Quality and Low Volatility: Calm in the eye of the storm

Chris Heakes

CFA, M.Fin., Vice President, Portfolio Manager, Global Structured Investments, BMO Asset Management Inc.


When all the signs point to uncertainty in U.S. markets, using factor-based strategies can be a welcome saving grace for your clients. To this end, seasoned ETF Specialist and Portfolio Manager, Chris Heakes, explores Quality and Low Volatility as core holdings that provide strong returns during the highs and the lows.

As we approach the third quarter, a number of macro issues are hanging over the U.S. economic outlook: a contentious presidential election, a lackluster response to the pandemic, and an economy frayed by shutdowns and flawed re-openings. With the future so cloudy, how should you prepare your clients for any – and all – market scenarios?  

As a starting point, ensure the portfolio is on stable footing. While it’s obviously important to select the right satellite positions for the current economic environment, your clients’ core holdings ultimately dictate success over the long term. This article is focused on two factors, Quality and Low Volatility, which provide a solid base across the full market cycle. 

The two complement each other quite successfully. Quality captures strong, sustainable gains on an ongoing basis, whereas Low-Vol fortifies the portfolio by offering a sort of “equity insurance,” meaning that it protects your clients’ investments on the downside. Together this pairing makes for smart beta and even smarter returns.

Quality: not an act, truly a habit

While only identified in recent years, Quality has been around for decades. It’s well known that Warren Buffett, perhaps the most successful and sought-after investor of our lifetimes, selects only Quality companies for his investment portfolio. But what defines quality? For us, it starts with profitability; we look for companies with stable earnings, strong balance sheets and a history of being more successful than their peers.

As a pioneer in the space, our definition has undergone rigorous vetting, and have partnered with MSCI, the leading provider of smart-beta indexes globally, to implement the exposure. The approach is systematic and rules-based, removing emotion from the decision-making process, to focus on performance measures. We look at a company’s profit margin, debt-to-equity ratio and competitive positioning within the industry. Lower leverage is key – this factor avoids companies that take on debt to fulfill their business models.

Using these metrics, we assign an equally-weighted composite score to each holding. In the BMO MSCI USA High Quality Index ETF (Ticker: ZUQ), we identify the top 125 of 500 companies in the MSCI USA Quality universe, seeking to only hold the top 25% of companies. (As part of the strategy, the holdings are also rebalanced twice a year.)

ZUQ proves quality outperforms in both bull and bear markets

Source: Bloomberg.

Why does this factor make sense in the current environment? It really comes down to the fact that Quality works for the bulls and the bears. The exposure is tilted away from the broad market, historically earning a higher return while also maintaining lower downside capture.

Of course, past performance does not guarantee for future results. However, Quality strategies do boast a strong track record, and we know from experience that stocks that are winning tend to stay winners. The only scenario where Quality tends to underperform is when markets are rallying indiscriminately, pulling up even junk assets, based on blanket positive sentiment. We are no longer in that world – today’s environment is headlined by a cautiously optimistic recovery, in which this factor works well.

Leveraging the Low-Vol advantage

As a complement to Quality, the BMO Low Volatility US Equity ETF (Ticker: ZLU) provides a more conservative exposure to U.S. equities. The overriding strategy is to target stocks with a beta of less than one, knowing they are typically undervalued by investors. Case in point: if you choose securities that have a 0.5 beta, logic would dictate that your expected returns should be half of the market. However, empirical studies have shown this is not true – and, in fact, picking lower risk stocks leads to better risk-adjusted performance in the long run.

That said, the benefits of Low-Vol can be difficult to discern in the short term. Although the downside protection was effective in early March (when many economies experienced shutdowns due to the coronavirus pandemic), the subsequent rally was concentrated in high-growth companies that were not included in the index. For instance, our Low-Vol strategy carries zero percentage weight in the technology sector, which constitutes the largest proportion in the S&P 500 and has been the single biggest driving factor in its current rally.

Despite the recent lackluster performance, investors should remember two important facts: First, while Low-Vol may not shine in each individual period, across market cycles it tends to deliver strong risk-adjusted returns. And second, the 10-year bull market is still underway – excluding March – and the real returns for low beta assets will likely be seen on the other side of a correction.

ZLU offers downside protection

Source: Bloomberg.

The ideal mix in the long term

While every client has unique preferences and goals, Quality and Low-Vol work as an ideal foundation for virtually any portfolio. Of course, the split does not have to be 50-50; you can overweight ZUQ for more growth-oriented investors, or lean into ZLU to reduce overall portfolio risk. Regardless, you should make it a point to look under the hood of your ETFs to confirm the track record, investing approach and risk profile align with your values.

Once the base is set, you can start to customize with satellite positions according to your clients’ preferences. We’re currently looking at factors that have underperformed in recent months, such as dividends and financials, which could provide some cyclical upside exposure in areas that are not covered as prominently by Quality and Low-Vol.

A dividends-focused trade can provide attractive yields at the moment, as well as the promise of upside gains when Value plays (which they are correlated to) rebound. Similarly, in the financials space, U.S. banks have been lacklustre but will likely join the ride eventually. Finally, geographic diversification is another way to build on the core duo of U.S. Quality and Low-Vol. One trend that warrants consideration is the performance of Europe Quality exposure. The region has seen its fair share of struggles, yet as it continues to grapple with the pandemic, our ETF has done much better than the rest of the European market. 

By any measure, factor investing offers an innovative and effective way to navigate our current 2.0 version of the market. That said, investors are well-served to use complimentary pairings that allow you to balance risk and return. No matter the investing style du jour, you don’t want to be tied to any single consideration, and your clients certainly won’t want all their eggs in one basket.


BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms.

®/™Registered trade-marks/trade-mark of Bank of Montreal, used under license.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.


Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus before investing. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the prospectus.  BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

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