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Additions
BMO Short Corporate Bond Index ETF (TSX: ZCS) – The bond market continues to be a challenging place for investors. Yields remain near historic lows, and the interest rate outlook is somewhat uncertain. In the U.S., it was a near certainty that the Federal Reserve would be moving rates higher several times over the year. It now appears that there is only a modest probability that we will see much in the way of increase rates. Closer to home, odds are we may see the Bank of Canada move lower before moving higher.
In this environment, I am adding this corporate focused short term bond ETF and removing the iShares 1-5 Year Laddered Corporate Bond Index ETF (TSX: CBO). There are a few reasons I am making this change. The first is ZCS offers a slightly higher yield to maturity. At February 28, the yield offered by ZCS was 2.05%, compared with 1.97% for CBO. This higher yield is expected to allow for a higher return, in the event we see rates remain flat.
Another reason for the change is ZCS has a slightly higher duration, coming in at 2.83 years, compared with 2.79 years for CBO. The duration of a bond portfolio is an indication of its interest rate sensitivity, with higher durations being more affected by changes in interest rates compared to lower duration portfolios. Given the expectation that Canadian rates are on hold for the near term, and potentially moving lower, I am favouring the slightly higher duration.
A third reason for the change is the lower cost of ZCS. In 2014, BMO cut the management fee from 0.30% to 0.12%. In comparison, the management fee is 0.25% for CBO, resulting in an MER of 0.28%. In an asset class where returns are expected to be rather low for the near to medium term, costs are extremely important.
Finally, according to Morningstar, CBO tends to trade at a higher premium to its underlying net asset value than ZCS, making it more expensive. For the past 12 months, ZCS has traded at a premium of 0.03% compared with 0.07% for CBO. Ideally, you will want to avoid paying a significant premium for an ETF, particularly in a low return asset class. While premiums may be unavoidable in many ETFs, you can take steps to try to minimize this additional cost.
Combined, these factors lead me to favour ZCS over CBO in the near to medium term.
Deletions
iShares 1-5 Year Laddered Corporate Bond Index ETF (TSX: CBO) – While I remain a fan of this laddered corporate bond ETF, I believe there are better options available in the near to medium term. As a result, I am removing it from the Focus List and replacing it with BMO Short Corporate Bond Index ETF (TSX: ZCS).
As outlined above, there are a few reasons I am making this change. The first is ZCS offers a slightly higher yield to maturity. At February 28, the yield offered by ZCS was 2.05%, compared with 1.97% for CBO. This higher yield is expected to allow for a higher return, in the event we see rates remain flat.
Another reason for the change is ZCS has a slightly higher duration, coming in at 2.83 years, compared with 2.79 years for CBO. The duration of a bond portfolio is an indication of its interest rate sensitivity, with higher durations being more affected by changes in interest rates compared to lower duration portfolios. Given the expectation that Canadian rates are on hold for the near term, and potentially moving lower, I am favouring the slightly higher duration.
A third reason for the change is the lower cost of ZCS. In 2014, BMO cut the management fee from 0.30% to 0.12%. In comparison, the management fee is 0.25% for CBO, resulting in an MER of 0.28%. In an asset class where returns are expected to be rather low for the near to medium term, costs are extremely important.
Finally, according to Morningstar, CBO tends to trade at a higher premium to its underlying net asset value than ZCS, making it potentially more expensive. For the past 12 months, ZCS has traded at a premium of 0.03% compared with 0.07% for CBO. Ideally, you will want to avoid paying a significant premium for an ETF, particularly in a low return asset class. While premiums may be unavoidable in many ETFs, you can take steps to try to minimize this additional cost.
Combined, these factors lead me to favour ZCS over CBO in the near to medium term.
ETFs of Note
PowerShares Senior Loan CAD Hedged ETF (TSX: BKL) – With worries a slowing economy could result in higher default rates, high yield bonds and leveraged loans were sold off by investors, pushing yields and credit spreads higher. For the three months ending January 31, BKL lost nearly 2%, but managed to finish in the upper half of its peer group. This loss was even with the U.S. Federal Reserve finally moving rates higher in December. This was the worst performing fixed income ETF on the Focus List, and was the only one to finish in negative territory.
