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ETFs of Note
Invesco Senior Loan CAD Hedged ETF (TSX: BKL.F) – It was a tough period for BKL.F, falling 2.2% between October 31 and January 31. In fact, of all the bond ETFs on our Focus List, this was the only one that ended in negative territory. Loans, along with all risk assets struggled in the last two months of the year as investor worries over trade and the potential for a slowing economy weighed on sentiment. Despite the loss, the ETF managed to outperform the other floating rate ETFs because of its higher quality portfolio. It invests in the 100 largest and most liquid loans in the U.S.
Over the past few months, I have been speaking with several bond managers and a few have expressed concern that an ETF or mutual fund structure may not be the best structure for a leveraged loan investment. Their rationale is that there is a significant mismatch in the settlement period between the ETF and a levered loan investment. ETFs settle two days after the trade is placed, while a leveraged loan may take upwards of twenty days to settle. Their concern is a significant run on the ETF may cause a liquidity crisis in the underlying investment portfolio.
We spoke to Invesco about this, and they noted there are several safeguards in place to prevent such a liquidity crisis. First, the ETF tends to hold approximately 5% in cash. While this may be a short-term drag on performance, it can provide sufficient liquidity to fund redemptions in most situations. Second, the ETF may hold up to 10% in more liquid short-term high yield bonds which can be converted to cash in a day or two. Third, the Managers have arranged a line of credit of up to one-third of the net asset value of the portfolio which can be tapped in such an emergency.
Given these safeguards, I continue to have a very high level of comfort around this ETF and see it as a strong way to reduce duration exposure when used in a well-diversified portfolio, with one caveat: an investor in this ETF should have a longer time horizon, as the loan asset class is more exposed to the credit cycle and potential for an economic recession given the higher debt levels of its borrowers.
iShares Core Canadian Universe Bond Index ETF (TSX: XBB) – With market volatility on the upswing in the final months of the year, traditional fixed income performed very well. This core offering from iShares was up 3.8% between October 31 and January 31, one of the strongest performers in the period. A key reason for the strong showing was its significant exposure to government bonds. At the end of January, the ETF had 72% in government bonds and 28% in corporate bonds. In volatile markets, government bonds have historically outperformed as investors seek a safe haven refuge from the wild market fluctuations. I expect we will see volatility higher than in 2017 and the first half of 2018, making government bonds a great defensive holding in a portfolio. Another factor to consider is the recent economic data has been mixed but is indicating a slowdown in overall economic activity. If this trend holds, it is expected the Bank of Canada will not be raising rates in the near term. In fact, we are now starting to hear predictions that the Bank’s next move on rates will be a rate cut. With rates on hold or lower, combined with yields now at higher levels than a year or so ago make holding government bonds a somewhat attractive option. This ETF provides meaningful exposure to government bonds, but still has some exposure to corporates for higher yield potential. Another factor to consider is this is one of the largest and most liquid bond ETFs in Canada with an MER of 13 basis points making it a great ETF to consider.
Invesco Canadian Dividend ETF (TSX: PDC) – This dividend focused ETF ended the period up 5.6%, making it the best performer on the Focus List. However, the ride was anything but smooth, falling by nearly 6% in December trailing the broader market only to bounce back nicely in January with an 8.8% rise. The main reason for this was its exposure to the energy sector, which sat just north of 30% at the end of January. Enbridge and TransCanada were strong contributors to performance, both surging higher in the past couple months. Banks and utilities have also been strong contributors. I continue to like this ETF for a few reasons. It offers a very attractive yield of 5%. Valuation levels and other fundamentals look attractive. Finally, given where we are in the economic and market cycle, I expect that dividend focused ETFs have the potential to provide better risk adjusted returns based on yield and fundamentals. With a Management Fee of 0.50% it remains an attractive option for investors and I continue to use it as a core Canadian equity holding in many of my ETF focused portfolios.
iShares Core S&P 500 Index ETF (TSX: XSP) – The S&P 500 has historically been one of the most difficult indexes to beat on a consistent basis, and this ETF is designed to track that index. While I appreciate that the iShares U.S. Fundamental Index ETF (TSX: CLU) looks more appealing from a fundamental perspective, I believe the liquidity profile of the underlying holdings, combined with the momentum of the U.S equity markets make this a more attractive ETF. In my models, I am using the unhedged version, XUS, which provides the same exposure but with unhedged exposure to the U.S. dollar. My rationale is the U.S. dollar has historically rallied in periods of market volatility as investors seek a safe haven. Given my defensive outlook, I am looking for that downside buffer. However, of late, many economists have noted the U.S. dollar appears to be overvalued and may weaken. If that were to occur, the fully hedged XSP would be the better choice. However, for now, with the potential for volatility to remain high, I will continue to hold XUS as I believe the benefit of the downside protection outweighs the risk of loss from a depreciating U.S. dollar.