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Additions
First Asset MSCI Europe Low Weighted ETF (Hedged) (TSX: RWE) – The outlook for European equities remains mixed, but still somewhat positive. This is thanks to the increasing probability the European Central Bank (ECB) will take additional stimulus measures to help spur the moribund economy. Further, lower energy prices and a weakening Euro help to provide an underpinning of support. We are seeing business confidence improving, and according to consulting firm EY, investment and consumer spending is expected to improve in the next few quarters. This is not without risks, as recent terror attacks in Paris have the region on high alert, and high debt levels from some EU members remains a concern.
While it might be a bit early to step into direct European equity exposure for many people, those with a higher appetite for risk may want to consider it. One interesting way to get some exposure to the region without taking on the full risk of the market would be to use this ETF. It provides exposure to the 100 least volatile stocks in the MSCI Europe Index. Stocks that have a lower level of variance are given a higher weight within the index, while those with higher volatility carry a lower weight. Currency exposure is hedged, which will help protect against any adverse movements in the value of the Canadian dollar. The index is rebalanced on a quarterly basis.
Given the selection methodology, the portfolio looks somewhat different than the MSCI Europe Index. Company size tends to skew a little smaller, with an average market cap that is about two-thirds that of the index. Sector weights are also different, with this ETF holding overweight positions in more defensive sectors such as real estate, consumer staples, industrials, and utilities.
While the ETF is relatively new, launched in early 2014, back tested data going back to 1999 shows this risk weighted index would have significantly outperformed the broader MSCI Europe Index over the past three, five, and ten year periods. Over the past year, the ETF outpaced other hedged ETFs, gaining an impressive 14.5%. While this is impressive, what really catches my attention are the risk metrics. According to the back tested data provided, the level of volatility was about two thirds that of the broader European market. Further, it had a down capture ratio of 47%, meaning on average, it only experienced about half the downside of the market, yet was still able to participate in more than 70% of the upside.
Going forward, I would expect that with the potential for higher volatility not only in Europe, but with markets in general, I see this as a reasonably attractive way to access European equities, without taking on a lot of extra risk. I would expect that it will continue to strongly outperform in falling markets, but lag in rising markets. This is a tradeoff I am comfortable making!
Deletions
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ETFs of Note
PowerShares Senior Loan CAD Hedged ETF (TSX: BKL) – It was not a good quarter for riskier parts of the fixed income market, including leveraged loans. For the three-month period ending October 31, BKL dropped 2.07%, lagging its peers, and delivering the worst performance of any fixed income fund on the Focus List. With markets becoming extremely volatile, investors shunned riskier assets, and instead moved into safer haven assets. If nothing else, this loss highlights why floating rate notes and loans should only be a portion of your fixed income allocation, and not as many wholesalers may suggest, a core part of it. Since the summer, floaters have been down, and BKL has now given back all the gains it earned in 2014 and the first few months of 2015. But as they say, past performance is not indicative of future performance, and I believe that to be the case here. The market fully expects the U.S. Federal Reserve will start moving interest rates higher in December, which will be a positive for this ETF. That said, there is no rush to get into this, as many of the loans in the portfolio have rate floors in place, which will limit gains until rates move significantly higher. I don’t expect much of a pop in this fund in the near term, but I do like the longer term outlook with it likely rates will begin moving higher soon.
PowerShares Tactical Bond ETF (TSX: PTB) – This is a tactically managed, diversified bond portfolio that provides exposure to Canadian government, investment grade corporate, and real return bonds, as well as U.S. high yield, and emerging market debt. The portfolio management team will tactically shift the exposure to a number of underlying ETFs in an effort to best position the portfolio for the market. To be blunt, so far, they’ve failed, gaining a very modest 2.55% for the year ending October 31, while the FTSE/TMX Canadian Universe Bond Index has gained 4.43%. The big reason for this underperformance is its exposure to emerging market debt, high yield, and real return bonds. Each of these asset classes has struggled, compared with more traditional, investment grade Canadian bonds.
However, as I look ahead, with rates likely to start moving higher, I would expect this well-diversified, actively managed ETF to hold up better than the more traditional bond ETFs. The team is fairly active in shifting the positioning, making several tactical moves over the quarter. That should certainly help as rate volatility moves higher. A drawback to this strategy is if the management team is not reactive enough in making these changes, any outperformance may be limited.
I continue to watch this ETF closely, and if there is not a sufficient turnaround in performance, it will be removed from the Focus List.
