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.
You can download a PDF copy of this report here.
List Changes
Additions
PowerShares Tactical Bond ETF (TSX: PTB) – With yields likely to start moving higher in the next couple of quarters, there is a good chance the traditional bond indices will be hit harder than high quality actively managed bond funds that have the ability to tactically shift their asset mix according to the conditions. This PowerShares offering is a hybrid between a passively managed index and an actively managed fund. It invests in a mix of fixed income ETFs offered through PowerShares and other providers. Each month, Invesco’s Global Asset Allocation team examines the environment, and increases or decreases the underlying holdings to best position the portfolio. The asset mix ranges are:
| Asset Class | Range |
| Canadian corporate bonds | 30% – 90% |
| Canadian long-term government bonds | 15% – 50% |
| Canadian real return bonds | 0% – 15% |
| High Yield Corporate Bonds | 0% – 20% |
| Global/international/emerging market fixed income | 0% – 10% |
| Gold and/or silver | 0% – 10% |
I believe that this ETF offers a great one-ticket solution for those looking for diversified fixed income exposure. It can serve as a core bond holding within a well-diversified portfolio. Given its makeup, I expect that it will hold up better than XBB when rates do begin to grind higher.
iShares International Fundamental Index ETF (TSX: CIE) – Like the other fundamentally constructed ETFs on the list, this one ranks its holdings based on four valuation metrics; sales, cash flow, book value and dividends. Not surprisingly, this is a portfolio that is more attractively valued than any of the other ETFs in the international equity category. Another note is that the average market cap tends to skew a bit smaller than the other ETFs. Despite struggling over the past three months, I believe that the more favourable valuation metrics will allow for stronger risk adjusted performance over the long term. You should note that it has the potential to be more volatile than XIN.
BMO MSCI Emerging Markets ETF (TSX: ZEM) – While many risks remain in the emerging markets, it is beginning to look that the worst is behind us. Despite ongoing concerns around China’s housing market, it has delivered some positive economic surprises recently. Other Asian markets, including Indonesia and Singapore remain strong thanks to positive growth forecasts. Geopolitical troubles in Russia and the Ukraine continue to hang over the region like a dark cloud. Considering all the factors, it appears as though the risk reward balance is beginning to shift towards growth. This is becoming evident with investor sentiment, which, according to a recent report from iShares has seen net inflows into emerging market ETFs for the 12th straight week. They also state that short selling activity in the region is near one year lows, which is a big reversal from the record highs near the end of the first quarter. Given that the worst appears to be behind us, those with above average risk tolerances may want to start moving back into the region. In my view, the best Canadian traded ETF to do that is the BMO MSCI Emerging Markets ETF. It is virtually identical to the iShares version, yet boasts a lower MER and a lower tracking error. As with all specialty ETFs, this has the potential to be extremely volatile, and investors should exercise caution.
Deletions
iSharesAdvantaged U.S. High Yield Bond ETF (TSX: CHB) – Valuations of high yield bonds have become rather extended. There has been significant outflows from the asset class in recent weeks. I am strongly suggesting you take profits if you haven’t already. In my broader asset mix outlook, I recently cut high yield from an overweight to an underweight position. This will only be a temporary situation until valuations return to more normalized levels. Also, once I bring high yield back onto the list, I will likely be adding the iShares U.S. High Yield Bond CAD Hedged ETF (TSX: XHY) over this ETF. It offers a very similar credit exposure, duration and yield, but it is cheaper and performance on a pre-tax basis has been stronger. The reason I am making the switch is the forward agreement that CHB is currently using to offer tax advantaged income is set to expire in early 2015. Without the tax advantaged income stream, it becomes a less attractive option.
iShares Global Monthly Advantaged Dividend Index ETF (TSX: CYH) – In hindsight, it was a mistake for me to have put this yield focused ETF on the list. My original premise was the dividend and yield focus of this ETF would help it outperform. That did not play out as expected. It has failed to keep pace with the MSCI World Index by pretty much every metric available. For the three years ending July 31, it gained an annualized 9.2%, while XWD, the MSCI World ETF gained more than 19%. Volatility has been substantially higher, and it carries a higher MER. Considering the above, I am removing it from the Focus List effective immediately.
ETFs 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 substantially. Looking at the portfolio, the yield to maturity is listed at 4.46%, 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 3.6%. 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. A worry that some have expressed about the asset class is the potential illiquidity, should we see a rotation out of the loan space, which has the potential to amplify price movements. While that is a concern, this ETF invests in the largest loans, meaning that liquidity is likely to be a lesser concern than with some of the actively managed mutual funds in the space. Still, I wouldn’t use this as a core holding, but instead as a part of the fixed income portion of your portfolio. It can be helpful in managing your interest rate risk.
iShares 1-5 Year Laddered Corporate Bond Index ETF (TSX: CBO) – With the U.S. Federal Reserve’s massive bond buying program expected to be wound down in October, traders’ focus will likely now shift towards the timing of any rate increases. While most are expecting any moves to be made in mid to late 2015, it is highly likely that their speculation will cause a return of volatility to the bond markets. When that happens, one of the best ways to mitigate this volatility is to shorten the duration of your bond holdings. This ETF is a great way to do that. It invests in a laddered portfolio of corporate bonds that have maturities between one and five years. One thing you may note is that just under half of the portfolio has maturities that are in excess of five years. In these cases, the bonds in the portfolio are callable within five years, and the call date is used rather than the maturity date. This is because it is highly likely the bonds will be called. For those comfortable taking on a bit more risk, I believe this to be a better choice than XSB, as it offers a higher underlying yield, which will help it outperform in a flat yield environment. It does however have a higher duration, which may result in slightly more downside when rates rise.
