This rules based ETF is built using a process that rates and ranks the Canadian universe of stocks on key fundamental factors including sales, cash flow, book value, and dividends. The stocks are each ranked by the four fundamental measures, which results in a total score for each company. They are then ranked by their scores from best to worst, and the top 100 or so make up the ETF. Stock weights are determined by the fundamental score, with the better ranked stocks making up a higher weight in the ETF. There are no constraints on sector weights, which is where I begin to get a little worried about this particular ETF. It has a very high level concentration in the financials and energy sectors, which combined make up nearly 65% of the portfolio. I can be comfortable with this in a specialized mandate, it concerns with a more broadly focused ETF.
The counterargument is these are the sectors that are currently exhibiting the favourable valuation criteria, so over the long run, it should not be an issue. I am on board with that from a theoretical standpoint, but as we saw through most of 2015, with energy selling off dramatically, this ETF struggled, falling nearly 10% over the year. Year to date, with some stability returning to the energy markets, it has rebounded, recovering substantially all of the drop of 2015. So far in 2016, it has risen by nearly 13%, and for the three months ending April 30, it gained nearly 15%. Even with this rise, valuation levels remain rather attractive when compared to its peers. Looking at the forecasted growth numbers, they are strong, making this a reasonably compelling ETF from a pure numbers perspective.
I believe this ETF should do as well as a traditional cap weighted index over the long term. However, the level of concentration remains a concern, and has the potential to result in periods of higher than average volatility. I expect that volatility levels will remain higher than normal for the near term. I continue to monitor the ETF for increasing concentration and any further erosion in the risk reward metrics.