Welcome to our inaugural edition of our ETF Focus List. The goal of this list, like our Recommended List of Funds, is to help you narrow your focus on what we believe to be the best ETFs available in a wide range of asset classes.
This first edition is focused solely on Canadian traded ETFs, but over time will grow to include ETFs that also trade in the U.S.
You can download your copy of this report here.
A brief commentary and some highlighted ETFs follows:
It was another solid quarter for the ETFs on our Recommended List, with all finishing in positive territory for the three months ending April 30. Canadian equities were the strongest performers, thanks largely to a nice gain in energy, materials and financials, the sectors that dominate the S&P/TSX Composite Index. Global equity funds weren’t too far behind, with each of our picks posting respectable gains.
These gains have helped to push valuations higher than they were last time around, and there is some concern that we may be somewhat overvalued in the equity space, particularly in Canada and the U.S. According to Morningstar, the S&P 500 is trading at more than 18 times earnings, while the S&P/TSX is up around 17.5 times earnings, which are above historical averages. In comparison, the MSCI EAFE Index is shown to be trading at 15.5 times earnings, which is much more attractive.
While the EAFE may look attractive based on a valuation perspective, the pace of corporate earnings growth has been very disappointing and there isn’t much on the horizon to suggest things will change. Recently however, there has been widespread talk that the European Central Bank will step up and take aggressive action to spur the region’s moribund economy. If this plays out as expected, it could be a big boost for global equities in general.
While the valuation levels are a concern with equities, they are frightening with bonds. Yields have continued to fall, with the ten year U.S. Treasury bond closing at 2.45% on May 30, down from 2.63% at the end of April. It is a similar story in Canada, where the ten year closed May at 2.25%, down from 2.40% at the end of April. Further fueling valuation worries is the fact that yield spreads between high yield and government bonds have been on the decline. The spread measures the difference in yields between bonds and comparable term government bonds. The lower the spread, the less additional yield one earns for taking on additional risk. Or put another way, the lower the spread, the higher the price on riskier bonds. Recent spreads are at the lowest levels we have seen since before the recession.
With such narrow spreads combined with low bond yields, there could be trouble for a lot of bond investors. It would be particularly troublesome if yields rise and spreads widen, creating a big downdraft for corporate and high yield bonds. While I don’t expect to see any meaningful increase in yields in the next few months, I still see more risks to the downside than to the upside for fixed income investments.
Considering the above, I continue to favour equities over fixed income. Within the fixed income I remain underweight in government and investment grade corporate bonds, and overweight in global bonds. I was overweight in high yield, however, with the recent drop in spreads, I have moved to a more neutral weight.
Within equities, I have pulled back my allocation to U.S. equities from overweight to neutral on valuation concerns. In this environment, I would suggest taking some profits out of your U.S. exposure. I have increased international equities from Underweight to Neutral. This is based on two factors. First is the level of valuation on a relative basis is more favourable than either Canadian or U.S. equities. Second, the potential of aggressive action from the ECB could provide a nice boost for international equities in the near to medium term.
ETFs to Buy
PowerShares FTSE RAFI Canadian Fundamental (TSX: PXC) – There are some differences with this ETF, and the iShares S&P/TSX Capped Composite Index ETF (TSX: XIC). Perhaps the biggest would be how the ETFs are constructed. XIC is based on a “cap weighted” index, which is more or less the largest companies that trade on the Toronto Stock Exchange. PXC is constructed using a fundamental approach, where stocks are rated and ranked based on a number of factors, such as earnings, sales, cash flow, and dividends, with the top 90 or so companies making up the index. The result is a portfolio that is more fundamentally sound than a portfolio simply built using market capitalization. This, combined with the more favourable valuation metrics lead me to recommend this ETF over XIC at the moment.
iShares MSCI EAFE Index (C$ Hedged) (TSX: XIN) – While the levels of economic growth coming out of Europe and Asia have certainly left a lot to be desired, there are rumblings that the European Central Bank is considering taking action to get the economy rolling. It is expected that they will announce a quantitative easing program, similar to what many other central banks around the world have done. If this happens, I expect that it will be a positive for Eurozone stocks, pushing this ETF higher. Another reason I’m starting to like this ETF is that on a relative value basis, it appears more reasonably valued than most of the North American focused ETFs. I am not suggesting that you sell your North American holdings, but rather, I believe it may be a good time to start taking or adding to your international equity position, and this appears to be a great way to do that.
iShares US Fundamental Index C$ Hedged (TSX: CLU) – Despite having a higher cost and a slightly higher level of volatility, I am currently favouring this fundamentally constructed offering over the cheaper, cap-weighted iShares S&P 500 Index C$ Hedged ETF (TSX: XSP). My main reason for this is that from a valuation standpoint, it appears to be more favourably valued than the XSP. The portfolio is also better diversified, holding roughly twice the names, with a much broader range of company sizes. I believe that it is somewhat better positioned to outperform in the next few months.
