.
Download PDF Version of this Report
.
Additions
Vanguard Canadian Short Term Bond Index ETF (TSX: VSB) – This TSX traded ETF provides exposure to a portfolio of Canadian government and corporate bonds, that have a maturity that ranges between one and five years. It looks to track, on a net of fee basis, the performance of the Barclays Global Aggregate Canadian Government/Credit 1–5-year Float Adjusted Bond Index. The index is weighted by market capitalization.
Credit quality is high, with more than 55% of the fund rated AAA, 25% rated AA, and the balance A or BBB. Approximately 70% is invested in government or agency debt, with the balance being in corporate bonds. From a maturity perspective, nearly 30% comes due within one to two years, with the balance pretty even spread between the other yearly maturity buckets. This works out to an average maturity of 2.9 years, and an average duration of just 2.8 years. Geographically, it invests only in Canadian issues. The average yield to maturity is a mere 1.1%. With a management fee of 0.10%, the resulting MER is 0.11%, once taxes and other expenses are taken into account.
On balance, this looks rather similar to the iShares Canadian Short Term Bond Index (TSX: XSB). While the underlying indices on which they are based are slightly different, the resulting asset mix, credit quality, and duration profile are very similar. The differentiator is the cost, with Vanguard offering an MER that is 17 basis points lower than the 0.28% MER of XSB. It is the cost differential which has caused me to replace XSB with VSB on my ETF Focus List. I believe that the lower cost profile will provide it a better chance at outperforming XSB over the long term, particularly in a flat or rising rate environment, where a higher fee will create more significant headwind.
As we enter the latter part of the year, the outlook for short term bonds remains muted. Many are expecting the U.S. Federal Reserve will look to move rates higher in the next few months, but it is unlikely the Bank of Canada will follow suit. This means that short rates here are likely to remain lower for longer. That said, short term bonds can still be an excellent way to reduce overall volatility within a portfolio. With their shorter duration, they are less sensitive to movements in interest rates, making them a good way to lower your overall duration exposure. Also, they tend to be much less volatile than medium and long-term investment grade bonds, making them solid choice for very conservative investors. And with the higher credit quality offered by this ETF, it is also likely to benefit from periods of market volatility on a flight to safety trade if we see any periods of extreme uncertainty in the equity markets.
While this is a great pick for the very conservative investor, I continue to favour the BMO Short Corporate Bond Index (TSX: ZCS) for those with average or higher risk tolerance, mainly because of its higher yield to maturity and lower duration. Combined, this should allow ZCS to outperform in a flat or rising rate environment.
Deletions
iShares Canadian Short Term Bond Index ETF (TSX: XSB) – This has been an excellent short term bond ETF for many years, and remains one today. However, with an MER of 0.28%, it is considerably more expensive than what is available with the Vanguard Canadian Short Term Bond Index ETF (TSX: VSB), which is a very similar offering. With both ETFs having a portfolio with a nearly identical credit quality, sector mix, duration profile, and yield to maturity, the lower cost will provide the potential for better returns over the long term. This is particularly so with rates expected to remain quite low in Canada for the foreseeable future.
If you already hold this ETF, you may be better served to just hold on to it, depending on the size of your investment and what your transaction costs would be. However, if you’re looking to make a new investment in a short term bond ETF, I’d suggest you consider either ZCS or VSB depending on your situation.
ETFs of Note
iShares Canadian Universe Bond ETF (TSX: XBB) – With a sluggish economic growth environment, muted inflation expectations, and investor worries over Brexit, bond yields remained under pressure, pushing bond prices higher. The yield on the Government of Canada ten-year bond fell from 1.50% in April, to 1.03% in July, while long bonds saw yield drop from 2.06% to 1.69%.
As we look ahead, the rate environment is expected to remain challenging. It appears as the U.S. Federal Reserve is setting the stage for a rate hike in the fall or early in the new year, while Europe and Japan are now living with negative interest rates. This divergence may make bond investing difficult in the near term, and more volatility is expected. Even if we do see rates move higher in the U.S., barring a sharp recovery in oil prices, the growth outlook for Canada remains somewhat muted. This should help to keep some level of support under bond prices.
