ETF Focus List – June 2015

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Decent quarter for ETF Rec List…

It was a pretty solid month for the funds on the ETF Recommended List, with nearly 75% of the funds posting gains. The best performing ETF was the iShares S&P/TSC Capped Financials Index (XFN), which shot higher by nearly 10% on the back of stronger oil prices and a buoyant Canadian housing market. Still, there are worries on the horizon as recent economic numbers show a significantly slowing economy, which could create headwinds in the near term. If you have held this for a while, you might want to take some money off the table by rebalancing back to your initial weight, but the long-term outlook remains positive.

Foreign ETFs, particularly those that fully hedge their U.S. dollar currency exposure were also big winners as the European Central Bank’s stimulus package was applauded by traders. Also helping the cause was recent data showing that signs of life may finally be returning to the moribund region. The BMO MSCI EAFE Index (C$ Hedged) (ZDM), which provides exposure to large cap stocks outside of the Americas, posted an impressive 8.7% gain. The fact that it fully hedges its currency exposure helped maintain returns, in the face of a strengthening Canadian dollar. While the medium and long term outlook to the region remains strong, near term, valuation levels have gotten ahead of growth, which has the potential to press the pause button on gains.

Closer to home, Bank of Canada Governor Stephen Poloz noted that “…the Canadian economy is once again on a course towards sustainable balanced growth, although it continues to face headwinds.” He also said that the impact from the oil price collapse has hit faster than expected, but not worse, and the economy continues to be on track to reach full capacity by the end of 2016. This was a signal to the market that it is unlikely that he will make a further cut to the Bank’s overnight lending rate. This resulted in bond yields moving higher, unwinding the market’s expectation of more cuts.

With rates on the rise, the dollar followed, closing out April at $0.8252, up from $0.7863 at the end of January.

Looking ahead, my investment outlook remains fairly consistent. My short term outlook for fixed income remains NEUTRAL, however, it does have a negative outlook, as the medium to long term prospects are not overly rosy in the face of rising rates. Near term, I don’t expect rates to shoot higher from here and remain comfortable with a more index like stance for now. However, I am becoming more cautious and am positive on short term and higher yielding bonds.

Within the equity space, even with the higher valuation levels, I continue to favour the U.S. over the other regions. It is not so much a case that the U.S. is a great place to invest, but more the other regions are facing headwinds. I see the potential for a continuation in the recent rally out of EAFE stocks, but that will be more a shorter lived momentum play, and expect a pause. Canada remains uncertain in the near term, given the uncertainty caused by the oil shock.

My current investment outlook is:

ETFs Added to the List

Horizons Active Canadian Dividend ETF (TSX: HAL) – This actively managed dividend ETF is managed by Sri Iyer and his team at Guardian Capital, using a proprietary, multi factor quantitative model that screens the Canadian equity universe looking for positive rates of change in the fundamentals of companies. The model looks at 31 key factors including growth, payout ratios, efficiency, valuation and investor sentiment. Each of the factors is weighted, with growth, payout and sustainability factors being the most important for this strategy. The model is run on a daily basis, with the highest ranked stocks receiving a “buy” rating, and lower ranked securities rated as “sell”. The team will conduct a fundamental review to validate any of the potential buy candidates to ensure the rating is appropriate.

The result is a well-diversified portfolio that will typically hold between 50 and 60 names. The sector mix is the byproduct of the bottom up stock selection process. To ensure sufficient diversification, it must have exposure to at least seven of the ten GIC sectors at all times. The maximum sector weight is capped at 25% of the fund, and emerging market exposure is limited to 15%.

The process is quite active, with portfolio turnover that has been well above 100% since the fund’s inception. A stock is sold when its rating falls into the bottom 30% of the universe.

I really like the investment process used by the managers. It is disciplined and repeatable. It focuses more on rates of change rather than the value. I also like that it takes a lot of the potential emotion out of the process, yet has the fundamental oversight of the investment team. In other words, it’s not simply a black box strategy.

I would expect this ETF to deliver average to above average returns, with lower than average volatility. It is also quite different than its bench-mark. This of course can be a double edged sword, and could potentially result in periods where it underperforms for an extended period of time. Still, I believe it can be a great core global equity holding for most investors.