iShares S&P/TSX CDN Preferred Share Index ETF (TSX: CPD) – Preferred shares can be a great way to generate above average income, without taking on the full risk of the equity markets. Preferreds are an interesting hybrid of equity and debt securities. Like fixed income, preferred shares will typically pay a set coupon that is paid in the form of a dividend. Some will have a fixed maturity date, while others may be perpetual, meaning there is no fixed term. Typically, they trade more like fixed income investments because of their fixed coupon payments. Because it is a dividend, it receives a more favourable tax treatments than interest payments from a bond. Other benefits of preferreds include a higher yield than many fixed income investments, and they offer price stability when compared to the issuer’s common stock. Drawbacks include a high level of interest rate sensitivity, the risk of the preferred being called away by the issuer, as well as credit risk and liquidity risk. I like preferreds for those more investors looking for yield, and are willing to take on a bit more risk than with fixed income. In my view, this ETF is the best way to gain exposure to a diversified portfolio of preferred shares. It offers a lower cost, better liquidity and slightly higher credit quality than the other preferred offerings.
BMO Low Volatility Canadian Equity ETF (TSX: ZLB) – One of the more interesting investment strategies that has gained popularity of late has been low volatility investing. The basic premise is that stocks that exhibit lower volatility tend to outperform in most market environments, except for a sharp market rally. The idea is that a low vol strategy will deliver comparable returns to the broader market, with a lower risk profile. Since its launch, this ETF has done just that, nearly doubling the gain of the S&P/TSX Composite, with much less volatility. The key difference between this offering and the iShares low vol ETF is this invests in the 40 largest low beta stocks, while the iShare offering invests in around 75 stocks with the lowest standard deviation. There is no right answer as to which is better, but to date this has outpaced the iShares offering on both an absolute and risk adjusted basis. With volatility expected to return to the equity markets in the fall, some exposure to this low vol offering may help to mitigate any potential drawdowns.
iShares S&P/TSX Canadian Dividend Aristocrats ETF (TSX: CDZ) – Studies have shown that stocks that are able to grow their dividends over time have a history of outperforming those that do not. That is why this is such an interesting ETF. To be included, a company must have increased dividends in each of the past five years. The result is a diversified portfolio of companies of all sizes. Unlike the traditional dividend fund that is heavily focused in financial services, this ETF has about 20% invested in financials. It also has significant exposure to consumer cyclicals, energy and communications. Another interesting thing about this ETF is that it tends to have a smaller average market cap than many of its peers. As a result, it has the potential be more volatile than the broader market. This is a good choice for those looking for a mix of yield, which is currently above both the index and category average, and capital growth potential.
Vanguard MSCI U.S. Broad Market (C$ Hedged) (TSX: VUS) – The most popular U.S. equity ETF has been the iShares Core S&P 500 (CAD Hedged) ETF (TSX: XSP), which tracks the performance of the S&P 500.While the S&P is a good proxy of the U.S. market, it is mainly focused on the large cap names, and leaves out many smaller and mid-sized companies. That is where this Vanguard offering differs. It looks to replicate the CRSP US Total Market Index, which is a cap weighted index that represents nearly 100% of the U.S. public equity markets, with nearly 4,000 holdings. While I like the idea of capturing the entire market, I am favouring XSP over this at the moment. I would expect that in periods of elevated market volatility, XSP will outperform marginally. In a recovery phase where the smaller names tend to outperform, this would be my pick. Given my expectation for higher volatility in the fall, XSP is my pick.
iShares Gold Bullion Fund ETF (TSX: CGL) – The outlook for gold, at least in the short term remains rather muted. From a price perspective, it is within Dynamic Funds estimate of fair value. There are a number of factors that support a higher gold price over the long term, including high global debt levels, central banks increasing their gold reserve levels, and the potential for increased demand from India and China. Unfortunately for gold bugs, there aren’t many near term factors that will increase demand, except for the uncertainty caused by the increasing geopolitical situations in the Ukraine and Gaza. Should we see a sustained escalation in either of those conflicts, expect a jump in gold prices. If we don’t, expect more of the same.
BMO Global Infrastructure ETF (TSX: ZGI) – One of the more interesting investment themes for the past few years has been rebuilding the world’s crumbling infrastructure. This ETF looks to capitalize on that by investing in companies that are involved in the development, ownership, or management of infrastructure assets such as energy, pipelines, bridges, airports and toll roads. It holds approximately 50 names, and not surprisingly, it is heavily concentrated in energy and utilities. It tracks the Dow Jones Brookfield Global Infrastructure North American Index, which means that the majority of the holdings are large, well-capitalized companies. A benefit to this is they tend to generate meaningful dividends for investors. At the end of July, the dividend yield of the underlying holdings was 3%, which is higher than the broader global equity market. It passes some of this along to investors through a regular quarterly dividend, which has been $0.145 per quarter per share so far this year. I like this over the iShares Global Infrastructure ETF (TSX: CIF) because it has shown a more favourable risk reward profile at a lower cost. I believe the near to medium term outlook for infrastructure remains strong, and ZGI is a great way to gain exposure. While volatility may be lower than the broader equity markets, I would still treat this as a sector fund and limit exposure in a portfolio.