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Markets start to get choppy on China worries…

The three months ending July 31 was disappointing for most of the ETFs on the Recommended List, with just more than half finishing in negative territory. The worst performers in the period were the PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC), which lost 8.6%, and the iShares S&P/TSX Completion Index (TSX: XMD) which was down 8.1%. In both cases, a large weight in energy names was the biggest drag, with the sector losing more than 20% after crude dropped more than $12, ending July at $47.12. With energy expected to remain volatile in the near term, expect both of these ETFs to face potential headwinds.

Another big loser was the iShares Gold Bullion ETF (TSX: CGL) which lost nearly 8%, moving lockstep with the price of gold. With weak demand for physical gold, and many questioning gold’s traditional status as a safe haven trade, the outlook remains decidedly negative.

On the positive side, the low volatility ETFs on the list did exactly what they were supposed to do, holding up nicely in the volatile markets. The BMO Low Volatility Canadian Equity ETF (TSX: ZLB) was the only Canadian equity ETF in positive territory, gaining a modest 1.7%. Internationally, the iShares MSCI EAFE Minimum Volatility Index (TSX: XMI) was the top performing ETF on the list, gaining an impressive 8.4% in a rough market environment. I certainly don’t expect this level of outperformance to continue, but see these ETFs as a decent place to be in volatile times.

As we head into the fall, I expect a continuation of the volatility we experienced in July and August. With many questions around the economic health of China dominating the headlines, combined with the potential for a rate increase from the U.S. Federal Reserve, things could get very rocky. Not to mention, historically, September has been the cruelest month for investors. All this points to a potentially volatile couple of months.

Even with the potential for higher volatility, my investment outlook remains somewhat neutral. I am keeping a neutral weight in fixed income, and am maintaining neutral exposure to all bond sectors, except for real return bonds, which I am keeping underweight. Within equities, I remain neutral on all regions, except for the emerging markets. There is far too much uncertainty in China to be comfortable with the risks there right now. While I am neutral, I have a slight bias to the U.S., given the relative strength of their economy. I am less favourable on Canada, given the uncertainty in the oil sector, and EAFE markets because of the China overhang.

My current investment outlook is:

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ETFs of Note

PowerShares Senior Loan CAD Hedged ETF (TSX: BKL) – With many expecting the U.S. Federal Reserve to start moving rates higher at their meeting later this month, floating rate notes and loans have once again been put on investors’ radar. This is one of the better floating rate ETFs available. It provides exposure to the S&P/LSTA U.S. Leveraged Loan 100 Index, which is the largest 100 loan facilities in the S&P/LSTA Leveraged Loan Index. The interest rate paid on these loans will generally move with a benchmark rate such as LIBOR. However, even if the Fed starts moving rates higher, don’t expect the coupon rate on this ETF to move higher at the same pace. That is because the majority of the loans have an interest rate floor built into them. The interest rate floor is the lowest rate used to calculate the coupon payment. For example, if the interest rate floor is set at 1%, and the benchmark rate falls to 0.5%, the coupon payment will be determined using the 1% floor instead of the 0.50% actual rate. This feature was put in place to protect investors against falling interest rates. At the end of November 2014, 87 of the 100 loans had an interest rate floor, and 64 of those loans had a floor of 1% or higher, according to a report published by S&P Dow Jones Indices. In other words, there is unlikely to be a meaningful movement in returns until we see an increase in the benchmark rates. Ironically, this protection feature that was put in place to protect investors on the way down will hurt them on the way back up. I expect very modest levels of return in the near to medium term.

iShares 1-5 Year Laddered Corporate Bond (TSX: CBO) – Recently, FTSE/TMX Global Debt Capital Markets, the provider of the index on which this ETF is based, announced some changes to the index construction methodology. The first change allows bonds rated BBB to be included in the index. Previously, only those bonds rated A or higher could be included. This change is expected to result in a higher running yield than previously. The next change eliminates the maximum number of bonds in each maturity bucket. Previously, the number of bonds in each maturity bucket was capped at 20. This will allow for a greater level of diversification within the portfolio. The final change increases the rebalancing frequency from annually to semi-annually. On balance, these changes are positive for the ETF. A drawback however is the reconstitution of the index has caused a slight increase in the duration as the bonds with the most recent maturities were removed from the index and replaced with longer dated bonds. Over the next several months, the duration will naturally drop until the next reconstitution of the index.

iShares Canadian Universe Bond Index ETF (TSX: XBB) – Given the lackluster economic numbers posted by the Canadian economy, and news that we were officially in recession in June, many are expecting the Bank of Canada to cut rates again at their next meeting. If that does happen, this is an ETF you’ll want to own. It provides exposure to the Canadian bond universe, with two thirds in government bonds, 30% in corporates. All the bonds are investment grade, and the duration is in the 7.4 year range. This makes a great core bond holding for most investors.

