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Additions
iShares Core Canadian Universe Bond Index ETF (TSX: XBB) – The iShares Core Canadian Universe Bond Index ETF is designed to provide broad based exposure to the Canadian investment grade bond market by tracking the performance of the FTSE/TMX Canada Universe Bond Index. The index is very well diversified, holding nearly 1500 individual issues, representing governments and corporate issuers. The ETF uses a sampling process to replicate the index, and at the end of January held more than 1200 issues.
I am adding XBB to the ETF Focus List to replace the Vanguard Aggregate Bond Index ETF (TSX: VAB), which had been my top bond pick for the past year or so. There are a couple of reasons for this change. First, when I added VAB, it carried a management fee that was significantly lower than XBB. Until recently, XBB had a management fee of 0.30%, which resulted in an MER of 0.34%. In May 2017, iShares cut the management fee to 0.09%, which results in a significant reduction in the MER and make the two ETFs more competitive from a cost perspective. Further, the outlook for interest rates has shifted, with further increases expected. XBB has a higher exposure to corporate bonds, which results in a higher yield-to-maturity and lower duration, translating into a modestly lower sensitivity to interest rates.
At the end of January, the XBB had just under 70% in government issues, with the balance in corporate credits. In comparison, VAB had more than 77% invested in governments. XBB had a yield to maturity of 2.7% compared to 2.6% for VAB, and a duration of 7.4 years compared with 7.6 years for VAB. This profile favours XBB in a flat or rising yield environment, which is what is expected in the near to medium term as the Bank of Canada and other central banks look to normalize interest rate policy.
VAB remains an excellent way to gain exposure to the broad Canadian bond market, however, I believe that the cut in management fee combined with the outlook for interest rates makes XBB a slightly more attractive option.
Deletions
Vanguard Aggregate Bond Index ETF (TSX: VAB) – I am removing VAB from the ETF Focus List because I believe that as we head into a potentially more challenging interest rate environment, investors will be better served by the iShares Core Canadian Universe Bond Index ETF (TSX: XBB), which carries greater exposure to corporate bonds, meaning a higher yield to maturity and lower interest rate sensitivity.
XBB tracks the FTSE/TMX Canada Universe Bond Index and VAB tracks the Bloomberg Barclays Global Aggregate Canadian Float Adjusted Bond Index. While they are similar, there are some key differences, with the higher corporate weight in the FTSE/TMX Universe being the biggest.
Historically, VAB had modestly outperformed XBB. For the five years ending January 31, VAB earned an annualized 2.72% while XBB returned 2.69%. Now that XBB has substantially reduced its management fee, it is likely that XBB will outperform VAB because of its lower fee hurdle.
VAB remains an excellent way to gain low cost exposure to the broad Canadian bond market, however, I believe that XBB offers more attractive positioning for the expected rate environment, and the new lower management fee further adds to its attractiveness.
ETFs of Note
PowerShares Senior Loan CAD Hedged ETF (TSX: BKL.F) – With interest rates moving higher in recent months, BKL.F was the best performing fixed income ETF on our ETF Focus List, gaining 0.94% for the three months ending January 31. In comparison, the FTSE/TMX Canadian Universe Bond Index lost 0.43%, while the FTSE/TMX Canadian Short-Term Bond Index was lower by 0.54%. This disconnect comes from the nature of the underlying investments, which are senior secured, floating rate bank loans.
Unlike a traditional bond, which pays a regular fixed coupon, bank loans pay a coupon rate that is reset based on a benchmark interest rate, in most cases three-month LIBOR. If the reference rate moves higher, so too will the interest paid to investors. Conversely, if the reference rate is lower, the return to investors will also be lower. This is opposite to traditional bonds which tend to move in the opposite direction of rates.
Because the coupon payments move in tandem with interest rates, floating rate notes can be an excellent investment in a rising yield environment. They have virtually no duration risk, and because most of the loans tend to be unrated, they offer very high yields. The yield to maturity of BKL.F is listed at 5.1%.
