ETF recommended list review

Fiscal cliff could result in more volatility. No major changes to recommended list.

Historically, it has been the autumn months which have been the most volatile for investors, with September and October having the reputations of being particularly harsh. Fortunately this year, most of the volatility that was expected failed to materialize, resulting in a decent quarter for the global markets. Much of this relative stability can be attributed to the various easing measures announced by global central banks, most notably the European Central Bank and the U.S. Federal Reserve. Both announced massive easing programs, restoring investor confidence and increasing their appetite for risk.

In Europe, investors rejoiced, pushing markets higher as expectations grew that announced bond buying program will dramatically cut the likelihood of an escalation of the European sovereign debt crisis. While this program effectively buys time for policy makers to craft a workable solution, it does very little to actually solve it.

Closer to home, the U.S. Fed’s program, dubbed QE3 by market participants, was launched with the intention of helping to stimulate the housing market, create jobs and keep long term interest rates low. Under the plan, the Fed will buy up to $40 billion of mortgage back bonds each month until the outlook for the jobs market improves substantially.

There is little doubt that these actions are largely positive, yet we remain cautious. With Obama winning a second term and very little change in the balance of power in the senate or congress, the debate on the U.S. fiscal cliff may escalate into a very tense time. The fiscal cliff is the expiration of a number of Bush Era tax cuts and automatic spending increases which many economists predict could cut U.S. GDP by as much as 5%, throwing the fragile recovery back into recession.

While both sides have shown early signs of willingness to compromise, much work remains before an agreement can be reached and we can all breathe a collective sigh of relief. While we believe that a deal will be reached, until it occurs, the potential for market volatility remains high.

Looking ahead, it is our expectation that interest rates will remain very low for at least the next few quarters. Under this scenario we do not expect a large selloff in bonds. Instead, we expect that returns will be flat to modestly positive with corporate bonds outperforming governments because of their higher yields. We are not suggesting that one sell their government bond holdings, only that they shouldn’t overweight them. Government bonds still have great safe haven appeal should an unforeseen crisis emerge.

We continue to favour equities over fixed income. There are many high quality equities available that are priced at a significantly more attractive level of valuation than bonds. Considering this, we like many of the higher quality, large cap focused funds that invest in companies offering attractive dividend yields. Again, we are not suggesting that bond positions be sold, but rather the fixed income allocation should be in line with your long term investment objectives. We firmly believe that investors should begin to think of fixed income as a way to dampen volatility in their portfolios, rather than a significant driver of return going forward.

While we like the dividend story in Canada, we are less enthused about it south of the border. Our reasoning for this is that many experts expect that the tax rate on dividends will be increased from the current 15% to something closer to 40%. Should this happen, it is likely that we may see a selloff of higher yielding dividend stocks as investors pour into more growth focused names. If this does indeed occur, any selloff may create a compelling buying opportunity for longer term investors in higher yielding U.S. names. Regardless, we remain cautious in the short term.

We are also becoming more positive on gold in the short term due to the quantitative easing measures that have been introduced of late. While the economic system has been flush with liquidity for some time, the recently introduced programs are effectively unlimited in scope, which may help to further fuel the inflation flames once the economic recoveries begin to gain a foothold. Historically, gold has been a great hedge against inflation. We would expect that to be the case again this time around.

Upgrades and New Additions

iShares S&P/TSX Canadian Dividend Aristocrats (CDZ) – Much of the market momentum in the past few months has been focused in the more cyclical names which are expected to benefit from the central bank easing announcements. While the cyclicals rallied sharply higher, many of the stocks which have a history of paying and growing their dividends also rallied, but at a much more modest pace. In addition many of these high yielding stocks have been sold off in the weeks since the U.S. election, making them more attractive from a valuation standpoint. Considering these factors, we believe that now may be a good time to add some exposure to high quality, Canadian dividend stocks, and this ETF, with its emphasis on companies that have a demonstrated history of increasing their dividends year in and year out, is a great place to start. It pays a monthly distribution of $0.06, which works out to an annualized yield of around 3.2%. According to information provided by Morningstar, the underlying portfolio has a dividend yield of 4.25%, which indicates that this level of distribution is likely sustainable going forward. We also like the 0.67% MER. As a result, we are upgrading CDZ from a HOLD to a BUY.

