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ETFs of Note
PowerShares Senior Loan Index ETF (TSX: BKL.F) – One of the appeals of floating rate investments is there is very little duration risk because the interest rate earned on the fluctuates with a reference rate, quite often LIBOR. This makes them an attractive investment in periods of rising yields, and that was certainly the case over the past few months.
For the three months ending January 31, this ETF rose by more than 1.4%, while the FTSE/TMX Short Term Bond Index fell by 0.33%, and the broader FTSE/TMX Canada Universe Bond Index was off nearly 2.7%. The drop in the indices was the result of a rise in yields, which have been quite volatile in the aftermath of the U.S. presidential election. The combination of the U.S. Federal Reserve increasing rates in December, combined with market expectations of Trump’s economic plans likely to result in higher inflation pushed global yields up. In Canada, the benchmark Government of Canada five-year bond saw its yield rise from 0.69%, ending January substantially higher at 1.11%. It was a similar story with other rates, with the three-month LIBOR rate jumping from 0.88% to 1.03% in the same period.
With the underlying reference rate on the rise, so too were the prices of many of the loans in the portfolio. The gain in the portfolio was significantly lower than the rise in the underlying yield in the portfolio. This is because many of the loans had a rate floor in place, meaning the lowest rate the loan would pay was set at a predetermined level. In most cases, this floor rate was set at 1%, so even though there was a sharp rise in the reference rate, the coupon rates on many of the loans wouldn’t start moving higher until LIBOR crossed that 1% threshold. Now that LIBOR is above this threshold, Invesco estimates that nearly 95% of floating rate loans now meet or exceed their rate floor, making them floating rate instruments once again.
Looking ahead, most market participants are expected at least two, maybe even more moves from the U.S. Federal Reserve. Regardless of whether that plays out or not, it is widely expected there will be increased volatility in the interest rate markets. That should prove to be a positive for floating rate products, particularly if we see further upward pressure on yields.
For ETFs, this remains my top pick. It offers broad exposure to floating rate loans, has a yield to maturity of 4.4%, and is available at a reasonable cost. This can be a solid addition to the fixed income sleeve of your well-diversified portfolio.
PowerShares Tactical Bond ETF (TSX: PTB) – This is a tactically managed portfolio that invests in a mix of underlying fixed income focused ETFs. Because of this tactical management, I believe it has the potential to outperform a more traditional passive bond index, particularly in periods of market volatility. That played out in the past three months, with a modest outperformance, losing 2.2%, while the broader FTSE/TMX Canada Universe Bond Index dropped 2.7%.
At the end of January, a little more than half was invested in short term, investment grade bonds, which outperformed the broader market. This helped contribute to the modest outperformance. Also contributing to the return was the high yield bonds, which made up 14% of the portfolio, and was the only sleeve of the portfolio that finished the period in positive territory.
There were a couple of detractors, namely the long-term government bonds, which sold off heavily in the face of rising rates. The modest real return bond holdings were also a significant headwind during the period.
Still, this did what I would expect it to do – outperform in a volatile market. The tactical management from Invesco’s Intactive team is expected to provide risk managed exposure to the various segments of the fixed income market, which can help the fund hold up better in periods of volatility. The drawback to this ETF is how well the team can execute, which so far has been decent, but unspectacular. Performance has matched the broader market over the past three years, with comparable volatility, but has lagged in the past year. Another drawback to this ETF is its cost, which carries an MER of 0.52%, compared with 0.13% for Vanguard’s Aggregate Bond Index ETF (TSX: VAB). Still, I see this having the potential to outperform in a volatile market, helping to more than offset its higher cost.
PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) – This has been one of the better performers for the past couple quarters. With a gain of 7.15% for the three months ending January 31, it handily outpaced the broader market and its peer group. For the year, it has gained 33.8%, more than 1000 basis points above the S&P/TSX Composite.
Instead of weighting its holdings ETF based on the market capitalization of the underlying companies, as is the case with most traditional passive ETFs, the holdings are weighted based on how they are rated on four key fundamental factors; cash dividends, free cash flow, sales, and book value. Each company is rated on each of these factors, and the scores are totaled. Those companies that score the best are given a larger weight in the portfolio than those that rank poorly. This will result in a mix that is much different than the broader market, with significantly more attractive fundamentals.
