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Additions
iShares S&P/TSX Small Cap Index ETF (TSX: XCS) – The iShares S&P/TSX Small Cap Index ETF provides exposure to a diversified portfolio of Canadian small cap stocks. It replicates a market cap weighted index that holds more than 200 individual positions, with the top ten making up under 15% of the portfolio. While it may be diversified on an individual security basis, it is more concentrated on a sector basis, with energy and materials representing more than half the ETF. Given the sector mix of the Canadian market, I don’t expect that this composition will change dramatically in the near term. The index and ETF are rebalanced quarterly.
The average market capitalization is significantly smaller than iShares S&P/TSX Completion Index ETF (TSX: XMD) coming in at $870 million compared to nearly $5 billion for the Completion index.
The Management Fee is 0.55%, which is identical to XMD.
The main reason for including this on the ETF Focus List is its earnings and valuation outlook. Forward looking earnings look to be in line with the mid-cap index, however the valuation is considerably more attractive. There is a higher level of risk associated with this ETF over XMD, but I believe the valuations make this a more attractive opportunity over the medium to long-term.
Truthfully, in the Canadian small cap space, an investor is often better off using an actively managed fund than an ETF. Some of my favourites in the space include CI Cambridge Pure Canadian Equity or the IA Clarington Canadian Small Cap. A drawback to these funds is they tend to run higher market caps and carry a higher price tag with MERs well north of 1%. However, I believe the risk adjusted return profile more than offsets this higher cost. That said, if an investor is very cost conscious and looking for Canadian small cap exposure, I believe this can be a workable option for the medium to long term, given the valuation differential offered over mid-caps. But be warned, this has the potential to be volatile, and should only be used as a modest piece of a well-diversified portfolio.
Deletions
iShares S&P/TSX Completion Index ETF (TSX: XMD) – The main reason I am removing this ETF from the ETF Focus List is I believe that XCS offers a more compelling valuation and growth outlook for the medium to long-term now. Both offer cap weighted exposure to Canadian stocks, however, this trades at a higher level of valuation. As market volatility increases, I believe that valuation will become increasingly more important to investors. In the near-term however, investors may continue to favour the more richly valued growth names.
Further, this ETF invests in stocks that are in the S&P/TSX Composite Index that are not part of the S&P/TSX 60 Index. Meaning if you held this and the iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC), there would be significant stock overlap between the two, resulting in higher correlations and less effectiveness as a portfolio diversifier.
As mentioned above, I am a firm believer in using actively managed products for exposure to Canadian small and mid-cap stocks. The inefficiency of the market lends itself to sustainable outperformance from managers who are willing to roll up their sleeves and do the work necessary to uncover high quality, well managed, sustainable companies with the potential to add value over the long-term. Investors willing to pay the higher price for active management are more likely to be rewarded with stronger risk adjusted performance in an active fund than with a lower cost, passive small or mid-cap ETF.
ETFs of Note
PowerShares Senior Loan CAD Hedged ETF (TSX: BKL.F) – With interest rates moving higher south of the border, combined with continued tightening in credit spreads, floating rate loans had a strong showing compared with more traditional fixed income indices. These loans pay a rate of interest that is tied to a prevailing broader interest rate, usually LIBOR. Over the period, the three-month LIBOR rate moved from 1.77% to end the month at 2.35%. Most of the floating rate loans will reset their interest rate every 90 days. Looking at BKL.F specifically, the days to reset is sitting around 25 days. This higher coupon rate helped generate returns over the period.
In a rising yield environment, floating rate instruments can be an excellent way to protect against the potential damage caused by higher rates. With it likely the U.S. Federal Reserve will increase rates one or more times before the end of the year, there will be continued pressure on interest rates across the full yield curve.
This ETF provides exposure to the 100 largest, most liquid loans issued, making it an excellent way to access the asset class. Not necessarily the cheapest way to play the space, it does offer diversified exposure and is, at least in my opinion, one of the least risky ways to access the space.
That said, floating rate loans are not without their risks. In recent years, there have been a significant amount of new floating rate loans issued, and not all of it being of exceptional quality. As the broader economy starts to slow down, some of these newly minted loans may become delinquent or in some cases become in default, which may create potential volatility down the road. This ETF is partially protected from that because it invests in only the 100 largest, most liquid loans. While it is partially protected, it is not fully immune because if we encounter a situation where investors run into liquidity issues with lesser quality, smaller loans, they may be forced to sell their higher quality liquid loans to raise capital. That could result in higher volatility if we see a crisis. However, it will likely be a short-term phenomenon as the higher quality loans will also be the ones expected to bounce back the quickest.
I am not expecting any breakdown in the credit markets any time soon, but the way the markets reacted to the recent Italian government troubles has highlighted that there is still risk in many fixed income issues and we are very late in a credit cycle. I remain aware, but not concerned in the near term, and am looking to move to become more defensive over the coming months and quarters as the economy peaks.
PowerShares Tactical Bond ETF (TSX: PTB) – This was the worst performing fixed income ETF on our Focus List over the period, falling by 0.63% while the broader Canadian bond market rose by more than 0.40%. PTB is a tactically managed ETF that invests in a basket of other bond ETFs, providing diversified exposure to the bond market. It is repositioned monthly.
During the period it was dragged lower by its exposure to emerging market bonds and high yield bonds, both of which have been under pressure. Also, with interest rates pressing higher, the long-term bond exposure was another headwind that combined resulted in a disappointing three-month performance.
