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ETFs of Note
Invesco Senior Loan CAD Hedged ETF (TSX: BKL.F) – One of the questions I’ve received about this pick is why I still like it when a couple others, namely Mackenzie Floating Rate Income ETF (TSX: MFT) and BMO Floating Rate High Yield ETF (TSX: ZFH) have outperformed it over the past year or so. For the year ending August 31, BKL.F has gained 2.8%, while MFT is up 7.2% and 5.4%. To understand this significant performance differential, we need to look more closely at what these other ETFs actually do.
As a refresher, the Invesco Senior Loan CAD Hedged ETF is a passive ETF that invests in the 100 largest, most liquid senior bank loans issued in the U.S. In comparison, the Mackenzie Floating Rate Income Fund is an actively managed ETF that invests in a diversified portfolio of floating rate loans, issued by mid-market companies, largely in the U.S. There are two key differences with this compared with BKL.F. The first is it is actively managed, meaning the manager is buying and selling loans on a regular basis. Manager Steve Locke and his team use a mix of top down macroeconomic analysis, combined with quantitative and fundamental credit research to find what they believe to be high quality loans that are trading at an attractive yield with the potential for modest capital gains.
The second difference is the issuer size. BKL.F tends to focus more on larger, big cap companies, while MFT invests in more mid-market companies. Mid-market loans are more likely to trade at higher spreads and offer a higher return potential for investors, although they may carry a slightly higher level of risk.
This combination of active management and mid-market focus allow the Manager to generate higher returns in most market conditions. In addition, the manager may also make small currency bets as a way to opportunistically generate excess alpha.
The BMO Floating Rate High Yield ETF is also a much different investment than BKL.F. It provides exposure to a diversified portfolio of high yield bonds through positions in high yield credit default swap index (CDX). CDX provide exposure to the credit movement of the underlying reference portfolio and the value will move with the widening or tightening of credit spreads of the underlying. So far this year, credit spreads of high yield bonds have moved significantly tighter, which has benefitted this ETF. With spreads trading at very tight levels, the potential upside is more limited, which may affect the potential return on a go forward basis. Further, if we see a sharp and significant widening in spreads, the value of the ETF is likely to be negatively affected.
Looking ahead, I am following the Mackenzie offering very closely. Thus far, I have been reasonably impressed with the Manager and the investment process employed. I also understand that the recent spread tightening has been a net benefactor to the ETF and will want to see how it performs in a more volatile credit market. It is on my radar and under serious consideration for inclusion on my ETF Focus List.
In the interim, I continue to favour the passive Invesco offering for its higher quality investment portfolio, reasonable fees, and strong liquidity profile. I expect that if we see a significant credit event, this ETF is likely to hold up better than its peers.
Horizons Active Canadian Dividend ETF (TSX: HAL) – This systematically managed ETF has delivered very strong absolute and risk adjusted returns for investors since its launch in February 2010. For the five years ending July 31, it has gained and annualized 9.6%, outpacing the S&P/TSX Composite, which returned 8.8% over the same period. For the past 12 months, it earned 12.6%, beating the 11.7% of the index.
Manager Sri Iyer and his team at Guardian Capital look for Canadian companies that have the ability to pay, sustain, and grow their dividends. The team uses a ruled based screening process that puts the Canadian equity universe through screens that analyze 31 different factors, looking for positive rates of change. These factors focus on growth, payout ratios, efficiency, valuation, and investor sentiment.
The result is a well-diversified portfolio, holding around 60 names, with the top ten making up just under 30%. It invests in companies of any size, and roughly 43% is in big cap names, with the balance invested in small and mid-caps. The sector mix is dramatically different than the Canadian market, with an overweight in energy, consumer cyclicals, real estate and utilities. It significantly underweight in financials, with modest underweights in consumer defensives and materials. The top holdings look much like you’d expect from a dividend focused ETF, with RBC, Pembina, Dream Global REIT, Rogers, and collision repair operators Boyd Group rounding out the top five.
Valuation looks a bit rich compared to the broader market and the peer group. However, stronger quality metrics and higher forward looking earnings growth rates more than offset the higher valuation, making it one of the more attractive options in the dividend ETF category.
Adding to its attractiveness its volatility profile. It has been one of the least volatile ETFs in the category, while delivering returns that are well above average. Looking at the defensive positioning of the portfolio, there is nothing indicating a higher level of volatility is expected.
The biggest knock on this ETF is its cost. It carries an MER of 0.79%, which is well above the category average. Still, the alpha generated has more than offset this higher cost.