With rates likely on hold in Canada for the near term, this ETF provides an excellent way to gain exposure to the broad bond market. The yield to maturity sits at approximately 1.74%, which is a good estimate of expected return if we see rates hold steady. However, with a duration of 7.7 years, it is fairly sensitive to movements in rates, so if we see a move higher, this ETF will be under pressure. As we see the potential for stronger economic growth, we may want to take some measures to reduce the overall level of interest rate sensitivity, and look at some of the shorter term or more corporate focused ETFs on the list.
PowerShares Tactical Bond ETF (TSX: PTB) – This tactically managed bond portfolio provides investors with exposure to a dynamic mix of Canadian government, investment grade corporate, and real return bonds, as well as U.S. high yield bonds. Managed by the Invesco Global Asset Allocation team based in Atlanta, they review the economic environment and outlook on a monthly basis, and will adjust the asset mix based on this view. It invests in a mix of PowerShare and other Canadian traded ETFs.
At the end of July, it was somewhat conservatively positioned with more than 43% invested in the short-term focused PowerShares 1-5 Year Laddered Investment Grade Bond ETF (TSX: PSB). It also held about 27% in long-term government bonds, 13% in high yield, 10% in real return bonds, and around 6% in emerging market debt.
It was the strongest performing fixed income ETF on this list this period, thanks largely to a strong showing from the long-term government bonds, which handily outpaced the broader bond market. Emerging market bonds were also a strong contributor in the period. The significant allocation to short term bonds was a headwind, muting overall gains.
As we move into a challenging period for fixed income, I like that this ETF is tactically managed. I believe that having a manager tilting the portfolio based on market conditions will go a long way in helping better navigate the potentially difficult environment. Further, with allocations to high yield and emerging market bonds, it is likely to deliver a yield to maturity that is much stronger than a more traditional fixed income ETF. At the end of July, the yield to maturity was sitting at 2.36%, which is well above the 1.74% offered by XBB.
The biggest drawback to this ETF is cost, with an MER of 0.52%, which is higher than XBB. Still, all things considered, I see this as a solid pick for the long term, particularly if we see a bump in the volatility of the rate market.
PowerShares S&P/TSX Composite Low Volatility ETF (TSX: TLV) – Low volatility funds and ETFs continue to generate strong interest with investors, and as we head into the most volatile period of the year, I would expect that trend to remain in place. What’s not to love about low volatility funds? They have shown that they can deliver decent returns with better downside protection when markets get rough.
With a gain of 6.80% over the three months ending July 31, this was one of the stronger performing Canadian equity ETFs on the Focus List. In comparison, the S&P/TSX Composite Index rose by 5.30%. While impressive, the main drawback to many of the low vol products is investors have bid valuations up significantly. For example, according to Morningstar, the BMO Low Volatility Canadian Equity ETF (TSX: ZLB) trades at a price to earnings ratio of 22.9, and the iShares Edge MSCI Minimum Volatility Canada ETF (TSX: XMV) trades at more than 19.5 times. The broader market trades at around 17 times earnings. At these extended valuation levels, generating above average returns will become increasingly difficult.
Turning to this low vol ETF, TLV is more reasonably valued, trading at a P/E of around 15. The main reason is its sector positioning. Compared with other low vol ETFs, it has less exposure to the consumer defensive, technology, and utility sectors, all of which are trading at very elevated multiples. Further, it has about a third of the fund invested in real estate, which is trading at levels well below the broader market. The forward looking growth forecasts also look more favourable, making TLV the most attractively valued low vol Canadian ETF right now.
Given the more favourable valuation and growth outlook, I continue to favour TLV as my pick for the Canadian low vol space. That said, I continue to favour more actively managed investments, as I feel they are better suited for Canadian equity exposure at the moment.
PowerShares FTSE RAFI Canadian Fundamental ETF (TSX: PXC) – With a modest 4.17% gain for the three months ending July 31, this fundamentally weighted ETF lagged many of its peers. This was largely due to the significant exposure to energy and financials, two sectors that underperformed in the period. For the three months, financials gained approximately 1.25%, and energy rose by a little more than 1%. Combined, these two sectors make up nearly two-thirds of the portfolio, creating a modest headwind for the ETF.