At its May rebalancing, the duration was reduced, lowering the overall sensitivity to higher interest rates. More than 60% is invested in the PowerShares 1 – 5-year Laddered Investment Grade Corporate Bond ETF (TSX: PSB). It also marginally increased its exposure to long-term government bonds, which is anticipation of higher volatility in the equity markets. When equity markets get rocky, long-term government bonds tend to benefit on the flight to safety trade. High yield exposure is very modest at just under 10% of the portfolio.
I really like the theory and simplicity of this ETF, offering a “just add water” fixed income solution. However, periods like we recently experienced highlight the potential downside, where if the managers get it wrong, the ETF may perform much differently than the broader market. However, that risk is also one of the potential benefits where when the managers get it right, they are likely to outperform their more passive peers. As we head into an environment where volatility is likely to remain higher than we’ve recently become accustomed, I would prefer a team watching things and adjusting the portfolio as necessary, rather than relying on issue size as the determinant of portfolio positioning.
Costs are a little higher than I would like them to be, but they are less than you can get from an F-Class mutual fund in most cases. All things considered, this remains a solid pick for those looking for a one-ticket fixed income solution for a challenging market environment.
First Asset Morningstar Canadian Momentum ETF (TSX: WXM) – Research has shown that momentum has been one of the strongest factors driving outperformance in the Canadian equity markets. This ETF is designed to capture that by replicating the Morningstar Canada Target Momentum Index, which provide exposure to companies whose share price has performed well in the recent past. The index uses a rules-based approach that first screens for liquidity, looking for the 250 most liquid names that trade on the Toronto Stock Exchange. The stocks are then scored and based on several momentum factors including return on equity, estimate revisions, earnings surprises and price change over a few different periods. The top 30 names make up the index and the securities are all equal weighted. There are controls in place around sector exposure to ensure there is proper diversification across industry sectors. The index is rebalanced and reconstituted on a quarterly basis.
What I like about this process is there is a significant weight assigned to the return on equity component, helping to ensure there is a reasonable level of profitably and quality, rather than just investing in a basket of high momentum names. I believe this “quality” screen can help to better manage risk and keep volatility reasonably well contained.
Given the recent moves in the market, it is not surprising to see the portfolio overweight in technology and consumer names which have been on a tear lately. It is underweight financials, healthcare and utilities. As a result, the valuation levels are higher than the broader market and the peer group but the forward-looking growth rates far exceed the benchmark, more than offsetting the richer absolute valuation levels. The average market cap is also much lower than the broader market. At the end of May, the average market cap was approximately 30% that of the S&P/TSX Composite Index.
All things combined, this is an excellent way to access momentum stocks in the Canadian market. However, it should be noted that I don’t view this as a core holding, but rather an addition to the equity sleeve of an otherwise well diversified portfolio
iShares Core S&P 500 Index ETF (CAD Hedged) (TSX: XSP) – The S&P 500 has been one of the best performing equity markets for the past couple of years, driven largely by the FANG stocks (Facebook, Amazon, Netflix, and Google). It has also been one of the most difficult market indices to outperform over history, given the market efficiency of the U.S. stock markets. For those looking for exposure to U.S. large cap equities, this ETF is one of the best ways to gain that exposure. It is very well priced with a management fee of 10 basis points resulting in an MER of 11 basis points. This compares very favourably to even the most attractively priced active U.S. equity mutual funds available.
This version provides fully currency hedged exposure. There is another version, XUS which provides unhedged currency exposure. In the past quarter, I have been favouring it (XUS) given my view that the U.S. dollar is likely to continue to strengthen relative to the loonie. I still subscribe to that view and expect to see modest appreciation in the greenback in the next few months. I believe that the Fed will be able to push interest rates higher at a pace much quicker than the Bank of Canada. Further, with trade wars looming and equity markets at elevated valuation levels, there exists a reasonably strong case for further dollar appreciation. Historically, when equity markets sell off sharply, there is a rise in the U.S. dollar, which reduces the loss for unhedged investors. The rise in the value of the currency helps to partially offset the losses from the equity holdings. Given this, I am using XUS in my portfolios to help mitigate against this potential volatility. As we see the U.S. dollar rising, it may be prudent to begin to move some of the U.S. equity exposure to the fully hedged XSP to lock in the currency gain.
Regardless of your view on the currency, these two ETFs are excellent ways to access low cost, passive, core exposure to U.S. equities.
iShares S&P/TSX Capped Financials Index ETF (TSX: XFN) – Despite posting strong earnings numbers and offering very attractive valuation levels, Canadian financials have underperformed the broader market. To the end of April, the S&P/TSX Composite Index is down 2.8%, while the Financials index is lower by 4.3%. There is no one factor that is responsible for this lag but many are pointing to a slowing Canadian housing market, higher levels of consumer debt, rising interest rates, and an overall worry on the state of the markets as being some potential causes.
Strip away the bigger picture issues and look deeper into the fundamentals of the sector, and the outlook is not nearly as grim. Bank profits have held up very well in the latest earnings period and in most cases outperformed expectations. With U.S. President Trump injecting uncertainty into the markets at every opportunity thanks to an America First trade policy, worries over the state of the Canadian economy remain high. However, the Canadian economy continues to hold up well with strong employment numbers, rising wages, and modest economic growth. Debt levels are high but have remained largely flat over the past couple years, indicating that Canadians are not digging themselves into a deeper hole and debt remains manageable. Finally, the dividend yield offered by many of the banks is higher than the broader market. The yield on XFN is 3.7% compared with 2.9% for the S&P/TSX Composite Index.
Putting it all together and the outlook for financial stocks is positive, and this ETF provides an excellent way to access the sector in a highly liquid, reasonably priced manner.