ETFs to Sell
None
Funds of Note
PowerShares Senior Loan CAD Hedged ETF (TSX: BKL) – This provides exposure to the 100 largest loan facilities in the U.S. It includes such companies as Heinz, Hilton, and Valeant Pharmaceuticals. These loans pay a coupon rate that floats with an underlying benchmark rate such as LIBOR. These types of investments have gained a lot of favour with investors of late, and that has pushed valuations up. Looking at the portfolio, the yield to maturity is listed at 4.18%, which is a good starting point for estimating the expected return of the ETF. If we then back out the 0.80% management fee, we are left with an expected return for the next 12 months of approximately 3.2%. It’s not great, but if rates do move higher, so too will the coupon payments, basically eliminating the interest rate risk that is embedded in more traditional bond investments. Given the medium term rate outlook, it is not surprising that investors have taken notice of this asset class. I wouldn’t use this as a core holding, but as a part of your fixed income portion of your portfolio, it can be helpful in managing risk.
iShares Advantaged U.S. High Yield Bond ETF (TSX: CHB) – High yield bonds have been on a tear of late, pushing valuations to post recession highs, and are now firmly in the overvalued camp. To understand the valuation, you need to take a look at the yield spread, which is the difference between the yield offered by a particular bond and a comparable government bond. The smaller the spread, generally the more expensive a bond is. Recently, spreads on high yield bonds have shrunk to around 350 basis points, which is the lowest level in more than four years, and well below historic averages, which according to Barron’s is just under 500 basis points. At these levels, I see more risk to the downside than to the upside, and you should think strongly about taking some profits in your high yield exposure.
That said, I like this ETF for investors in taxable accounts because it offers tax advantaged distributions, thanks to a legacy forward agreement that expires in January 2015. Because of this forward agreement, distributions are treated as capital gains, which are taxed at a more favourable rate than interest income. For those investors in non-taxable accounts like an RRSP or TFSA, I would suggest you take a look at the iShares U.S. High Yield Bond CAD Hedged ETF (TSXL XHY). It offers a very similar credit exposure, duration and yield, but it is cheaper and performance on a pre-tax basis has been stronger. I am watching this one very closely and will likely sub it in for CHB in the latter half of the year.
iShares Diversified Monthly Income Fund ETF (TSX: XTR) – With the objective of generating consistent monthly distributions, with the potential for modest capital gains, this ETF invests in a portfolio of other iShares offered ETFs. With the emphasis on cash flow, about half the fund is invested in fixed income focused ETFs, more than a third in equity ETFs, and the balance in the iShares S&P/TSX Canadian Preferred ETF. Performance has been strong, handily outpacing many fixed income balanced mutual funds. The five year annualized gain to the end of April was 14.80%, more than double the Fundata Fixed Income Balanced benchmark. Volatility however, has been much higher than both the benchmark and peer group. As impressive as the performance has been, it is highly unlikely that it can be repeated, given the interest rate sensitivity of the portfolio and the likelihood that we’ll see yields grind higher over the next several quarters. Despite that, this can still be a great core holding for those investors looking to generate a reasonable level of cash flow. It offers a current distribution yield of 5.86%, which is also about what I would expect it to return going forward.
iShares Gold Bullion Fund ETF (TSX: CGL) – Gold had a nice little run at the start of the year, but seems to have peaked in March. There was a nice flight to safety trade in April coming out of the Ukrainian conflict, but with much of that tensions moving towards the backburner, that opportunity also seems to have abated. In a recent commentary published by Dynamic Funds, they believe that the fair value of gold is in the $1,250 to $1,350 range. As I write this, the price is at the low end of that range, and it certainly doesn’t appear to be a strong buying opportunity. I am moving my rating back down to a hold.