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ETFs of Note
PowerShares Senior Loan CAD Hedged ETF (TSX: BKL.F) – After the Bank of Canada caught most of the market by surprise with their abrupt about face on interest rates back in June, there has been much upward pressure on Canadian rates, particularly at the short end of the yield curve. During the period, global and high yield bonds were the best performers, but on our ETF Focus List, it was this ETF, which provides exposure to 100 large, liquid, senior floating rate loans that led the pack.
These loans pay a rate of interest that floats with a market interest rate, usually LIBOR. In most cases, this coupon rate is reset monthly, essentially eliminating duration risk. The days to reset is 20 days, meaning that on average, the coupon paid will change every 20 days.
These loans are typically non-investment grade, or unrated credits that are often well-collateralized with seniority in the capital structure, providing protection against potential defaults. At the end of August, about 21% was in BBB- rated bonds, 75% in non-investment grade, and only 4% in unrated issues.
While the bias for yields in Canada is likely to be higher in the near term, south of the border the rate outlook is more muted. In a flat environment, I wouldn’t expect to see significant capital gains from these types of securities, but rather would expect to see a rate of return that is more in line with the coupon rate. As of August 25, the coupon yield of BKL.F was listed at 4.18%, with an MER of 0.81%.
Another benefit is floating rate investments tend to have low correlation to the more traditional asset classes, making them a strong diversifier when incorporated in a well-diversified portfolio.
Currency exposure is fully hedged, which has proven helpful in the recent months, when we have seen the Canadian dollar rise sharply against the greenback after the Bank of Canada raised rates. Currency has been a very significant headwind for any investments that have unhedged currency positions.
In the ETF space, I see this as the most attractive option. Given the complexity of the asset class, I would most likely lean towards an actively managed offering, with the IA Clarington Floating Rate Income Fund (CCM 9944 – F Class), managed by Jeff Sujitno being my top pick.
Vanguard Canadian Short Term Bond ETF (TSX: VSB) – Historically, short-term bonds have been thought of as a fairly safe place to park funds and reduce interest rate sensitivity of a portfolio. However, the past few months have shown that while the risks may be lower than a more traditional bond investment, there is still a potential for loss.
Short-term yields started feeling pressure in June, after the Bank of Canada made comments, hinting that a rate hike was an almost sure thing at the July meeting. Yields jumped higher, and continued to rise until the July meeting, and closed on July 31 sharply higher. The yield on the Canada two-year bond was 0.70% on May 1, and closed on July 31 at 1.30%, a jump of more than 85%. Not surprisingly, this hurt the short end of the yield curve, with the FTSE/TMX Short-Term Bond Index falling by 1.2%, with most of the damage occurring in June. The markets had bounced back nicely in August, and had largely settled, however saw another drop after the Bank of Canada rate hike in September.
Despite this recent selloff, short-term bonds can still play a key role in a more conservative portfolio and this Vanguard offering is currently my top short-term bond ETF pick. It is designed to track the performance of the Bloomberg Barclays global Aggregate Canadian Government / Credit 1 – 5 Year Float Adjusted Bond Index. Costs are very reasonable, with an MER of 0.11%. It should be noted, that BlackRock recently cut the management fee on the iShares Core Canadian Short-Term Bond ETF (TSX: XSB) from 0.25% to 0.09%, which is expected to increase returns. We will review the effect of that change in the coming quarters.
The portfolio holds about 70% in government issues, 28% in corporates, and the rest in other. It offers a modest yield-to-maturity of 1.8%, which is just below the 1.9% offered by XSB. The duration is listed at 2.8 years, which is the same as XSB. Credit quality is extremely high, with less than 1% being unrated.
Given the recent fee cut by BlackRock, combined with the higher yield-to-maturity, I will be taking another look at XSB in the coming quarters. If there is a noticeable increase in the risk reward metrics, I will likely switch the two ETFs on the Focus List.
PowerShares S&P/TSX Composite Low Volatility ETF (TSX: TLV) – One of the key selling points of low volatility funds is they are designed to outperform in flat and falling equity market environments. That certainly held true in the most recent period. For the three months ending July 31, the broader S&P/TSX Composite was down by 2.1%, while this low vol offering was lower by 1.5%, despite an MER of 0.34%.
