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Additions
Vanguard Canadian Aggregate Bond Index ETF (TSX: VAB) – This TSX traded ETF provides broad exposure to the Canadian bond market. It is designed to track the Bloomberg Barclays Global Aggregate Canadian Float Adjusted Bond Index, net of fees. The index is cap weighted and holds investment grade government and corporate bonds of Canadian issuers.
It is rather like the iShares Canadian Universe Bond Index (TSX: XBB), but there are some differences. The first is VAB has a higher exposure to government bonds than XBB. VAB holds around 80% in government bonds, which is equally split between provincial and federal/agency debt. In comparison, XBB holds 70% in government debt, with a very slight tilt towards federal/agency debt. Because of this, the average credit quality is higher with VAB. A drawback is the interest rate sensitivity is higher. The duration of VAB is 7.8 years, compared to 7.3 years for XBB. In practical terms, this means VAB is likely to be hit modestly harder in the event of a bump in yields. Given the market volatility of the past few weeks, this has played out as expected, with XBB dropping by 2.05% in November, while VAB was down 2.18%.
Much of this drop was the result of expectations that the U.S. Federal Reserve would step up and increase overnight rates at their December meetings. A few bond managers have noted they now believe the majority of this rate hike has been priced into bonds, and no further increases are expected until mid-2017. In Canada, it remains likely the Bank of Canada will keep rates steady for the foreseeable future. Volatility in the rate market is expected to remain high, but they are not likely to move significantly in one direction or the other.
In this environment, expected returns become muted, and costs matter. The MER on VAB is listed at 0.13%, compared with 0.34% for XBB. For that reason, I am replacing XBB with VAB on my ETF Focus List. I believe that over the longer term, the lower cost will more than offset the higher volatility, and greater interest rate sensitivity, and allow for VAB to provide a slight level of outperformance relative to VAB.
As we move forward and the pace of economic growth picks up in Canada, the potential for higher yields will also increase. As that occurs, investors may want to take steps to reduce the overall interest rate sensitivity of their fixed income holdings. To do this, investors may want to consider increasing their allocation to short term bonds, corporate and high yield bonds, or looking towards a high quality, actively managed bond fund that allows the manager the ability to adjust sector mix, credit quality and duration positioning based on the outlook. These can help reduce the headwind that will be created as bond yields rise.
Deletions
iShares Canadian Universe Bond Index ETF (TSX: XBB) – This has been an excellent Canadian broad market bond ETF for many years, and remains one today. However, with an MER of 0.34%, it is considerably more expensive than what is available with the Vanguard Canadian Aggregate Bond Index ETF (TSX: VAB), which is a similar offering.
Both ETFs invest in a broad mix of Canadian government and investment grade corporate bonds. XBB offers a slightly lower duration, and a higher yield to maturity, but my analysis shows that over the long term, any advantage gained from this will be offset by the higher cost. Thus, I am removing it from the ETF Focus List.
ETFs of Note
Vanguard Canadian Short Term Bond ETF (TSX: VSB) – The period between July 31 and October 31 was rather interesting for this short-term focused ETF. During this time, the ETF lost 0.27% in market value, yet gained 0.22% on a net asset value (NAV) basis. On a market value basis, it also dramatically underperformed its peers. The reason for this is somewhat complicated. Over the summer, the ETF realized fairly large inflows, which resulted in the market price of the ETF trading at a significant premium to the underlying net asset value. In the month of August, as fund flows normalized, this significant premium corrected, resulting in underperformance on a market value basis. The returns of the net asset value tracked the underlying benchmark reasonably well.
This also highlights one of the more complicated aspects of investing in ETFs. There may be short term periods where the market value fails to accurately track the true value of the underlying investments. This can happen to the positive, resulting in the ETF trading at a premium to NAV, or it can underperform, resulting in it trading at a discount.