Again, I reiterate that this recent selloff highlights that these types of investments are NOT suitable as a core holding in your portfolio, despite what fund companies will have you believe. Instead, they are really only suited to higher risk investors who are comfortable taking on additional risk of loss over the short term, in return for the potential for reduced interest rate sensitivity.
As I look ahead, I still believe that this is the best choice in the category for those looking for an ETF that provides exposure to floating rate loans. That said, I am lukewarm at best on the asset class in the near to even medium term. Many of the loans held have interest rate floors in place that remain above the current short term yields, meaning we will need to see rates move even higher before the true value of these funds is realized. Until then, because the overwhelming majority of bank loans are unrated, investors will instead be focusing on the risk of default, which I expect will result in higher than average levels of volatility. If higher volatility is a concern, you will likely want to avoid floating rate notes and bank loan focused investments for the next little while. Longer term, particularly when we start to see some meaningful movement higher on interest rates, these types of investments can play a role in a well-diversified portfolio.
iShares Canadian Universe Bond Index ETF (TSX: XBB) – With the Bank of Canada expected to keep interest rates on hold for the next little while, bonds are likely to remain a positive contributor to portfolio performance. This ETF is my top pick at the moment. It provides exposure to a diversified portfolio of Canadian government and investment grade corporate bonds. It is a high quality portfolio, with about 70% invested in government issues, and the balance in corporates. Its duration is fairly long, coming in at 7.42 years at the end of February. The higher the duration, the more sensitive it is to the movements in underlying interest rates. This is not a concern at the moment, but when rates start to move higher, it is likely to experience heightened volatility and the potential for some modest short term losses. But for now, with an MER of 0.33%, this is a great, low cost way to get high quality Canadian bond exposure.
BMO Low Volatility Canadian Equity ETF (TSX: ZLB) – Low volatility funds and ETFs have become rather popular with investors lately, and it’s not hard to see why. Who doesn’t love the idea of getting returns that will come pretty close to the broader market, but with a lot less downside? It sounds too good to be true, and while the track records are still relatively short, the early results are very encouraging.
This low volatility ETF was the best performing Canadian ETF on the Focus List over the period, falling 1.3%, compared with a drop of 4.8% for the S&P/TSX Composite Index. The longer term numbers are also rather impressive. For the three years ending January 31, it gained an impressive 16.4%, compared with 3.4% for the index. More impressive however, is this was done with a level of volatility that was about three quarters of the market, and it posted a downside capture ratio that was negative, which means that on average, when the broader market was down, this ETF was positive.
As impressive as this level of outperformance has been, it is not sustainable. One key reason is the ETF has very little exposure to the hard hit energy sector, and no exposure to materials, which has been the biggest drags on the S&P/TSX Composite. Once we see energy stabilize and start to rebound, this ETF is likely to lag the broader Canadian market.
Another worry I have relates to the valuation levels of the underlying portfolio. According to Morningstar, the price to earnings ratio of ZLB is 19.4 times. In comparison, the S&P/TSX Composite is trading at a more modest 15.5 times earnings. It is a similar story for other key valuation metrics, with ZCS exceeding the market on a price to book, and price to cash flow basis. Turning to earnings, the historic earnings growth rate of ZCS lags the index, and the forecasted earnings growth is significantly lower than the market. In other words, investors have significantly bid up the price of these lower beta names, and they now trade at levels that are not justified by both the current and expected level of earnings.