First Asset Morningstar Canadian Momentum ETF (TSX: WXM) – While not technically an actively managed, this ETF uses a proprietary rules based approach designed by Morningstar to invest in a focused portfolio of Canadian stocks that exhibit favourable momentum characteristics. The stocks that trade on the Toronto Stock Exchange are rated and ranked on six fundamental factors. These factors are return on equity, earnings revisions, earnings surprises, and price changes over a three, nine and 12 month period. Once complete, the stocks are ranked first to worst, with the top 30 making up the ETF. The model is rerun on a quarterly basis, with necessary changes being made.

Performance has been excellent, handily outpacing the S&P/TSX Composite Index over a one and three year period, with levels of volatility that are in line with the broader market. This is somewhat interesting, given that the underlying holdings tend to skew towards mid-cap names. While the ETF has only been around for a little over three years, the model on which it is based has a track record dating back to December 2000.

Given the momentum focus of the ETF, valuation levels are on the high side when compared with the broader market. However, this may be somewhat justified by the higher levels of earnings growth shown by the portfolio, both on a historic and forward looking basis.

I would expect that this ETF to deliver above average returns with levels of volatility that are at or above the broader market. My reasoning is that with the concentrated, mid-cap focused portfolio, the potential for above average volatility exists. I would also be reluctant to use this as a core holding. Instead, it may be an interesting way to get some mid-cap exposure in your portfolio. It is also a good candidate to be used as a return enhancer in an otherwise well-diversified portfolio.

iShares MSCI World (TSX: XWD) – Compared to the other new additions to the Focus List, this offering is downright boring. But that’s not a bad thing. It is designed to track the performance of the MSCI World Index, net of fees, in Canadian dollar terms. The index itself is largely regarded as the global equity benchmark. It provides exposure to large and mid-cap equity exposure across 23 developed market countries. It covers approximately 85% of the free float adjusted market capitalization in each, making it a decent proxy.

Unfortunately, there aren’t a lot of Canadian traded ETFs that cover a global index. Still, even if there were more index options, this would still be my pick, given its place as the global equity benchmark. Costs are a little higher than I’d like to see, with an MER of 0.46%, but it is still considerably cheaper than the average F-Class global equity mutual fund. This makes it an excellent pick for do it yourself investors with modest portfolio sizes. However, if you are investing a significant amount, you may want to consider buying 60% XUS and 40% ZEA, which will give you roughly the same investment exposure for a combined MER of 0.17%. This only makes sense if the cost savings from the lower MER will offset the additional trading costs of having to buy 2 ETFs.

ETFs Removed from the List

None

ETFs of Note

PowerShares Tactical Bond ETF (TSX: PTB) – With the U.S. Federal Reserve widely expected to finally begin moving interest rates higher in September, volatility in rates is likely to emerge. In a volatile environment, a more tactical approach can help mitigate some of that volatility and outperform. Based on that premise, I believe this rules based, tactically managed ETF should outpace its more traditionally constructed, index focused peers. At the end of April, slightly more than half was invested in investment grade corporate bonds, 31% in long term government bonds, and 11% in high yield. Credit quality is strong, with less than 2% invested in non-investment grade issues. Duration sits at 6.77 years, which is slightly below the FTSE/TMX Canadian Universe Bond Index. This exposure to long-term bonds helped in the earlier part of the year, but has dragged performance of late. While I do expect this to outperform XBB, I don’t believe it will do so until we start to see a marked increase in bond market volatility.

iShares 1-5 Year Laddered Corporate Bond (TSX: CBO) –Investing in a laddered portfolio of credits with maturities between one and five years, it offers both a higher yield and shorter duration to the iShares Canadian Short Term Bond Index ETF. Barring a complete collapse in the credit markets, I would expect that higher yielding corporate bond names will outperform government issues, even in the shorter part of the curve. That makes this my top pick in the short term space as we head into the summer.