This ETF invests in the 50 least volatile stocks in the S&P/TSX Composite Index with the stocks with lower volatility making up a higher weighting. It is rebalanced on a quarterly basis. The portfolio looks different from the broader index, with a significant overweight in real estate, telecom and utilities, and underweights in energy, and materials. A concern about this portfolio would be concentration, as financials and real estate make up a combined 54%. Another difference in the portfolio is it skews a bit more mid-cap than the index with 51% in mid-caps, compared with 22% for the TSX.
A knock on low volatility funds a few quarters ago was that valuation levels were high when compared to the broader equity markets. That has been largely corrected, and many low vol funds now trade at levels that are more attractive than the index. At the end of August, Morningstar listed the price to earnings ratio at 15.2 times, compared with 16.6 for the S&P/TSX Composite. Other valuation ratios, including price to book, and price to cash flow were also more attractive. The growth picture is a touch more muted than the broader index, but given the more attractive valuation levels, I believe this is more than offset.
Considering the above, this remains my top pick for those looking for low volatility Canadian equity exposure.
iShares Core S&P 500 Index (CAD Hedged) ETF (TSX: TLV) – The S&P 500 continues to be one of the most difficult market benchmarks to beat, and this period was no different. Of the U.S. focused ETFs on our List this was the strongest performer, gaining 3.75%, handily outpacing the iShares U.S. Fundamental Index (CAD Hedged) ETF (NEO: CLU) which rose by 2.74%.
Much of this outperformance can be attributed to XSP’s greater exposure to some of the key market drivers, namely Apple, Amazon, Facebook, Netflix, and Microsoft. Combined, these five names contributed nearly half of the outperformance of XSP over CLU. While recent performance of these stocks has been very strong, valuation levels have become stretched making a repeat very unlikely. Even factoring in the above average growth rates, the valuation levels do not appear sustainable. This is likely to result in a pullback or a period of below average gains, while fundamentals catch up to valuations.
Even still, this remains my top pick for U.S. equity exposure. While its valuations look modestly better, the growth outlook for CLU is muted compared with either XSP or the Vanguard U.S. Total Market ETF (CAD Hedged) (TSX: VUS). I slightly prefer XSP over VUS because VUS has a greater exposure to small and mid-cap names, which may be prone to higher levels of volatility at this point in the market cycle.
In the past, I have mentioned XUS which has the same investment exposure as XSP, without the currency hedge in place. While this may have been a decent option in the past, I would be hesitant to invest now with it likely the interest rate paths in Canada and the U.S. will continue to diverge, creating further strength in the Canadian dollar. As the dollar continues to gain, XUS will start to become a more attractive option to capture any weakening in the Canadian dollar while still maintain excellent U.S. equity exposure.
BMO MSCI EAFE Index (CAD Hedged) ETF (TSX: ZDM) – It’s hedged currency positioning was a key reason this ETF was the top performing International / Global ETF on our Focus List. While this ETF gained 2.4%, ZEA, which provides the identical investment exposure, but with the currency unhedged was down by 2.6%.
In the near term, with the Bank of Canada more likely to raise rates than the U.S. Federal Reserve, I expect there is a strong potential for further appreciation in the Canadian dollar, making hedged currency preferable. Given that, this is my top international / global ETF.
iShares S&P/TSX Capped Financials ETF (TSX: XFN) – With the aftermath of the Home Capital scandal looking as though it is in the rearview mirror, at least for now, financial stocks rebounded, with XFN gaining 0.55% for the three months ending July 31. While this is respectable, the sector still hasn’t fully recovered from the selloff experience in March, April, and May.
Now that the dust has settled and we now see this was only an isolated incident and not endemic of a larger problem we can again focus on the factors that drive profitability. There is some concern about the broader housing market. Recent government actions have helped to cool, at least temporarily some of the markets that were overheating. In time, this can be a good thing and help the sector realize a soft landing. Further, with Canadian interest rates starting to move higher, margins at many of the banks are expected to improve. Comparing the sector to the broader Canadian market, valuation, profitability, fundamental, and growth metrics all look stronger for financials. Further, the dividend yield is superior, with a current yield of 3.65%, compared to the S&P/TSX Composite, which yields a more modest 2.96%. All this points to an attractive medium to long-term outlook for the financial sector.
I would not use this as a core equity holding, but instead would suggest it be used as a part of an otherwise well diversified portfolio.