There are some drawbacks to this type of investment, with credit risk and risk of default being the largest. However, these risks are somewhat mitigated by the fact that senior secured loans often rank at the top of the capital stack, meaning they will be paid out first in the event of insolvency. Another potential risk would be lack of liquidity, where they may be few buyers. This is what happened to the space in 2008, when the credit markets encountered short-term issues. However, in 2009, these issues were sorted, and trading returned to normal. Further, by investing in the largest and most liquid loans, the liquidity risk is much less for this ETF than it would be withindividual loans or with active funds or ETFs that invest in off benchmark issues.
The longer-term return numbers have been less than exciting, with a five-year return of 2.46%. However, much of that is the byproduct of being in a low and falling yield environment. With central banks looking to normalize interest rates in the near to medium, it is highly likely we’ll see more upward pressure on yields and overall higher levels of volatility, making floating rate products significantly more attractive than traditional fixed income.
For those looking for a way to reduce their interest rate exposure, but are comfortable taking on some additional credit risk, this is an ETF worth considering.
PowerShares FTSE RAFI Canadian Fundamental ETF (TSX: PXC) – Over the past few quarters, equity markets had largely ignored fundamentals, instead getting caught up in “fun” stories like weed stocks and crypto currency plays. Stocks with no real fundamentals seemed to skyrocket, while higher quality, reasonably valued names just sort of hung around. Low levels of market volatility only exacerbated the situation as many investors seem to have forgotten what a market selloff feels like.
In the past few months, we have seen a slight shift with fundamentals once again starting to matter. It is that shift which allowed the PowerShares FTSE RAFI Canadian Fundamental ETF to have a decent showing for the three months ending January 31. During the period, it rose by 1.4%, outpacing the broader S&P/TSX Composite Index by nearly 100 basis points. Much of this outperformance is the result of its overweight in financial, and underweight in industrials and utilities.
This difference in weightings comes from the way the portfolio is built. Instead of building the portfolio based solely on the market capitalization of a stock, as is done in traditional indexing, fundamental ETFs use factors that are believed to better predict outperformance. These factors include sales, cash flow, book value, and dividends. The main criticism with a traditional market cap weighted index is the potential for overconcentration, as bigger companies take up a disproportionate weight in the portfolio. Fundamental indexing reduces that likelihood, at least at the stock level as position sizes are determined by the fundamental attractiveness.
At the sector level however, the risk of concentration is real, as there are no set limits on sector weights within the ETF. This can result in levels of sector concentration that are as high or even greater than what you would see with a traditional market cap index. For example, at the end of January, the ETF had nearly 65% invested in just two sectors; energy and financials. In comparison, the S&P/TSX Composite Index had approximately 50% in those two sectors.
Theoretically, fundamental indexing should result in a better built, and more diversified portfolio than an index that is simply made up of the largest publicly traded companies in Canada.
From a performance standpoint, while the shorter-term numbers have lagged the broader markets, the longer-term numbers have outperformed the traditional cap weighted index. However, the volatility has also been higher than the broader markets, which has meant that on a risk adjusted basis, the PXC has lagged XIC. I would suspect that much of this higher volatility is the byproduct of the larger exposure to energy.
Looking ahead, I still believe in the theory behind fundamental indexing, and believe that as the overall level of market volatility increases, a fundamentally constructed index is likely to outperform the traditional cap weighted indices. Further, looking at the valuation levels and growth outlook for PXC, it is well positioned to deliver above average growth over the long term.
iShares Core S&P 500 Index ETF (CAD Hedged) (TSX: XSP) – The S&P 500 continues to be a tough bogey to beat, again posting the strongest results in the period, modestly outpacing both the more broadly diversified, cap weighted Vanguard U.S. Total Market (TSX: VUS), and the fundamentally built iShares U.S. Fundamental index (TSX: CLU). A higher weighting in technology, healthcare, and financials, combined with less exposure to small and mid-cap names helped to drive the outperformance. A drawback to this positioning is the valuation levels of the portfolio are modestly higher than the other two ETFs, which may create a headwind as we move forward from here.