This can occur with any ETF, and the phenomenon is usually rather short lived. Over time, the premiums and discounts tend to shrink, and most of the well-managed, liquid ETFs tend to track their indices fairly closely. Investors must be aware that these situations can occur. The best way to minimize the likelihood is to avoid purchasing an ETF that is trading at a significant premium to its NAV. You will also want to make sure that you trade smart, and use limit orders to get the ETF at a price that makes sense, rather than going with a straight market order.
Even with this blip in performance, VSB remains an excellent ETF for investors looking for low cost exposure to a diversified portfolio of short term Canadian government and corporate bonds.
iShares Diversified Monthly Income ETF (TSX: XTR) – For investors looking for a simple, low cost, diversified income generating ETF, this iShares offering pays investors a regular monthly distribution that has been set at $0.05 per month. At recent prices, this works out to an annualized yield of approximately 5.3%.
The focus is heavily tilted towards Canada, which makes up more than 71% of the ETFs exposure. Nearly a quarter is invested in the U.S., with the balance being cash and “other”.
Portfolio turnover has been very modest on a historic basis, so the asset mix is not expected to change dramatically from one quarter to another.
At the end of November, the asset mix was nearly 60% in fixed income, and 40% in equity investments. The equity sleeve is heavily tilted towards higher yielding ETFs including the iShares S&P U.S. Dividend Growers Index (TSX: CUD), iShares S&P/TSX Equity Income Index (TSX: XEI), and iShares Canadian Select Dividend ETF (TSX: XDV). It also has direct exposure to REITs and Utilities. This results in a high level of interest rate sensitivity, which has been a drag on the portfolio in the recent months. The U.S. Dividend, REIT and Utilities exposure has detracted from returns in recent months.
Turning to the fixed income sleeve, it is a rather diversified mix that includes exposure to corporate, high yield, government, and short term bonds. The average credit quality is high, averaging BBB, and the duration is well below the market, coming in at 4.35 years. In comparison, the broader Canadian bond market has a duration of 7.4 years. This lower duration will result in slightly less sensitivity to interest rates, but it is still highly dependent on rates.
With the U.S. Federal Reserve poised to move rates upwards at their December meeting, it is very likely we will see continued high levels of volatility in interest rates, including those here in Canada. This will translate into potentially higher levels of volatility for this ETF, and its underlying constituents, making for a bumpy ride for investors.
I am typically not a fan of prepackaged balanced funds, as I believe most investors and advisors can do a better job in creating their own. That said, for those looking for simplicity and a one ticket solution, this isn’t a bad option. Costs are reasonable, with an MER of 0.56%, it offers an attractive distribution yield, and it is fairly well diversified. The drawback is the high level of interest rate sensitivity, and the potential for increased volatility as we move into a more uncertain interest rate environment.
Horizons Active Canadian Dividend ETF (TSX: HAL) – Managed by Sri Iyer and his Systematic Strategies team at Guardian Capital, this ETF looks to find Canadian companies that have the ability to pay, sustain, and grow their dividends. To find these, the team runs the Canadian equity universe through screens that analyze 31 different factors, looking for positive rates of change. These factors focus on growth, payout ratios, efficiency, valuation, and investor sentiment. Further, the team will conduct a fundamental review to validate any of the potential buy candidates to ensure the rating is appropriate.
The portfolio is well-diversified, holding around 60 names, with the top ten making up just under 30% of the ETF. It invests in companies of any size. Roughly 45% is invested in big cap names, with the balance invested in small and mid-caps. The sector mix is dramatically different than the broader Canadian market, with an overweight in consumer cyclicals, utilities, telecom, and energy. It is significantly underweight both financials and energy. Despite this overweight to the higher yielding sectors, valuation metrics look more attractive than the broader market and the peer group.
This positioning has led to decent outperformance in the short-term, but over the long term, it has lagged the S&P/TSX Composite Index. Volatility numbers have been in line with the index.
Going forward, the managers remain defensive. They are placing a greater emphasis on companies that offer higher earnings and cash flow visibility, and higher than average dividend yields. This would be expected to allow for better downside protection if we see a large pullback in the market.