Looking ahead, this remains one of my top picks for a Canadian dividend ETF, with the fundamentally constructed Invesco Canadian Dividend ETF (TSX: PDC) being the other. I expect that both will hold up better than the broader market in the event of a selloff, thanks to their focus on quality and valuation, while still providing investors with decent returns in rising markets. Over the long-term, I continue to favour dividend stocks as a core holding for most investors.
iShares U.S. Fundamental Index ETF (NEO: CLU) – Looking at the recent performance of this fundamentally built ETF it’s easy to dismiss it compared to the lower cost, cap weighted ETFs. However, I don’t believe that recent performance tells the whole story. A significant portion of the cap weighted return has been driven by a few mega-cap tech stocks. Depending on the time period you look at, anywhere from a quarter to a third of the index return has been driven by five stocks, often referred to as the FANGs; Facebook, Amazon, Apple, Netflix, and Google. Combined, these make up roughly 15% of the S&P 500. While the FANGs have been rallying higher, valuation levels have also continued to climb. At the end of July Amazon was trading at more than 112 times forward earnings, Facebook, despite its July haircut was trading at more than 25 times earnings, and Netflix was trading at just shy of 130 times earnings. Clearly these levels are not sustainable over the long-term and some correction, either through an extended period of below average return or a meaningful selloff will need to occur at some point. Obviously when this happens is anyone’s guess. The downside of this sharp rally is the valuation levels of the broader U.S. equity market have also been pulled to the upper end of the historic averages, making the cap weighted index ripe for a potential selloff.
One way to help insulate against this risk is to use an ETF that is built using a set of rules that focuses on more than just the size of a company. This fundamentally built ETF may be just the ticket. This ETF scores the U.S. equity universe on several fundamental metrics including dividends, free cash flow, sales and book value. Those that score better based on the fundamental ranking make up a larger portion of the portfolio than those that score poorly. The valuation levels are significantly more attractive than the cap weighted indices, but the growth profile is a little less favourable, given the underweight positioning of some of the high flyers. For example, the FANG stocks make up less than 5% of the portfolio, significantly less than the cap-weighted ETFs.
While a cap weighted ETF for U.S. equities has historically been an excellent choice, I believe that if we hit a period of extended volatility, or we see a major correction in the FANG names, the fundamentally constructed ETF will offer a more attractive risk return profile. I expect this ETF will also outperform when the market focus returns to valuation and quality. If you are concerned about a potential drawdown in the U.S. equity market, the higher margin of safety offered by CLU may be a better bet than XSP. That said, XSP remains an excellent pick for the long-term and has been a tough one to beat. One concern with CLU is its cost. The MER is 0.72%, compared with 0.11% for XSP. While I believe this higher cost can be offset in a down market, it does act as a headwind in a flat or rising market.
iShares MSCI World Index ETF (TSX: XWD) – With a three month return of 4.96%, this global ETF was the strongest performer of the global equity ETFs on our list. This has not been a fluke as it has outpaced the other ETFs in the category in all time periods out to five years. There have been two drivers of the return in the recent past. The first is the U.S. equity exposure. The U.S. equity market has been one of the strongest performers over the past year, and really since the start of the bull run in early 2009. Further, this currency exposure of this ETF is unhedged, which has been a strong tailwind as we have seen the U.S. dollar appreciate significantly against the Canadian dollar. Going forward, in the short term, I expect the U.S. equity markets to continue to be strong given the pace of corporate earnings and economic growth numbers. Europe and Asia are expected to continue to struggle in light of the ongoing trade skirmish with the U.S. Longer term, I expect the U.S. to lag.
This trade skirmish is also expected to continue to weigh on the Canadian dollar. Until the trade file is settled, I reckon the Canadian dollar will continue to lag the U.S. greenback. Assuming a trade deal can be reached, the Canadian dollar would be expected to bounce back sharply and find a new higher level. In the event of a market selloff, the U.S. dollar would be expected to rally, which will allow this unhedged ETF to outperform a fully hedged ETF. For smaller investors, this remains an excellent way to get a one-ticket global equity solution. Larger accounts can buy 60% XUS & 40% ZEA for roughly the same exposure at lower cost
Vanguard FTSE Emerging Markets All Cap ETF (TSX: VEE) – Emerging markets have been under significant pressure in recent months on a number of fronts. Between rising U.S. interest rates, a strengthening U.S. dollar, and the ongoing global trade disputes, market sentiment has continued to worsen. Factor in Argentina’s recent fiscal woes, Turkey’s economic mess, Brazilian elections and South Africa’s contentious land reform bill, and the fear of contagion in the emerging markets continues to spread. While I am always reluctant to suggest one try to time the markets, there are far too many unknowns in the emerging markets now for me to be comfortable with any meaningful EM exposure. While there is strong upside over the long-term, I see much more risk to the downside in the very near term. Given this, I would likely wait for the various situations to settle, providing some additional visibility around the overall fiscal health of the region before making any additional allocations.