During big market downturns, different types of investments can often start to move in similar directions—typically downward—regardless of their expected behaviour. Practically speaking, this means that low-volatility ETFs, while generally effective, might not always protect a portfolio from losses when the entire market drops sharply.
Remember the COVID-19 market crash in February and March 2020? The max drawdown—meaning the largest drop from peak to trough during a specific period—of ZLB was nearly as significant as that of XIU. So even ETFs that are normally considered less volatile can still experience large declines in value during widespread market downturns.
The concept of a “free lunch” in risk management refers to the ability to reduce risk without significantly impacting returns. It was American economist Harry Markowitz who said: “Diversification is known as the only free lunch in investing.” So, ideally, if you could decrease risk by one unit, you would want your returns to be reduced by less than half a unit or not at all.
However, achieving this balance depends heavily on maintaining low correlations between assets—where one asset zigs while another zags. Unfortunately, this balance is fleeting because during severe market downturns, correlations between different types of investments often converge toward a beta of 1.0, meaning they can all lose value simultaneously.
Additionally, the few assets that do pay off reliably when markets tank, like put options and long volatility derivatives, aren’t suitable for long-term holders as the maintenance costs can exceed the payoffs in most scenarios.
Many fancy hedge-fund-like alternative ETFs promise to offer this balance, but they often come with high fees and survivorship bias. Survivorship bias is the tendency to consider only successful examples in an analysis while ignoring those that failed—a key thing to watch out for when screening funds.
For most Canadian ETF investors, a pragmatic investing approach involves “diversifying your diversifiers.” That means incorporating a variety of asset types that each respond differently under various market conditions, with each offsetting the weakness of another. Your team of assets together create the ultimate Fantasy sports team.
For example, if your portfolio contains global equities, adding high-quality bonds can provide a buffer during economic recessions, as bonds typically perform better when stocks falter. To further safeguard against inflation and rising interest rates when bonds might underperform (like in 2022), some might add commodities to their mix. Finally, holding some cash equivalents provides liquidity and stability if all else fails.
