, investors have had a difficult time avoiding the negative impact RIM has had on their portfolio … unless they didn’t own it. That’s where LVP’s come in.

RIM is a good example of a bigger problem. The Canadian stock market is simply too concentrated.

The largest 10 stocks make up 34% of all stock market capitalization in the entire Canadian stock market (and the largest 20 stocks make up 50%). The largest 10 stocks comprise 45% of the largest 60 stocks.

What about sector concentration? Financials 30%. Energy 26%. Materials 21%. Everything else 27%.

And individual Company concentration? Royal Bank alone is 5.3% of the Canadian stock market. Only a handful of stocks make up each sector and all stocks within a sector are so highly correlated that the differentiation is marginal at best. (Royal Bank and Bank of Montreal were at one time correlated at over 94%. If one moved by $1, the other moved by $0.94. So what’s the difference?). There is nowhere to hide.

By comparison, the U.S. market, as represented by the S&P 500, the largest 10 stocks are only 18% of the U.S. stock market capitalization … and there are, well, 500 of them (versus 60 at most in Canada).

From a sector view, the U.S. stock market is spread more evenly. Financials 15%. Energy 13%. Materials 4%. Everything else 68%. The largest U.S. sector is IT (Information Technology) at 17% and the largest stock, is Exxon at 3.4%.

  Canadian stock market U.S. stock market
Largest 10 stocks

34%

19%

Largest 20 stocks

50%

30%

Financials

30%

15%

Energy

26%

13%

Materials

21%

4%

Everything else

27%

68%

Largest stock

5.4%

3.4%

Canada has always been concentrated in three sectors (Financials, Energy and Materials). Over the years the leadership among these three sectors has changed as has the component makeup. (For example, materials were ~40% of the Canadian markets in the late 1960’s. Golds now form roughly ½ the Materials weight).

From any view the Canadian stock market is too concentrated.

Commerce Grads will recall the Herfindahl index (an anti-trust measure of industry concentration). The Canadian stock market is so concentrated today that for the first time since the late 1960’s the Herfindahl index indicates unhealthy concentration. (Except for one brief spike up in 2000 … when Nortel was a ridiculous 1/3rd of the entire Canadian market).

Since 2000, Canadian Energy, Materials and Financials have delivered out-sized returns – returns well above longer-term averages. That’s not a problem. The problem occurs when these sectors and stocks migrate back to more average results (regression to the mean). Because there are only a handful of highly correlated stocks within each sector, they bring the entire sector (or the entire market) down with them.

Like RIM …

Investors can use LVP to offset some of the Canadian concentration inherent in traditional, market cap weighted indexes. For investors, both individual and institutional, who are risk averse (who hate down volatility) but don’t want to take a performance hit, LVP’s are a natural fit. But investors should be aware that LVP’s will not look like the TSX. They will not have the same risk characteristics and therefore will deliver different return patterns. LVP’s will be very different from any mutual fund, index fund or ETF that the individual investor has invested in to date. And that’s good because LVPs will provide much-needed and long overdue offset to those more ‘traditional’ product offerings.

See March 12, 2011 Blog post for some of the benefits of LVP’s and stay tuned here as this blog will update product availability if and when.

In the meantime, check out the relative performance of the MSCI World minimum volatility index versus the MSCI World index and the MSCI North American minimum volatility index versus the MSCI Canada and U.S. indexes (in local $’s).

Next time?
Risk management.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
Advertisements
2 Comments Post a comment
  1. As far as I am aware, the current providers of Institutional LVP product include: TD, BMO, Hillsdale, CCL Group and Analytic Investors. (Plus one Euro provider).
    If the retail offering comes from BMO, it will likely be an ETF and likely reasonably priced.
    If it comes from TD, it will likely be added to their e-index product suite … and about the same pricing … 0.75% – 1%???
    Regardless, i think the move to offset the flaws of market cap weighted indexes are good ones.
    Stay tuned.

    Like

    June 24, 2011
  2. diversifyme #

    Will be interesting to see how a LVP product compares to a fundamental index product in terms of management fees, etc. Different strategies, but common insofar as they try to take advantage of possible drawbacks to market cap weighted indices.

    Thanks, Doug. Educational read as always.

    Like

    June 23, 2011

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: