ETF Recommended List Review

With volatility returning to the markets, caution is warranted with a renewed focus on quality

As we entered into 2012, our expectation was that markets would remain volatile for a number of reasons including the ongoing uncertainty coming out of Europe, worries over the health of the U.S. economy and concerns of an economic slowdown in China and other emerging markets. During the first quarter, many, including ourselves, were caught off guard as volatility was virtually nonexistent. Investors put the European debt crisis on the backburner and instead focused on the signs of improvement that were coming out of the U.S. This resulted in strong gains in global equity markets and bond markets were largely down.

Then, almost at the stroke of midnight on the first day of April, things changed and volatility reemerged with a vengeance. In the first quarter there were some positive steps towards controlling the European debt crisis. In the first days of April, it all began to unwind, first with a ratings downgrade on Spanish bonds and then uncertainty caused by election results in a number of countries, most notably France where Francois Hollande, an anti austerity candidate won over Nicolas Sarkozy, and in Greece, where the parties were unable to form a coalition government. This did not sit well with investors who quickly sold off equities and returned to the safe haven of government bonds.

There were also signs that China, which has been a key driver of commodity prices, is experiencing a more severe slowdown than previously expected. This will likely result in continued weakness in commodity prices as demand continues to slow.

We expect that this volatility will remain in place for the foreseeable future. It is our view that investors should continue to be relatively defensive. For those with a medium to long term time horizon, we are favouring high quality, dividend paying large caps over more cyclical small cap names. However, for those with a higher risk tolerance, there may be some short term opportunities in the small and mid cap space after their recent pullback.

From a country perspective, we prefer the U.S. over Canada. Much of the Canadian growth story will be dependent not only on the U.S., but also China and how the economic recovery unfolds in those two countries. Europe is currently in the throes of a recession and we expect high levels of uncertainty and volatility to remain firmly entrenched for the next several quarters.

For fixed income investments, it is our expectation that the days of high single digit returns are gone. We are now expecting fixed income to be modestly positive. We are no longer looking to fixed income investments to be a major source of investment returns over the medium term, but instead are looking for fixed income to act as a volatility buffer in periods of uncertainty. For the safe haven appeal, we like high quality government and corporate bonds.

Interest rates are expected to move higher, but likely not until next year. That said, we do favour a shorter duration over a longer duration in the near to medium term as a way to help protect invested capital. For those with a higher appetite for risk, there may be some opportunities to generate modest returns within the high yield space.

During the quarter, we did not make any additions or deletions in our ETF Recommended List.

Ratings Changes

iShares Canadian Dividends Aristocrats Index (CDZ) – This recently renamed offering was formerly known as the Claymore S&P/TSX Canadian Dividend ETF. It is designed to replicate the S&P/TSX Canadian Dividends Aristocrats Index which includes only those stocks with a market capitalization that is over $300 million, and which have increased their dividends for at least five consecutive years. The portfolio is currently made up of about 60 names. Performance has been strong, outpacing not only the broader S&P/TSX Composite Index, but also the majority of its peer group. We see this as a great way to access high quality, large cap dividend paying stocks, which we believe will outperform over the long term. We upgraded this ETF from HOLD to BUY.