iShares S&P/TSX Capped Composite Index (XIC) – For investors looking to add to their Canadian equity holdings, this ETF is a great way to do just that. It invests, to the extent possible, in the stocks that make up the S&P/TSX Capped Composite Index. It has an MER of 0.27%. While the BMO ZCN provides the same investment exposure at a lower cost, we still prefer this one given the longer term track record, which has outpaced its lower priced rival. Much of this outperformance is because until August of this year, the ZCN tracked the Dow Jones Canada Titans 60 Index. We are continuing to monitor the BMO ETF and if we continue to see relative outperformance as a result of its lower cost, we may consider switching to ZCN for our Canadian equity exposure. In the interim, we are upgrading XIC from a HOLD to a BUY.

iShares Gold Bullion Fund ETF (CGL) – With central banks announcing further quantitative easing measures in the fall, many investors are becoming quite worried about the potential inflationary impact of these programs. Gold has historically been an excellent hedge against inflation, and should inflation reemerge as some expect, we expect it to be this time around as well. This ETF is one of the best, most cost effective ways to access gold bullion in your portfolio. It invests primarily in physical gold bullion, but can also invest in gold certificates. On September 30, it held 349,383 ounces of gold bullion held in the vaults of ScotiaMocatta. The MER is very reasonable, coming in at 0.55%. It is available in both a currency hedged and non currency hedged version. At the moment, our preference is for the hedged version, as it eliminates the potential affect of any currency movements. However, if you believe that the U.S. dollar is poised for a rally, then the non hedged version is the better choice. We are initiating coverage of CGL with a BUY rating.

Downgrades and Deletions

iShares 1-5 Year Laddered Government Bond (CLF) – For very conservative investors looking for short term bond exposure, this is a good choice. With its focus on government bonds, it will hold up very well in very volatile times as investors tend to flock to government bonds for their safe haven appeal. However, given that we don’t expect significant volatility at the moment, we believe that investors will be better off going with the corporate focused iShares 1-5 Year Laddered Corporate Bond (CBO) which will provide a higher yield with a comparable duration. In a flat or rising rate environment, we believe it will do better. Because of this, we are downgrading CLF from a BUY to a HOLD.

iShares DEX Universe Bond Index (XBB) – In the current environment, it is our opinion that investors are better off focusing on investment grade corporate bonds over government bonds because of the additional yield that corporates generate. In a flat interest rate environment, this higher yield will provide better return potential, and should result in better downside protection when rates do move higher. XBB is a great, low cost way to provide access to a wide range of bonds in Canada. However, it is very heavily weighted towards government bonds, which make up slightly more than 70% of the total portfolio. Because of this emphasis on government bonds, we are downgrading XBB from a BUY to a HOLD for the moment.

iShares Global Monthly Advantaged Dividend (CYH) – With ongoing negotiations to avoid the impending “fiscal cliff” of tax increases and spending cuts that are scheduled to be implemented in the new year, most experts seem to agree that it is very likely that the tax rate on dividends in the U.S. will rise sharply. If no deal is reached it is expected that the tax on dividends will nearly triple, rising from 15% to 43.4% for those in the highest bracket. Should this occur, it is likely that many investors will sell their dividend stocks in favour of more growth oriented stocks with lower dividend payouts. Because of this, we have some concerns with CYH since more than 40% of the fund is exposed to U.S. dividend stocks. We worry that it may experience a short term selloff while investors digest any changes to the dividend tax policy in the U.S. Considering this, we are changing the rating of CYH from HOLD to SELL for the near term while the uncertainty is remedied.

BMO Equal Weight REITs Index ETF (ZRE) – Generally, we like the longer term outlook for REITs. We believe that the fundamentals are fairly strong over the longer term and investors never ending quest for income will continue to underpin demand for them. This pays a monthly distribution of $0.083, which works out to an annualized yield of approximately 4.8%. The yield of the underlying REITs in the portfolio is estimated to be approximately 5.25%. From a valuation standpoint, REITs appear to be trading at or near what has historically been considered to be fair value. As a result, we are lowering the rating from BUY to HOLD for the near term. Should we experience a pullback in the short term, we would consider upgrading it back to a BUY rating.