The foreign currency exposure of XSP is fully hedged, which has helped its recent performance compared with other U.S. equity funds and ETFs that do not hedge their currency exposure. With it likely the U.S. Federal Reserve will move interest rates more quickly than the Bank of Canada, the U.S. dollar would be expected to continue to increase in value. If that scenario plays out, investors may be better off investing in XUS, which provides the same investment exposure, except that the currency exposure remains unhedged.
With a rock bottom MER of 0.11%, this continues to be the U.S. equity ETF to beat.
iShares MSCI World Index ETF (TSX: XWD) – During the period, this was the strongest international / global equity ETF on our ETF Focus List, with a gain of 3.7%. The next strongest performer was the iShares International Fundamental Index ETF (TSX: CIE), which earned 2.3%. The main reason for the outperformance of XWD compared to the other ETFs on the list is its has nearly 60% invested in U.S. equities, while the others have little, if any exposure to the U.S. During the period the U.S. was one of the strongest equity performers.
Returns were muted because of the ETFs unhedged currency exposure. If the currency had been fully hedged, it may have resulted in approximately 500 basis points or so in additional performance. However, had the Canadian dollar gained ground on the greenback, this ETF would have outpaced one that had fully hedged currency exposure.
While this ETF is on my ETF Focus List, it is only there for smaller, less sophisticated investors who are looking for a “one ticker” global equity ETF. For others, they are better off using a pure U.S. equity ETF (like XSP or XUS), combined with a pure EAFE ETF (such as ZEA or ZDM). This combination will provide a very similar investment exposure at a lower cost. For example, XWD carries an MER of 0.47%. If we were to take 60% of XUS and 40% of ZEA, the combined MER, not including any transaction costs, would be approximately 16 basis points. Over time, this lower fee hurdle will increase the potential return.
Vanguard FTSE Emerging Markets All Cap ETF (TSX: VEE) – Emerging markets continued to outperform developed markets during the three months ending January 31, with China leading the way higher. From a sector standpoint, technology was a leader, as were the commodity sectors, driven by higher crude oil and metals pricing.
Looking ahead, there continues to be a sustained improvement in global economic growth, and within the emerging markets specifically, there is stable to improving numbers being posted throughout Europe and Asia. China has been undergoing a recovery in profitability, and has seen improvements in consumer spending, industrial production, and business investment in the past few quarters. There have also been subtle shifts towards improving the quality and sustainability of growth within China, rather than simply maximizing growth. Elsewhere, economic reform is taking hold in India, and inflation in Brazil is on a downward trajectory. Each of these lays a solid foundation for emerging markets.
Adding to this, valuation levels of emerging markets are well below their more developed peers. For example, the P/E ratio of VEE is listed at 15.3 times, while the iShares Core S&P 500 ETF (TSX: XSP) is carrying a P/E ratio north of 21. Factor in a better than average growth outlook, and the emerging markets story gets even more compelling.
It is not without risks, as the recent tariffs announced by U.S. President Trump have the potential to start a global trade war, which could create a significant headwind for emerging markets that rely heavily on exports. While it is far too early to speculate on how this plays out, the uncertainty of it could see even higher levels of volatility in the near term.
Within the EM space, VEE remains my top pick for low-cost, passive exposure. It offers a broader exposure than the iShares and BMO offering, with just under a quarter of the portfolio invested in small and mid-cap stocks, compared with 8% for BMO and iShares. Over the long-term, this broader exposure would be expected to deliver modestly higher levels of return.
That said, emerging markets is an area where I tend to prefer an actively managed portfolio over a passive portfolio. The reason is there are inefficiencies in the emerging markets that a high quality, active manager can identify and exploit for profit. Within the active space, my top pick is the Trimark Emerging Markets Fund, which is a concentrated portfolio of EM names. I also like Brandes Emerging Markets, which is a more diversified, deep value portfolio. Both would be strong picks for the long-term when compared to a more passive strategy.