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Additions
PowerShares S&P/TSX Composite Low Volatility ETF (TSX: TLV) – Low volatility funds and ETFs continue to be popular choices with investors. It’s not too difficult to understand why they are appealing, with the prospect of market like returns over the long term combined with lower downside. The problem I see with many of the low volatility mandates is that investors have flocked to these funds and ETFs, and have bid up the values of many of the stocks held in these products to very high levels. For example, according to Morningstar, the P/E ratio of the BMO Low Volatility Canadian Equity ETF (TSX: ZLB) is 21.4 times forward earnings. In comparison, the S&P/TSX 60 Index trades at approximately 15 times forward earnings. While ZLB has significantly outperformed the other Canadian low vol ETFs (XMV, TLV), I don’t see how that is sustainable at these levels of valuation. Because of that, I have opted to remove it from the list and replace it with this PowerShares offering, which trades at a valuation level that is more in line with the broader market. Further, if you consider the forward looking growth rates, TLV looks to have a more positive outlook than ZLB, making the valuation levels that much more compelling.
There are a couple of other reasons to favour TLV over ZLB. One is TLV is rebalanced on a quarterly basis, while ZLB is done annually. This allows for the potential of a more responsive portfolio over ZLB. Another reason to like this over ZLB is the lower cost, with an MER that is about 6 bps lower.
A drawback to TLV lies in the sector constraints. There are technically no maximum limits on the sector exposure, while ZLB is capped at 35% per sector. With no constraints, TLV has the potential to get pretty concentrated, as is the case now, with the portfolio running about 27% in financials, and 31% in real estate, compared with 19% financial exposure and 13% real estate exposure in ZLB. A higher concentration portfolio can be a double edged sword, and can either help or hurt depending on what way the market moves.
The bottom line is I made this substitution for the long term as I don’t believe ZLB can continue to outperform at the current valuation levels. ZLB may very well outperform on shorter term momentum factors, but valuations typically regress back to the mean, making it highly likely it will experience a sustained period of underperformance in time. Considering all factors, I believe that TLV is better positioned at the moment.
PowerShares Canadian Dividend ETF (TSX: PDC) – In Canada, it has been shown that over time, between 65% and 70% of the total return of equities comes from reinvested dividends, depending on which time period you look at. That makes for a fairly compelling reason to make dividend paying stocks a big part of your portfolio. With that in mind, I looked for high quality, dividend focused ETFs for the Focus List. After doing a number of screens, this is an ETF that looked pretty attractive relative to its peers.
It invests in highly liquid Canadian stocks that have paid a stable or rising dividend over the past five years. It screens for dividends, and then holds the 45 largest stocks ranked by market capitalization. It is an adjusted market cap index, meaning it will make some adjustments to make sure one or two companies don’t dominate the portfolio. The index is reconstituted each year and rebalanced on a quarterly basis.
I am adding this ETF to the Focus List and removing the iShares S&P/TSX Canadian Aristocrats Index ETF (TSX: CDZ). There are a couple of reasons for this switch. PDC tends to focus more on larger names than CDZ, which is reflected by an average market cap that is nearly four times larger. The valuation and forward looking earnings picture appears a little more favourable to PDC, giving it the edge over the long term growth potential. The dividend yield of PDC is also slightly higher, allowing investors to receive a higher income while they wait for stock price appreciation. Costs for PDC are also slightly less, with an MER that 12 basis points lower.
If I have a concern with PDC, it is that it is highly exposed to the financial sector. At the end of April, it held more than 40% in financials and another 13% in REITs. The risk here is the potential impact to the banks if we see a meaningful slowdown in the Canadian housing market. More than 30% of the fund is directly invested in the banks, compared with a little more than 10% in CDZ.
Upon reviewing all factors, I believe PDC is a modestly more attractive option than CDZ for the near to medium term.
Vanguard FTSE Emerging Markets All Cap ETF (TSX: VEE) – Emerging markets have struggled in the past year as worries over a continued slowdown in China, combined with a selloff in commodities, namely oil have taken a toll. In recent weeks however, many have been calling for a turnaround in the region as many of the worries abate.
After some consideration, I have decided to replace the BMO MSCI Emerging Markets ETF (TSX: ZEM) with this offering. Both ETFs are similar, and in fact, until October followed the same MSCI benchmark. After the benchmark change, VEE now tracks the FTSE Emerging Index. The biggest difference between the two indices is FTSE has no exposure to South Korea, a country it deems as being more of a developed country. With names like Samsung and Hyundai, you would be hard pressed to disagree.