I like the process used by the management team. It has resulted in a portfolio that I believe is better diversified than the broader Canadian market. The drawback is its cost, with an MER of 0.79%, which is well above the 0.06% MER of the iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC). Even with this higher cost, I believe the ETF has the potential to deliver index like returns with better downside protection.
First Asset Morningstar Canadian Momentum Index ETF (TSX: WXM) –The ETF is founded on the premise that outperforming stocks tend to continue to outperform, and looks for stocks that have above average returns on equity, upward earnings estimate revisions, and strong technical price momentum indicators. In the first few years after its launch, performance was very strong, handily outpacing the broader market and many of its peers. More recently, this trend has shifted, and it has lagged. Year-to-date to the end of November, it has gained 6% while the S&P/TSX Composite has risen by more than 19%. So what has changed?
Nothing has fundamentally changed with the ETF. A few things hurt it over the past year. It’s technology, materials and financial names were subpar. It’s underweight in the hot energy and materials sector was also a headwind. And finally, poor stock selection in the mid cap names also hurt.
Looking ahead, this strategy is still expected to do well over the long term, but because of the momentum strategy, there are going to be periods when it dramatically outperforms and dramatically underperforms. Momentum strategies can run into trouble at market inflection points, and I have heard some rumblings from strategist that we may be at or near an inflection point now. That may help explain why we are seeing a period of performance that is out of step with the recent trends.
If I look at the valuation numbers of this portfolio, it appears to be way overvalued. According to Morningstar, it’s trading at a P/E of 23 times, compared with 17 times for the broader market. However, if I look at forward looking growth rates, WXM is forecasting earnings growth of nearly 27% compared to the market of just over 8%. Factoring in the earnings outlook, the valuation metrics are not nearly as out of line as they appear in isolation.
Over the long term, it has been shown that stock prices follow earnings. Short term, it’s all driven by sentiment, meaning it’s possible that more underperformance is imaginable, particularly given the nature of momentum investing. If your time horizon is short, you may want to reconsider your holding of this ETF. If you’re looking longer term, I remain comfortable with and believe it can deliver above average returns with average or slightly above average levels of volatility.
iShares MSCI EAFE Minimum Volatility Index ETF (TSX: XMI) – The whole selling point to low volatility funds and ETFs is they are supposed to hold up better in market drawdowns. Apparently, this ETF missed that memo, dropping 3.3% for the three months ending October 31. This was the worst of any foreign equity fund on the ETF Focus List, and one of the worst in the broader International equity category.
The biggest detractors in performance were in the healthcare sector, including Novartis and Roche. Other detractors included consumer giants Nestle, and Reckitt Benckiser Group.
Even with this selloff, portfolio valuations remain extended, with a P/E ratio of 17.3 times, compared with the MSCI EAFE Index, which trades at 15.2 times. The growth outlook is rather muted, largely the result of its defensive positioning, with overweight allocations to utilities, consumer staples, and healthcare. It is also overweight real estate, which is expected to struggle in the face of potentially rising rates. It has virtually no exposure to energy, which has done well, with the news of a recent OPEC agreement that sets the framework for a production cut that is widely expected to push the price of energy higher.
Considering these factors, I would expect to see continued weakness in this low volatility portfolio. Investors, particularly those with a risk tolerance that is moderate or higher would likely be better off with the BMO MSCI EAFE Index ETF. It is available in two versions; ZDM which has all currency exposure hedged back to Canadian dollars, and the unhedged ZEA. Your outlook in the Canadian dollar will help you decide which of these options is most appropriate for your portfolio.
Vanguard FTSE Emerging Markets All Cap ETF (TSX: VEE) – Throughout the campaign, President-elect Trump talked about making America great again, and has talked of tearing up trade deals. After his election, the much-anticipated Trans Pacific Partnership was put out of its misery. Add to this a rise in populism, increasing protectionism in the U.S. and Europe, a stronger U.S. dollar, and the near-term outlook for many trade reliant emerging market nations has dimmed considerably. I would also expect to see an increase in volatility in the short term.