BMO Monthly Income Fund (TSX: ZMI) – At the end of November, the ETF held nearly 60% in income equity ETFs, 37% in corporate bond, and the rest, just over 4% in emerging market debt. For the three months ending October 31, it was down by 2.2%, which while disappointing, did manage to outpace the 60/40 equity / fixed income benchmark. A big key to this recent outperformance stems from its conservative positioning, with nearly 30% in short term bonds, and most of the equity exposure focused on higher quality dividend mandates. It is scheduled to be reconstituted in January, which will see the asset mix shift back towards a 50/50 split, and will also see the short term allocation reduced to a maximum of 20%. This will result in a slight bump in the risk profile, both because of the higher equity exposure and the higher duration. This could be positive if we see a nice rally in equities, but could prove to be a negative in a market selloff. At the end of November, the distribution yield was just north of 4%, generating a nice cash flow for those looking for income. Still, I think this could be a good one ticket solution for smaller investors looking for diversified, income focused exposure. Those with larger portfolios are likely better off building their own, more tailored asset mix.
iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (TSX: CDZ) – This was the best performing Canadian equity ETF on the focus list for the period, losing a very modest 0.2%, while the broader market was down more than 5.7%. With market volatility on the upswing, investors’ attention started to turn to better quality, and higher yielding issues, which this ETF invests in. To qualify for inclusion, a company must have increased dividends for at least five consecutive years. Another thing I like about this ETF is its valuation metrics look more favourable than the broader market, with valuations lower, and a yield that is higher than the S&P/TSX Composite. This should help to offer stronger downside protection if markets remain volatile. It also pays a variable monthly distribution that has ranged between $0.074 and $0.080 per unit, which works out to an annualized yield of around 3.8%. My biggest worry about this is it is an all cap mandate, with a lot of exposure to small and mid-cap names. This could result in periods of above average volatility. Still, I see this as a solid dividend focused offering.
iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC) – Canadian equities have struggled of late, with the S&P/TSX Composite Index losing 5.8% on a total return basis. There were two key factors driving this decline; continued weakness in the energy markets, and Valeant Pharmaceuticals fall from grace. The energy sector was off more than 3.3% as the outlook for oil remains weak. Until we see a stabilization in the energy markets, I expect Canadian equities to remain volatile. Valeant is another story completely. Not too long ago, it was challenging for the top spot on the TSX, with a market capitalization that rivaled RBC. However, in August, many began questioning the sustainability of the firm’s business model, sending shares tumbling precipitously. In early August, it traded at more than $346 a share. It is now trading down around $130 per share, losing nearly two thirds of its value in just a few months. Looking ahead, barring a sharp rebound in price, Valeant isn’t likely to be a major factor that drives the market. The bigger issues will be energy, and the rate of growth in the U.S. I remain cautiously optimistic on both, and am somewhat positive on the medium term outlook for Canadian equities. Valuations appear to be quite favourable, particularly when compared with the expected earnings growth rates. Concentration within the financial and energy sector remains high, and somewhat concerning, but is less troublesome than it was before the energy selloff. Further, it is one of the most cost effective ways to access the space. Combined, these factors make this a solid pick for Canadian equity exposure.
iShares US Fundamental Index ETF (TSX: CLU) – Looking only at the fundamentals of the portfolio, this appears to be the most attractive U.S. ETF on my Focus List. Valuation metrics such as price to earnings, price to book, and price to cash flow are significantly more favourable than either the iShares Core S&P 500 Index ETF (TSX: XSP), or the Vanguard U.S. Total Market Index ETF (TSX: VUS). This is not particularly surprising, given the methodology used to select and weight the stocks in the ETF. Tracking an index constructed by Research Affiliates, it holds the top 1000 U.S. listed companies as ranked by three factors; total cash dividends, free cash flow, and total sales. It also considers book value in the ratings. What this fails to consider is earnings growth, and when this is taken into account, the other two ETFs on the Focus List look to be more attractive. Further, I had hoped the fundamental methodology would result in better risk measures, but unfortunately that has not played out as expected, as its volatility and down capture measures are in line with the others. While I favour the theory of the construction methodology used for this ETF, I prefer the more cost effective cap weighted options XSP or VUS at the moment.
iShares MSCI EAFE Minimum Volatility Index ETF (TSX: XMI) – Low volatility funds are designed to provide returns that are roughly in line with the broader equity markets, but also offer lower volatility, and much stronger downside protection. While there isn’t sufficient history for a lot of these funds, the early results are certainly encouraging. For example, according to Morningstar, for the past three years, XMI has shown a down capture ratio of 21%, meaning it experienced only a fraction of the downside of the broader market. This has resulted in a level of return that is much stronger than what has been experienced with the more traditionally constructed BMO MSCI EAFE Index (TSX: ZDM). One problem I have noted with other low vol funds is the level of valuation is significantly higher than comparable cap weighted ETFs. In the international equity space, that is not the case, with valuation levels of XMI, higher, but not significantly so when compared with ZDM. Things look even more attractive when forward looking growth rates are considered, making this my top international equity pick at the moment, even with the higher MER.
BMO MSCI Emerging Markets Index ETF (TSX: ZEM) – With the slowdown in China, and global demand for commodities weak, the emerging markets have struggled. For the year ending October 31, the MSCI Emerging Markets Index lost more than 14% in U.S. dollar terms. While the recent past is dismal, the medium to long term outlook is more positive. Valuation levels are significantly below historic averages. According to Brandes Investment Partners, the MSCI EM Index was trading at a 24% discount to the historic average, 30% to developed markets, and 35% lower than the S&P 500, based on the P/E ratio. Numbers were similar when comparing P/B and P/CF. This indicates that there is some upside to emerging markets equities. Unfortunately, with the uncertainty hovering over China and commodities, we may see more volatility and downside before things turn around, and the timing of any turnaround is unknown. I am avoiding direct exposure until we get a bit more clarity. Still, I believe this is the best option for passive emerging market exposure.