Looking forward, the ability of this ETF to outperform will be dependent on two things. First will be the rebound in the energy market. While some stabilization has occurred, we would still need to see a further rebound in prices for there to be significant growth in the sector. Financials are also somewhat affected by energy, but also by interest rates and the housing market. If we see any signs of trouble, banks may be sold off by investors. Even with those potential headwinds, the forward looking earnings estimates look strong, particularly when compared to the other ETFs on the Focus List.
Even with the stronger growth estimates and more attractive valuation, I remain cautious with this ETF in the short term, mainly because of the sector concentration. It is even more concentrated than the broader markets, which creates a greater risk over the short term. I continue to favour more actively managed investments for Canadian equity exposure in the current environment.
Vanguard MSCI U.S. Broad Market (C$ Hedged) ETF (TSX: VUS) – This ETF looks to provide exposure to the full spectrum of the U.S. equity market. Three quarters is invested in large cap names, with about 18% invested in mid-caps and 9% in small caps. It was this small and mid-cap exposure that helped it outpace its peers during the three-month period ending July 31, with these names outperforming handily. During the period, the Russell 2000 gained more than 8% in U.S. dollar terms.
But it is also this small and mid-cap exposure that is pushing the valuation levels up compared with the S&P 500. As a result, I continue to favour the iShares Core S&P 500 (CAD Hedged) ETF (TSX: XSP) for the near to medium term.
First Asset MSCI Europe Low Risk Weighted ETF (C$ Hedged) ETF (TSX: RWE) – In the months, and perhaps even years following the Brexit vote, many are expecting that volatility levels within the Eurozone to remain higher than normal. This ETF is a great way to gain exposure to the Eurozone, but in a more risk measured manner. To do this, it invests in the 100 least volatile stocks in the MSCI Europe Index, with the least volatile names getting the biggest weight in the index. Currency exposure is fully hedged, and it is rebalanced quarterly.
It is large cap focused, but the market cap does tend to skew a bit smaller than other Europe focused ETFs or the index. Sector mix is also rather different, with an overweight to the traditional low vol sectors including consumer discretionary, industrial, real estate, and utilities. Despite this, valuations appear to be more reasonable than other low vol ETFs, and when compared to more traditionally constructed indices.
Performance has been decent, but has lagged those ETFs that are focused on dividends or high quality stocks. Over the long term, I would expect this to deliver solid returns with below average volatility, and better downside protection. With an MER of 0.66% it is not cheap, but given the potential downside protection, I believe the higher cost may be worth it, particularly as we enter a period of potentially higher volatility. This is not for everyone, as I believe most investors can gain their European exposure through an EAFE or more global focused fund or ETF. But for those more risk averse investors looking for pure European exposure, this may be just the ticket.
Vanguard FTSE Emerging Markets All Cap ETF (TSX: VEE) – In a recent outlook piece, the BlackRock Investment Institute upgraded emerging market equities to overweight. Their rationale was that emerging market equities are well positioned to benefit from an increase in global growth expectations, and the lower for longer interest rate environment. Further, they note that investor appetite has been increasing, with significant inflows into emerging market mutual funds and ETFs since February. They also state that Asian investors have begun to rotate out of fixed income investments and are moving into equities, providing further support. From a valuation perspective, emerging markets are trading at a significant discount to developed markets from a forward earnings multiple perspective, and they expect that fundamentals could improve further, as companies focus on controlling expenses and improving profitability, rather than on increasing market share.
While the timing may be uncertain, and emerging market investing is not without risks, the medium to longer term outlook does look fairly compelling. While investors who have a more moderate risk tolerance may want to avoid the area, those with a healthy risk appetite may want to start looking at the region.
This Vanguard offering is my pick mainly for its lower cost. It tracks the FTSE Emerging Markets All Cap Index, which provides exposure to companies of all sizes in the emerging market countries.