Despite the weaker near term outlook, the longer-term outlook remains largely unchanged. Many developing nations are undergoing significant structural reforms that will see tremendous growth opportunities. Add to that the valuation levels of many emerging market companies is significantly more attractive than more developed stocks and the medium to long-term outlook becomes more appealing. In this environment, I am downgrading emerging markets from Neutral to Underweight.
For those looking for low cost passive exposure to the emerging markets, this ETF is my top pick. However, given the inefficiencies in the emerging markets, I tend to favour a high quality actively managed mutual fund over a cap weighted passive strategy. Funds I’m liking now include Brandes Emerging Markets Value, Trimark Emerging Markets, and RBC Emerging Markets Equity.
BMO Equal Weight REITs Index ETF (TSX: ZRE) – With the U.S. Federal Reserve all but assured of hiking rates at their December meeting, interest sensitive sectors, including real estate have been hit very hard. Further, expectations are that under a Trump presidency, inflation has the potential to increase at a pace that is much greater than what is being anticipated. This could make it challenging for Canadian REITs who have benefitted handsomely from the low rate environment. Most investors have been viewing REITs as a bond proxy, given the higher yields offered relative to what is available in the fixed income space.
As the tide turns on interest rates, REITs are expected to face growing headwinds. Even if the pace of increases is gradual and measured, we can expect significantly higher levels of volatility in the rate market, which can also have a negative effect on the price of REITs. In this environment, I am starting to favour actively managed real estate funds over the passive options. I will be taking a look at the available options in the coming months. In the interim, of the passive REIT ETFs, this remains my pick, given the equal weighting methodology, which results in a portfolio that offers greater diversification than the cap weighted options.
BMO Global Infrastructure Index ETF (TSX: ZGI) – On the campaign trail, President elect Donald Trump laid out plans to increase infrastructure spending in the U.S. to the tune of over $1 trillion. This is on top of Prime Minister Justin Trudeau’s plan to increase infrastructure spending by an extra $60 billion over the next ten years, bringing the total expected spending to more than $125 billion. Whether all this cash is ever deployed into new projects is another story, but with this kind of commitment, there is certainly a reason to be at least modestly bullish on infrastructure stocks.
The BMO Global Infrastructure Index ETF invests in companies active in the development, ownership, lease, or management of infrastructure assets. It is a cap weighted, passive portfolio that tracks the Dow Jones Brookfield Global Infrastructure North America Listed Index. It is North American focused, with two-thirds invested in the U.S., 22% in Canada, 9% in the UK, and the balance in Mexico and Brazil. From a sector perspective, utilities and energy make up more than 82% of the portfolio.
Performance has been strong, gaining nearly 15% to the end of November. In comparison, actively managed infrastructure mutual funds are lagging by about 1000 basis point. For example, the Sentry Global Infrastructure Fund (Series F) is up 6.4%, while other notable infrastructure funds are up between 5% and 6%. Volatility has been notably higher, but the excess return has more than made up for this.
Perhaps not surprisingly, given the strong performance numbers, valuations look stretched compared with its actively managed brethren. Morningstar reports that the P/E ratio of the portfolio is nearly 29 times earnings, while the other funds are trading between 20 and 27 times earnings. Factoring in modest growth projections, the valuation levels still appear to be stretched when compared to the broader market, but are on the low end of the other infrastructure options.
Costs are reasonable, with an MER of 0.61%. In comparison, an actively managed infrastructure mutual fund will carry an MER of between 1.4% and 1.7% in a fee based version, offering a considerable cost savings. Infrastructure is one of those specialized areas of the market where a high-quality manager should be able to outperform, but to date, the mutual fund options have largely disappointed, making this a solid choice for those looking for infrastructure exposure in their portfolios.