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Despite volatility returning to the equity markets with a vengeance, most held up relatively well in September and October. A notable exception was the Canadian equity markets, which saw the iShares S&P/TSX Capped Composite Index (TSX: XIC) fall by 4% for the three months ending October 31. The main reason for the drop was the big selloff in the energy sector, which plummeted by more than 17% on the deadly combination of higher supply and weaker demand.
Selling pressure has continued, and really picked up steam in the last couple days of November, after OPEC failed to deliver a cut to oil production, keeping their production cap set at 30 million barrels a day. With little expected to spur demand, the price of crude plummeted, closing at $66.15 on November 28, down nearly 18% on the month, and down by 33% so far this year. Many expect the price to drop even further.
One consequence of this precipitous drop in oil has been the fall in the Canadian dollar. It closed November at $0.8751 US, down slightly on the month. Many experts believe that if oil prices remain low, we could see the dollar test the $0.85 level, something we haven’t done since 2009.
One benefit to the weaker dollar is it makes our exports more competitive compared with our neighbors to the south. Also, it will help to put a little extra cash in our pockets, with gasoline prices also expected to drop. Unfortunately, it is also likely to put upward pressure on the cost of many imports.
While the lower oil price may hurt a good chunk of the Canadian economy, it can be viewed as a positive for the U.S., Europe, China and Japan, all of which will benefit. In the U.S., the lower prices will help to keep input prices in check. The other nations are expected to benefit because they tend to import most of their energy needs
Looking at the other regions, valuations in Europe appear to be the most attractive, however, there are still many issues surrounding economic stability. While there is hope that the European Central Bank’s stimulus measures will help spur a rally, to date, nothing has materialized. The emerging markets also continue to struggle. While the near term looks a little muddy, the longer term outlook remains solid. It isn’t so much a matter of if we go back into the emerging markets, but when, and what is the best way.
Despite its elevated valuations, the U.S. remains my favoured region for equities. The economy continues to improve, which helps to justify the higher valuations. To help manage valuation risk, I am focused more on fundamental ETFs. They remain more attractively valued, which should help to protect the downside if we encounter a selloff.
Within fixed income, I continue to remain cautious. High yield valuations have settled a bit, bringing them back to a neutral positioning in my outlook. With upward pressure on rates likely in the New Year, I favour investments that are conservatively positioned. Short term and tactical funds are favoured over those that simply provide exposure to the index.
Additions
BMO Monthly Income Fund (TSX: ZMI) – This invests in a basket of income focused ETFs issued by BMO. At the end of October, slightly more than half the portfolio was invested in high yielding equities, which is in line with its 50/50 fixed income / equity target mix. To be included, an investment must have a higher yield than the S&P/TSX Composite. The high yielding BMO Canadian Dividend ETF was the largest holding, coming in at around 14%. Other equity holdings include U.S. dividends, Canadian banks, utilities, and REITs. There is also a well-diversified fixed income sleeve, providing exposure across the bond landscape. Each July and January, the ETF is rebalanced and the model re-run to make sure it is in line with its objectives. Costs are reasonable, with an MER of 0.62%. It pays a monthly distribution of $0.053 per unit, which works out to an annualized yield of approximately 3.8% at current prices. It is a bit more volatile than the iShares Diversified Monthly Income Fund (TSX: XTR), but thus far, the additional returns have more than offset the higher risk. I see this as a decent, one ticket solution for those investors seeking a low cost, reasonably well-diversified income focused portfolio.
Deletions
None
ETFs of Note
PowerShares Tactical Bond ETF (TSX: PTB) – With yields likely to start moving higher in the next few quarters, it is likely the traditional bond indices will be hit harder than actively managed funds that can tactically shift their asset mix according to the conditions. This PowerShares offering is a hybrid between an active and passive strategy, investing in a mix of fixed income ETFs offered through PowerShares and other providers. Each month, Invesco’s Global Asset Allocation team examines the environment, and increases or decreases the underlying holdings to best position the portfolio. I believe that this ETF offers a great one-ticket solution for those looking for diversified fixed income exposure. It can serve as a core bond holding within a well-diversified portfolio. Given its makeup, I expect that it will hold up better than XBB when rates start to grind higher.
BMO Low Volatility Canadian Equity (TSX: ZLB) – I have to admit I was rather impressed with the way this low volatility fund held up during the selloff. Between September 1 and October 15, the S&P/TSX Composite dropped by more than 11%. During that same period, ZLB was down only 3.2%. Even more impressive is that on the way back up, the low volatility ETF outperformed the broader market by a substantial margin. While this is noteworthy, I don’t believe this type of outperformance in rising markets is sustainable. While it is only a six week period, I am very encouraged that the low volatility fund performed as advertised. A rare feat in today’s hype driven world.
iShares International Fundamental Index ETF (TSX: CIE) – Markets are not always rational, and sometimes, even though valuations may appear more compelling, underperformance happens. That’s pretty much the case with this fundamentally constructed offering, which sank by 3.65%, underperforming both the index and category. Still, with a portfolio that is built using four valuation metrics; sales, cash flow, book value and dividends, I expect it to outperform on a risk adjusted basis over the long term. Given that it will look different from the index, I would expect some periods of short term volatility. If you can stomach the short term pain, I think you’ll be rewarded over the long term.
PowerShares U.S. Fundamental Index ETF (TSX: CLU) – Despite a more attractive valuation profile, this fundamental ETF lagged the two cap weighted ETFs for the quarter. When building the portfolio, the U.S. equity universe is ranked and weighted on four key fundamental factors. They are book value, cash flow, sales, and dividends. The companies are scored, and the top 1000 names make up the index. In addition to the more favourable valuation profile, it tends to skew toward mid-cap names. The sector mix is also rather different, with about a third of the fund in cyclical names, compared with 30% in the S&P 500. This positioning should put it in a better position as the economy continues to grow. While we may see momentum continue to drive the overvalued names higher, over the long term, I believe that the more attractive valuations will allow this ETF to outperform on a risk adjusted basis over the long term.
BMO Global Infrastructure ETF (TSX: ZGI) – One of the more interesting investment themes for the past few years has been rebuilding the world’s crumbling infrastructure. This ETF looks to capitalize on that by investing in companies that are involved in the development, ownership, or management of infrastructure assets such as energy, pipelines, bridges, airports and toll roads. It holds approximately 50 names, and not surprisingly, it is heavily concentrated in energy and utilities. It tracks the Dow Jones Brookfield Global Infrastructure North American Index, which means that the majority of the holdings are large, well-capitalized companies. A benefit to this is they tend to generate meaningful dividends for investors. At the end of July, the dividend yield of the underlying holdings was 3%, which is higher than the broader global equity market. It passes some of this along to investors through a regular quarterly dividend, which has been $0.145 per quarter per share so far this year. I like this over the iShares Global Infrastructure ETF (TSX: CIF) because it has shown a more favourable risk reward profile at a lower cost. I believe the near to medium term outlook for infrastructure remains strong, and ZGI is a great way to gain exposure. While volatility may be lower than the broader equity markets, I would still treat this as a sector fund and limit exposure in a portfolio.