Two Ways to Reduce Risk in Your Investment Portfolio with ETFs

During major market downturns, different types of investments can often begin to move in the same direction – usually down – regardless of their expected behavior. In practice, this means that low volatility ETFs, while generally effective, may not always protect a portfolio from losses when the entire market takes a sharp downturn.

Remember the COVID-19 market crash in February and March 2020? The maximum drawdown—that is, the largest drop from peak to trough during a given period—for ZLB was almost as large as for XIU. Thus, even ETFs that are generally considered less volatile can still experience significant declines in value during broad-based market downturns.

The concept of a “free lunch” in risk management refers to the ability to reduce risk without significantly impacting profits. American economist Harry Markowitz said: “Diversification is known as the only free lunch in investing.” So, ideally, if you could reduce your risk by one unit, you would want your profit to decrease by less than half a unit or not at all.

However, achieving this balance largely depends on maintaining a low correlation between assets, with one asset fluctuating and another fluctuating. Unfortunately, this balance is fleeting because during severe market downturns, the correlation between different types of investments often approaches a beta of 1.0, meaning they can all lose value at the same time.

Additionally, the few assets that actually perform well when markets fall e.g. put options and long volatility derivatives are not suitable for long-term holders as servicing costs can exceed payouts in most scenarios.

Many fancy hedge fund-like alternative ETFs promise to offer this balance, but they often come with high fees and survival bias. Survivorship bias is the tendency to consider only successful examples in an analysis while ignoring unsuccessful ones—a key point to consider when testing means.

For most Canadian ETF Investorsa pragmatic approach to investing involves “diversifying your diversifiers.” This means including different types of assets, each reacting differently to different market conditions, with each compensating for the weakness of the other. Your team of assets work together to create the perfect fantasy sports team.

For example, if your portfolio contains global stocks, adding high-quality bonds can provide a buffer during an economic downturn, since bonds tend to perform better when stocks fall. To further protect against inflation and rising interest rates when bonds may underperform (like in 2022), some may add commodities to their portfolio. Finally, having some cash equivalents provides liquidity and stability when all else fails.