Both are cap weighted, meaning the individual constituent weights are set by company size, rather than other metrics. Drilling down to look at the underlying portfolio metrics, both are pretty similar from a growth and valuation perspective. VEE, because of its small and mid-cap exposure provides exposure to a larger number of stocks than does ZEM.
The key reason for the switch however was the lower cost of VEE. I have always maintained that if were looking at two investments with similar risk reward metrics, I would favour the one with the lower fee hurdle. VEE offers an MER of 0.24% compared with 0.29% for ZEM. Based on that, I am adding VEE to the Focus List.
Deletions
BMO Low Volatility Canadian Equity ETF (TSX: ZLB) – This has been one of the stronger low volatility ETFs around, gaining an impressive annualized 14.7% over the past three years, handily outpacing the PowerShares S&P/TSX Composite Low Volatility ETF (TSX: TLV). A consequence of this impressive run is valuations have been pushed to very high levels, with Morningstar showing a Price to Earnings ratio of 21.4 times, which is significantly higher than both the broader market and the peer group. Most other valuation metrics show a similar story. While there is a lot of investor demand for low volatility names, these valuation levels are definitely cause for concern, as over time, earnings multiples tend to regress back to the mean. While no one can predict timing with any level of certainty, there is a very strong probability this ETF will experience a period of underperformance as valuations catch up to earnings potential. Considering this, I am removing ZLB from the Focus List for the near term, and will continue to monitor it closely. In the interim, I am replacing it with the more reasonably valued PowerShares offering TLV, which has a forward looking P/E ratio that is in line with the market, according to Morningstar.
iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (TSX: CDZ) – This ETF’s goal is to replicated the S&P/TSX Canadian Dividend Aristocrats Index, net of fees and expenses. The index focuses on companies that have growing dividend streams, and any stock included in the index must have raised its dividend in each of the past five calendar years. Although, they can maintain the same dividend for two consecutive years within that five-year period. With this emphasis on dividend growth, the ETF tends to skew more towards small and mid-cap names. It boasts an average market cap that is less than a quarter of the broader S&P/TSX Composite Index. Performance has been strong, and it has outpaced the broader market over the past three and five year periods, with slightly less volatility.
It remains a decent pick for investors looking for dividend exposure. However, I am removing it from the Focus List, and replacing it with the PowerShares Canadian Dividend Index ETF (TSX: PDC). The two ETFs are somewhat similar, in that they both look for companies with rising dividends. However, the difference comes from how the stocks are weighted within the fund. With CDZ, stocks are weighted based on dividend yield, while with PDC they are weighted based on market capitalization. Drilling deeper into the underlying portfolios, I believe that PDC has a more favourable outlook in the near to medium term. I will continue to monitor CDZ closely.
BMO MSCI Emerging Market ETF (TSX: ZEM) – Emerging markets are starting to show some signs of a turnaround, and this ETF, which provides exposure to the MSCI Emerging Markets Index is a strong way to participate in that. Still, I have removed it from the Focus List this quarter and replaced it with the Vanguard FTSE Emerging Markets All Cap ETF (TSX: VEE). There are two key reasons for this switch. The first is VEE is an all cap ETF, and provides more exposure to small and mid-sized companies that would be expected to benefit as the turnaround takes hold. Secondly, VEE has a lower MER than ZEM. Still, ZEM is a solid passive emerging markets pick and one that I will continue to monitor closely.
ETFs of Note
PowerShares Senior Loan CAD Hedged ETF (TSX: BKL) – With better than expected corporate earnings, rebounding commodity prices, and dovish sentiments from global central banks, leveraged loans showed a nice bounce in both March and April, finishing the three-month period nearly 5% higher. According to comments in a PIMCO commentary, spreads for leveraged loans compressed, and it was the lower rated CCC loans that outperformed the higher quality brethren. Commodity focused sectors were also strongly higher, with loans in the materials sector gaining more than 11%, while energy names rose by more than 10% in April, as commodity strength lessened the risk of default. Still, it remains underwater for the past twelve months, with a modest 0.3% drop.