That is not to say a significant selloff is imminent. On the contrary. Instead, looking at the sector makeup, I would expect it to continue to hold up well in periods of higher than normal volatility. However, when the markets turn positive, this ETF would be expected to lag, in some cases significantly, while earnings catch up with valuations. If you have held this ETF for any period of time, I would strongly encourage you to take some money off the table, by rebalancing your portfolio and taking some profits.
iShares S&P/TSX Completion Index ETF (TSX: XMD) – It is rather tough to find a good small / mid-cap ETF with a focus on Canadian equities. There are really only about four that are considered to be Canadian Small / Mid Cap Equity ETFs. Sadly, this is the best option. Essentially, it provides exposure to the Canadian traded companies that are part of the S&P/TSX Composite Index, but are not part of the S&P/TSX 60 Index. Because of this, it tends to skew somewhat mid-cap, with an average that is about five times that of the S&P/TSX Small Cap Index. If you absolutely require an ETF for your small / mid cap exposure, this would be the one to use. However, if you are willing to consider mutual funds, I believe you may be better off looking at something like CI Cambridge Pure Canadian Equity Fund (CIG 11109), IA Clarington Canadian Small Cap Fund (CCM 520), or the Sentry Small Mid Cap Income Fund (NCE 721). Each of those offers what I believe to be a more compelling risk reward profile than this or any of the other available small / mid cap ETFs.
Vanguard U.S. Total Market Index ETF (CAD-hedged) (TSX: VUS) – Of the U.S. equity ETFs on the Focus List, this was the worst performer for the three months ending January 31, falling by 7.8%, compared with a drop of 6.6% for the iShares Core S&P 500 Index ETF (TSX: XSP). The main reason for this performance differential is VUS provides exposure to the entire U.S. equity market. Holding approximately 3,700 individual securities, about one third of the portfolio is invested in small and mid-sized companies. In comparison, XSP holds around 500 names, with virtually no exposure to small caps, and less than 20% invested in mid-cap names. During the period, small and mid-cap companies underperformed. While the shorter term outlook may be cloudy for small and mid-cap companies, the longer term outlook remains strong, making this a great way to get broad market U.S. equity exposure. Near term, I favour XSP, but only marginally. Longer term, I believe the additional exposure to small and mid-sized companies should allow this to provide slightly better returns.
iShares International Fundamental Index ETF (TSX: CIE) – I have to admit I really like the theory behind fundamental ETFs. The goal of a fundamental approach is to weight companies in the index based on their financial health, rather than by their size. Ideally, because of this focus on quality, it should provide a return that is comparable to a market cap weighted index, with less volatility. In this case, the top 1000 listed companies that trade outside the U.S. are ranked by four fundamental criteria; sales, cash flows, book value, and dividends. Unfortunately, the reality hasn’t quite lived up to the theory. While the longer term performance of this ETF has been comparable to the MSCI EAFE Index, it has also been more volatile, with a standard deviation that is above the index. Further, it has consistently underperformed the index in falling markets. Looking ahead, the valuation metrics of this portfolio appear to be more favourable than the broader market. However, according to Morningstar, the forward looking growth numbers are also lower, which indicates it may not be quite as favourably valued as it appears on the surface. I like the theory of this for the longer term, but am monitoring it further in the short term for a deepening divergence in returns or an uptick in overall volatility.
iShares Gold Bullion ETF (TSX: CGL) – Gold has been on a bit of a tear since early December, jumping more than 18%. Much of this gain has come from investors’ lack of faith in the ability of central banks around the world to get the global economy growing in a meaningful way. With negative interest rates becoming a possibility to a larger number of countries, investors are starting to look for places to park some of their excess cash, and for some, that is gold. While I’m not a gold bug per se, there may be some more room for bullion to move higher. Further, once growth does take hold, the possibility for inflation is also expected to grow, which would be another positive for gold. This ETF is a good way to gain exposure to gold. Given that gold trades in U.S. dollars, the currency exposure of the ETF is fully hedged. If you want to gain this exposure in an unhedged fashion, you may want to consider CGL.C. Alternatively, you could consider the Royal Canadian Mint Canadian Gold Reserves Exchange Traded Receipt (TSX: MNT), which is similar and carries a management fee of 0.35%. There is no currency hedging with this ETR.