PowerShares FTSE RAFI Canadian Fundamental (TSX: PXC) – The theory of a fundamentally constructed ETF is very sound. Instead of building the portfolio based solely on the market capitalization of a stock, as is done in traditional indexing, fundamental ETFs use factors that are believed to better predict outperformance. These factors include sales, cash flow, book value, and dividends. The main criticism with a traditional cap weighted index is the potential for overconcentration, as bigger companies take up a disproportionate weight in the portfolio. Fundamental indexing reduces that likelihood, at least at the stock level. They certainly can’t make that claim at the sector level. I nearly fell out of my chair when doing my latest review on this ETF and noticed that the weight in energy was 27%, compared with 22% for the cap weighted XIC. Financial Services are also significantly overweight, representing 39%, compared with 29% in XIC. Combined, there is two thirds of the portfolio in two sectors, compared with just half of the broader market. That is one heck of a bet for a supposedly diversified portfolio. Yes, the valuation metrics of PXC are better than XIC, but it’s difficult to ignore the concentration risk in the portfolio. If you are comfortable with this concentration, then I believe this ETF will do well over the long term. However, if you are uncomfortable with the risks, you will want to avoid it, and if you hold it, you will likely want to sell it.

BMO MSCI EAFE Index (C$ Hedged) ETF (TSX: ZDM) – Earlier in the year, the valuation levels of EAFE equities looked quite compelling. That’s not the case so much anymore, after an impressive 8.7% gain in the past three months helped close that valuation gap. Most of these gains were driven by the European Central Bank’s stimulus program was launched in March, and recent economic data that shows growth is returning to many European economies. At the end of April, Morningstar reported that the MSCI EAFE Index had a price to earnings ratio of 18.1, which is slightly below the S&P 500, but above the S&P/TSX Composite Index. While there still may be some legs in this trade in the short term, we will need to see further evidence of a sustained turnaround. There are also worries that a disagreement between Greece and its lenders could result in the country defaulting on an upcoming payment. This uncertainty has been weighing on stocks of late, and could be a serious headwind in the future. For that reason, I am suggesting caution in the near term.

iShares Core S&P 500 Index ETF (TSX: XSP) – The outlook for the Canadian economy is uncertain, and the valuation of EAFE names are not quite as compelling as they were a few months ago, making U.S. equities once again a strong contender. For U.S. exposure, this ETF remains my top pick. It is designed to track the S&P 500 and it fully hedges its currency exposure, so you receive the same return that a U.S. domiciled investor would have received. Intuitively that makes sense, but currency can play a huge role in returns.

For example, in our last Focus List review for the three months ending in January, XSP lost 0.7%, while the average U.S. equity mutual fund had gained an impressive 9.1%. The reason for this huge difference in performance was solely the result of currency, with the Canadian dollar dropping by nearly 12% against the U.S. greenback. Funds and ETFs that did not hedge their currency exposure benefitted from this drop. In the most recent three month period, the opposite happened, with the Canadian dollar gaining nearly 5%. This currency gain ate nearly all of the 5% rise in the market for those funds that were unhedged. Looking specifically at XSP, it rose by 4.9%, while the unhedged XSP lost 0.3%.

With the Fed poised to bump rates in the fall and the Bank of Canada likely to stand pat, we may see increasing volatility in the currency, with more pressure likely to the downside. The question now becomes do you hedge or not? Unfortunately there is no right answer to that question and really comes down to your personal preference. If you feel strongly the dollar will fall, then you are better off using XUS over XSP as it provides the same investment exposure, but without the currency hedging. If you expect the dollar to rise, XSP is the way to go. Personally, currency markets are unpredictable and I don’t have a strong sense on what way the dollar will move, making XSP my pick for now.

BMO Equal Weight REITs Index ETF (TSX: ZRE) – After a strong January, Canadian REITs have struggled to capitalize on that momentum, remaining flat. The main reason for this is the interest rate environment. January’s gain was the result of the Bank of Canada’s surprise cut in rates. Since then, we’ve seen some upward pressure on yields, which has made it tough for REITs to make any real headway. REITs are attractive because of the juicy yields they kick off, so when rates rise, they become less attractive. While the near term outlook remains cloudy based on the uncertainty caused by the interest rate picture, the medium and long term fundamentals make REITs and attractive investment for investors looking for cash flow and modest growth over the long term. Within the REIT space, this is my top ETF pick because it offers more diversified exposure to the Canadian REIT universe than either the iShares or Vanguard offering because of its equal weighting. It also offers a more attractive yield than XRE or VRE. If you hold it, be ready for some significant selloffs, which can be great buying opportunities.