First Asset Morningstar Canadian Momentum ETF (TSX: WXM) – Even with a concentrated portfolio, following a “riskier” momentum strategy, this rules based ETF continued to outperform. For the three months ending July 31, it lost 0.80%, which is pretty uninspiring, until you consider the S&P/TSX Composite lost 4.3% in the same period. The underweight in energy, and financials was a key reason for this outperformance. While I don’t expect the absolute level of outperformance to be sustainable over the long term, I do expect this to modestly outpace the broader market, with a slightly higher level of volatility. I likely wouldn’t use it as a core holding, but it could definitely be a nice return enhancing addition to an otherwise well diversified portfolio.

BMO Low Volatility Canadian Equity ETF (TSX: ZLB) – One of the worries that I have about many of the low volatility funds out there is that they won’t hold up when the going gets rough. If the most recent three month period is any indication, I think these products will be just fine. Of the seven Canadian equity ETFs on the focus list, this was the only one to finishing in positive territory, gaining 1.7%. Even in August, when the S&P/TSX Composite lost more than 4%, this was down by just under 3%, again, holding up better in volatile times. As we head into the fall, with September historically being the most volatile period for equity markets, I expect this ETF to continue to do what it is designed to do – provide better downside protection than the broader markets. Longer term, I have some concerns with the valuation levels of the portfolio as a whole, but if you’re comfortable with it, this could be a good pick for your portfolio.

PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) – I’ll be honest, I love the concept of a fundamentally constructed ETF. I like that it takes a look at a number of the same factors a good active manager would consider; things like earnings, sales, and dividends. Theoretically, it should result in a better built, and more diversified index than an index that is simply made up of the largest publicly traded companies in Canada. Unfortunately in practice, this hasn’t been the case. Looking at the sector mix, it is significantly more concentrated than the S&P/TSX Composite, which is itself fairly concentrated. For example, it has more than 40% invested in financials, not including real estate, compared with just over 30% for the index. It also has more than 23% in energy, compared with just under 20% for the index. The reason for this level of concentration is based solely on the relative ranking of the stocks, based on the fundamental criteria. While I can appreciate that, I believe that it has become just too concentrated a portfolio to be used as a core holding, with nearly two-thirds invested in two sectors. If you’re comfortable with that kind of concentration risk, this isn’t a bad option. However, if you are looking for marginally better diversification, you’re better off sticking with XIC for your Canadian equity exposure.

BMO MSCI EAFE Hedged to CAD Index ETF (TSX: ZDM) – After a pretty impressive run-up, this ETF has hit a rough patch, losing 7.8% in August, on fears of a global slowdown. With China playing an ever increasing role in the economy of many Asian and European nations, any significant pause will hurt the outlook for many EAFE based companies. This rough patch is what we are experiencing now. The other thing that has hurt this ETF is its currency hedging policy. With the Canadian dollar losing more than 12% on a year-to-date basis, ZEA, the unhedged version of this ETF has dramatically outperformed, solely on the weaker currency. Looking ahead, I believe that the worst of the drop is behind us, but still see the potential for more downside and heightened volatility. I still see this as the best option for EAFE exposure over the long term, but have some concerns in the near term. In the near term, I’m favouring the iShares MSCI EAFE Minimum Volatility Index ETF (TSX: XMI) for the potential for lower volatility. However, if you hold ZDM and are comfortable with the near term outlook, I’d suggest holding on to it. If you’re looking to step in and buy more, you’re likely better off waiting for a pullback.

iShares Core S&P 500 Index ETF (CAD- Hedged) (TSX: XSP) – If I had to rate the markets I feel will hold up best over the next few quarters, the U.S. is definitely at the top of that list. While the economy is far from firing on all cylinders, it is still growing at a modest clip, and is much stronger than Canada, Europe or Asia. That being the case, I continue to favour the U.S. for my core equity exposure. Sure, more volatility is expected into the fall, but the U.S. is expected to hold up better. While I don’t have it on my list, I am actually favouring XUS over this ETF in the near term. This is particularly true if the Fed does indeed start raising rates in the fall, as it will push the value of the U.S. dollar even higher, amplifying gains or muting losses solely because of the currency effect. However, over the long term, the fully hedged XSP remains my top pick.