That is certainly the case today, with the portfolio offering a very compelling valuation picture, trading at a price to earnings ratio well below the index or the peers, with a dividend yield that is also more attractive. The sector mix is significantly overweight to the three main sectors of the market; financials, energy, and materials. It is underweight industrials, and consumer names. The portfolio is also more weighted towards large cap stocks than the index, carrying an average market capitalization of nearly double the S&P/TSX Composite Index.
Apart from a few blips along the way, the longer-term performance numbers have been decent. To the end of January, the five-year annualized return was 9.2%, compared with 7.5% for the S&P/TSX Composite Index. Volatility has been a bit higher than the broader market over the past three years, which has resulted in it lagging on a risk adjusted basis.
The research has shown that over the long-term, a fundamentally built portfolio can outperform a cap weighted index. There may be shorter term periods where it lags. I don’t dispute the research, but I do have a couple of concerns around the ETF. The first is the level of concentration. The Canadian equity market is already heavily concentrated in three sectors. Combined, financials, energy, and materials make up nearly 65% of the index. In this ETF, those three sectors make up nearly 80%. While the fundamental factors may prove to be correct, that is a fairly concentrated bet in those sectors. For those comfortable taking that bet, this is a good way to play the Canadian equity market. However, those worried about concentration may want to look elsewhere.
Another concern I have is the cost. It carries an MER of 0.51% compared with just 0.06% for the iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC). To date, that additional cost has been more than offset by the incremental return, the higher cost may be a drag in a flat or falling market environment.
On balance, this is a solid choice, but you need to be comfortable with the concentration in the portfolio. It has a fairly high degree of cyclicality in the portfolio at the moment. Over the long term, I expect it to pay off, but in the short term there is the potential for higher levels of volatility.
iShares U.S. Fundamental Index ETF (NEO: CLU) – On February 21, 2017, this was delisted from the Toronto Stock Exchange, and began trading on the Aequitas NEO Exchange on February 22. The Aequitas NEO Exchange was founded in March 2015 and is owned by a group that includes OMERS Capital Markets, Barclays Corp, and Royal Bank of Canada.
What exchange it trades on does not affect its underlying investment portfolio. It will still look to replicate the performance of the FTSE RAFI U.S. 1000 Index, an index that was built based on fundamental factors, rather than market cap. The factors used to determine the underlying portfolio are dividends, free cash flow, sales, and book value. The stocks are scored on these factors, and then ranked based on their relative attractiveness, with the more attractive names making up a larger portion of the index.
While I don’t expect this change to have a marked impact on the ETF, I will continue to monitor it to ensure there is ample liquidity and trading volume.
For the three months ending January 31, it performed very well, and was the best performing U.S. equity ETF on the Focus List. It gained 8.9%, compared with a rise of 7.8% for the S&P 500. Unlike its Canadian counterpart PXC, the longer-term numbers aren’t quite as impressive. For the past five years, it has gained 13.4%, while the index rose by 13.6%. Further, the volatility of CLU has been roughly in line, although a touch higher than the broader market.
While there is a strong case for fundamental indexing, I still see the cap weighted S&P 500 as the best way to get your U.S. exposure. This is particularly the case given the cost differential. XSP carries an MER of 0.11% while this fundamentally weighted ETF costs 0.73%. If there was a lower fee, this would be an even more attractive offering. Still, it provides the potential to beat or exceed the benchmark over the long-term with comparable levels of volatility.
iShares International Fundamental Index ETF (NEO: CIE) – On February 21, 2017, this ETF was delisted from the Toronto Stock Exchange, and began trading on the Aequitas NEO Exchange on February 22. The Aequitas NEO Exchange was founded in March 2015 and is owned by a group that includes OMERS Capital Markets, Barclays Corp, and Royal Bank of Canada.
What exchange it trades on does not affect its underlying investment portfolio. The ETF will still look to replicate the performance of the FTSE RAFI Developed ex-U.S. 1000 Index, an index that was built based on fundamental factors, rather than market cap. The factors used to determine the underlying portfolio are dividends, free cash flow, sales, and book value. The stocks are scored on these factors, and then ranked based on their relative attractiveness, with the more attractive names making up a larger portion of the index.
While I don’t expect this change to have a marked impact on the ETF, I will continue to monitor it to ensure there is ample liquidity and trading volume.