Even with this recent rebound, I remain cautious in this space. While it is possible we may see the U.S. Federal Reserve move rates higher over the summer, recent jobs numbers have disappointed, pushing the likelihood a bit further down the road. Still, even if the Fed does move, many of the loans in the portfolio are subject to rate floors, meaning we may not see the benefit of a higher Fed rate for some time. Further, the underlying investments are essentially, short term, high yield investments, which tend to carry a higher level of risk than more traditional fixed income investments. I expect to see higher volatility in the space for the near to medium term. Another concern I have in this space is liquidity as these investments tend not to be as liquid as higher quality government and corporate issues.
Combined, these factors indicate that this is not a core fixed income investment for most investors, and should only be considered by those accepting a higher level of risk. Barring a continued rebound in commodities, I don’t envision this, or similar ETFs moving sharply higher in the near to medium term, but some gains are likely. I also expect higher than normal levels of volatility to persist in the space. That said, this remains my top pick in the category. I believe it to be the best option for those investors looking for a floating rate ETF in their portfolio.
iShares Canadian Short Term Bond Index ETF (TSX: XSB) – Short term bonds underperformed in the period, as stability in the commodity sector put upward pressure on Canadian short term rates. For the three months ending April 30, the yield on the Canada two-year bond rose from 0.42% to 0.68%, while the Canada five year finished the period at 0.87%, up from 0.67%. Despite this bump, XSB managed to end the period modestly higher.
Going forward, this remains my top short term pick for volatile times, given its mix of government and investment grade corporate bonds. While I believe the BMO Short Term Corporate Bond Fund (TSX: ZCS) will do marginally better over the long term, given its higher yield, XSB has higher slightly higher quality holdings and is expected to hold up better in periods of uncertainty on a flight to safety type trade. Further, the exposure to government bonds will also lessen concerns around liquidity, compared to a more corporate credit focused ETF. If downside protection is the most important factor for your short term bond exposure, I believe this is a great ETF for that. If you’re looking for a stronger total return profile, then ZCS would be expected to do better over the long term.
PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) – This rules based ETF is built using a process that rates and ranks the Canadian universe of stocks on key fundamental factors including sales, cash flow, book value, and dividends. The stocks are each ranked by the four fundamental measures, which results in a total score for each company. They are then ranked by their scores from best to worst, and the top 100 or so make up the ETF. Stock weights are determined by the fundamental score, with the better ranked stocks making up a higher weight in the ETF. There are no constraints on sector weights, which is where I begin to get a little worried about this particular ETF. This has resulted in very high concentration in the financials and energy sectors, which combined make up nearly 65% of the portfolio. I can be comfortable with this level of concentration for more specialized mandates, it worries me on a more broadly focused ETF.
The counterargument to my concern is that these are the sectors that are currently exhibiting the favourable valuation criteria, so over the long run, it should not be an issue. Again, I am on board with that from a theoretical standpoint, but as we saw through most of 2015, with energy selling off dramatically in conjunction with the free fall in oil prices, this ETF struggled, falling nearly 10% over the year. However, this year, with some semblance of stability appearing to return to the energy markets, it has rebounded sharply, recovering substantially all of the drop of 2015. So far this year, it has risen by nearly 13%, and for the three months ending April 30, it gained nearly 15%. Even with this rise, the valuation levels remain rather attractive when compared to its peer group. Further, looking at the forecasted growth numbers, they remain very strong, making this a reasonably compelling ETF from a pure numbers perspective.
I have had this ETF UNDER REVIEW for the past quarter or two, and it remains there for now. I believe that it should do as well as a traditional cap weighted index over the long term, the level of concentration within the index remains a concern. It has the potential to result in periods of higher than average volatility. Further, I expect that volatility levels will remain higher than normal for the near term. In the interim, I will continue to monitor the ETF for increasing concentration and any further erosion in the risk reward metrics.
First Asset Morningstar Canadian Momentum ETF (TSX: WXM) – With an underweight in energy, materials and financials, this momentum focused ETF underperformed during the three months ending April 30. The portfolio itself is an all cap mandate, with nearly 60% invested in mid cap and small cap names and the balance in large caps. It is fairly concentrated, holding roughly 30 names. Even with the growth tilt, the valuation levels are roughly in line with the broader market. If we factor in the projected growth rates, which are fairly strong, given the momentum mandate, the portfolio becomes even more attractive.
