A Defensive ETF Portfolio for Low-Risk Canadian Investors

Not everyone is comfortable with high levels of risk in their investment portfolio, and that's perfectly okay. The truth is, if you're prone to panic selling during market downturns, chasing the highest possible returns with an aggressive asset allocation might do more harm than good to your financial health.

For those who prefer a more cautious approach, you're in the right place. In this article, I'll be exploring two crucial metrics that every risk-averse investor should monitor closely, along with my thoughts on how you should approach and manage risk.

Additionally, I'll provide a model portfolio specifically designed for those with a low tolerance for risk, using a selection of BMO ETFs. This portfolio is tailored to offer stability and peace of mind, ensuring you can invest confidently without losing sleep over market fluctuations.

What is risk anyways?

Risk, in the context of investing, essentially revolves around two key aspects: uncertainty and the potential for unrealized losses.

Uncertainty in the investment world is often synonymous with volatility. Volatility refers to the fluctuations up and down in the value of your portfolio and is primarily measured by standard deviation.

For instance, a portfolio with a standard deviation of 30% per year is considered much riskier than one with a standard deviation of 10%. This is because the former suggests that, on average, the value of the portfolio can swing more dramatically over a given period, which indicates a higher level of uncertainty.

However, risk isn't just about volatility; it's also about the extent and duration of potential losses, which we refer to as drawdowns. The critical metric here is the maximum drawdown, which measures the largest peak-to-trough decline in the value of the portfolio during a specific period.

For example, a maximum drawdown of 50% that lasts 365 days implies a much more severe and prolonged period of loss compared to a drawdown of 14% that lasts 34 days.

It's important to note that both of these metrics—standard deviation and maximum drawdown—are retrospective. They provide historical data, which means future conditions could differ.

Nevertheless, understanding these metrics helps you gauge the worst-case scenarios that a portfolio has historically endured and determine whether you'd be comfortable facing similar situations.

Reducing risk: equities

All stocks carry market risk, which essentially refers to the risk that the entire market will decline, affecting virtually every stock regardless of individual company fundamentals.

For instance, even Berkshire Hathaway, a robust and fundamentally sound company led by Warren Buffett, experienced significant losses during the COVID-19 market downturn, underscoring that no stock is immune to market-wide pullbacks.

One straightforward way to reduce market risk is by selecting stocks with a lower beta. Beta is a measure of a stock's volatility relative to the overall market. It ranges from -1 to 1, where 1 means the stock’s price moves with the market, 0 indicates no correlation, and -1 suggests it moves inversely to the market.

Stocks with a beta lower than 1 are less volatile than the market, and those with a beta under 0.5 are particularly desirable for risk-averse investors because they still tend to move in the same direction as the market but in a more muted fashion.

You might assume that these lower-beta stocks would offer lesser returns due to their reduced volatility, but interestingly, the opposite is often true. This is known as the low volatility anomaly, where stocks with lower volatility have historically outperformed their higher-volatility counterparts.

For those looking to construct a low-risk portfolio, accessing these low-beta stocks can be efficiently achieved through ETFs. Two notable examples are the BMO Low Volatility US Equity ETF (ZLU) and the BMO Low Volatility Canadian Equity ETF (ZLB).

These ETFs have management expense ratios (MERs) of 0.33% and 0.39% respectively, and they specifically select low-beta stocks. Furthermore, both ETFs tend to have higher weightings in defensive sectors like utilities, consumer staples, and healthcare, which are often less sensitive to market fluctuations.

Reducing risk: bonds

As fixed income securities, bonds don't carry market risk but derive their returns from other sources of risk, primarily credit and interest rate risk.

First, let's discuss credit risk. This is fairly intuitive: the lower the credit rating of a bond, the higher the yield it needs to offer to compensate the investor for the increased risk.

This is why government bonds like Treasuries, which are considered the safest, typically offer the lowest yields, while junk bonds, which carry a higher risk of default, offer the highest yields. Investment-grade corporate bonds, which are rated between BBB and AA, sit somewhere in the middle in terms of risk and yield.

The second major risk factor is how fluctuations in interest rates affect a bond's price, governed by the bond's duration—a measure of interest rate sensitivity.

For example, a bond with a duration of six years would, all else being equal, lose approximately 6% of its value if interest rates were to rise by 1%. Therefore, bond prices move inversely to interest rates.

For low-risk investors seeking safety in bonds, the best approach is to opt for high credit quality coupled with low duration. This strategy may offer lower return potential, but it minimizes the impact of credit events and interest rate changes.

A suitable ETF for this strategy is the BMO Ultra Short-Term Bond ETF (ZST). With a low MER of 0.17%, this ETF holds mostly A and BBB rated investment-grade corporate bonds, with a very short average duration of just 0.33 years.

Currently, it offers a 4.91% annualized yield with monthly distributions, making it an attractive option for conservative investors looking for steady income with minimal risk exposure.

Putting it together in a portfolio

For conservative, low-risk investors looking for a defensive portfolio setup, here's a simple allocation: 40% in the BMO Low Volatility US Equity ETF (ZLU), 20% in the BMO Low Volatility Canadian Equity ETF (ZLB), and 40% in the BMO Ultra Short-Term Bond ETF (ZST).

Comparing this configuration to a traditional 60/40 portfolio, represented by the Vanguard Balanced ETF Portfolio (VBAL), from February 1, 2018, to July 26, 2024, reveals some compelling advantages.

The combination of ZLU, ZLB, and ZST achieved a higher total return of 7.22% compared to VBAL's 6.15%. Additionally, it experienced a lower maximum drawdown, recording -18.46% versus VBAL's -21.19%, which suggests a reduced loss potential during market downturns. The standard deviation, a measure of volatility, was also lower at 7.94 compared to 10.23 for VBAL.

Furthermore, the overall risk-adjusted return, as measured by the Sharpe ratio, was significantly better at 0.60 compared to 0.37 for the traditional 60/40 portfolio. This suggests that the tailored combination of ZLU, ZLB, and ZST not only provided better returns but did so with less risk.