Still, I would be reluctant to use this as a core holding for all investors. The main reason is the small and mid-cap focus give it a bit of a higher total risk profile than a more large-cap focused ETF. Still, for those with a higher risk tolerance, it could be used as a core holding, and for other investors, I see it as a great return enhancer to an otherwise well diversified portfolio.
iShares U.S. Fundamental Index ETF (TSX: CLU) – Like the PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) highlighted earlier, this ETF is constructed using the same fundamentally driven, rules based process, ranking stocks on a number of key fundamental criteria. There are a couple key differences between the two, the first being that the selection universe is U.S. traded companies. Another difference is this ETF holds roughly 1,000 individual names, ten times that of its Canadian counterpart. The concentration issue that is prevalent in the Canadian fundamental ETFs is not seen in the U.S. versions. While there is still an overweight in energy and financials, the combined weight is roughly half that of PXC.
As in Canada, the market rewarded the higher quality, better valued, fundamentally sound names, with CLU gaining an impressive 8.8% compared with 6.8% for the market cap weighted iShares Core S&P 500 Index ETF (CAD Hedged) (TSX: XSP). Most of this excess performance can be attributed to its higher exposure to energy, with Exxon and Chevron being the biggest contributors on a year to date basis. The valuation levels are certainly more appealing than the cap weighted XSP, however the forward looking growth estimates favour XSP. Over the long term, I expect this ETF to deliver comparable returns to XSP, but with modestly lower levels of volatility, resulting in slightly better risk adjusted returns. Still, I would likely favour XSP based on its cost, with an MER of 11 basis points, compared with 0.73% for CLU.
iShares MSCI EAFE Minimum Volatility Index ETF (TSX: XMI) – In most markets, low volatility ETFs have performed as advertised, outperforming the traditional cap based indices when markets fall. This ETF has broken that trend, falling 5.3% in Canadian dollar terms while the MSCI EAFE Index was down 3.9% during the same period. Much of the underperformance can be attributed to its healthcare and technology names, many of which struggled in the past few months. Another concern I have with this ETF is that like other low volatility offerings, its valuation numbers are very stretched relative to the broader market and other international equity ETFs, yet its holdings have a lower level of forward looking growth expectations. Given that, I am expecting to see underperformance over the near to medium term while valuation levels catch up with the underlying fundamentals. If you are comfortable sacrificing upside potential for better than average downside protection, this may be something to consider. However, if you are looking for a stronger balance between downside protection and growth potential, you may want to consider one of the other international offerings such as BMO MSCI EAFE Index (C$ Hedged) (TSX: ZDM).
iShares Gold Bullion ETF (TSX: CGL) – With gold continuing its rally, this was the strongest performing ETF on the focus list for the three months ending April 30. For the period, it gained more than 15.6% and is up more than 17% on a year to date basis. Much of this has been the result of a number of countries adopting a negative interest rate policy, with investors looking for a safe haven store of value. Further, the U.S. dollar had also been under some pressure, which also tends to support bullion. However, a few weeks ago, after U.S. Federal Reserve Chair Janet Yellen hinted strongly that a rate hike in June was on the table. This caused a surge in the U.S. dollar, and not surprisingly a modest selloff in gold. On Friday, June 3, U.S. job numbers were dramatically below expectations, which saw the prospect of a June bump in rates fade dramatically, causing the U.S. dollar to drop and gold to rally.
With the probability of a June increase now very remote, I expect that we could see a continued rally in gold. This ETF is a good way to gain exposure to gold. 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.
BMO Global Infrastructure Index ETF (TSX: ZGI) – Infrastructure names continued to struggle, with ZGI posting a very modest 0.3% drop in the three months ending April 30. This despite the strong rebound in the energy sector, which makes up nearly 40% of this fund. As we look forward, the outlook for infrastructure continues to improve. Economic growth globally appears to be more balanced, and many nations are now posting positive, albeit modest levels of growth. Global central banks also remain very accommodative with their monetary policy, which should prove to be a positive to many infrastructure names. Further, a number of countries, a great example being Canada, have had governments step up to the table with announced infrastructure spending. We are also seeing some stability return to the energy markets. Still, there is much uncertainty in the sector, and until that begins to settle, we may see further bouts of above average volatility. I remain cautious on infrastructure in the near term, but see the longer term outlook as quite strong. In the ETF space, this remains my top pick.