Jun 29, 2017

Daniel Straus' Top Picks: June 29, 2017

BNN Bloomberg

Daniel Straus , BNN

Daniel Straus, head of ETF research and strategy at National Bank Financial

Focus: Exchange-traded funds
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MARKET OUTLOOK

ETF LANDSCAPE
The number of ETF providers in Canada is set to grow to at least 26 in the near future. Evolve Funds and Galileo Funds have each filed preliminary regulatory documents for new ETF launches, and in the past few weeks, Franklin Templeton and Excel Funds introduced their first ETFs to the Canadian market. ETFs in Canada now total $130 billion in listed assets, and they've reached 583 in number after 86 new ETFs launched in 2017 so far. For comparison, during the same period last year, (first half of 2016), 51 new ETFs had launched, and 2016 was a record year for new ETFs in Canada (97 new ETFs started trading).

Amid this burgeoning marketplace, investors have a wide array of tools and strategies to use when constructing their portfolios.

GLOBAL EQUITY
Our economists believe that world equities have entered the expansion phase of the global economic cycle based on rising employment, high business confidence, growing international trade volume, and other leading manufacturing indicators such as PMI. Much has been made of rising and stretched asset price valuations relative to fundamentals, but equity investors will find precious few places to hide —with the exception of certain emerging markets, the financial price ratios of most regional indices are higher than their long-run averages. High valuations either portend a new order of lower growth, or they may signal a spirited anticipation of rising earnings. While the outcome remains to be seen, recent developments have turned our focus towards Europe, where most of the political risks are taking a breather or are “already priced in.”

CANADIAN EQUITY
Among the globe’s single-country equity benchmarks, Canada has been among the worst-performing for the first half of the year, but the time for mean reversion may be at hand. Based on a series of indicators, namely rebounding corporate profits, National Bank's strategists have recently changed their asset allocation by shifting towards Canada. Despite headwinds like weak energy prices and anaemic demand for bank stocks, not to mention worrying signals of eroding trade agreements emanating from the U.S., the Canadian economy remains sound, and valuations are more favourable than those in the U.S.

U.S. EQUITY
Unemployment is at 4.3 per cent, the lowest in 16 years. Increases in hours worked suggest real GDP may be accelerating in the second quarter. In sum, the outlook for economic growth and profits remains encouraging. That being said, the only thing we have to fear is the lack of fear itself — record low volatility, together with the U.S. market's ability to shake off bad news, is itself disconcerting. Investors concerned with rising valuations can use one of many value-factor or fundamentally-weighted ETFs as an alternative to benchmark exposure.

FIXED INCOME
The Fed’s recent rate decision wasn’t a surprise, but it still up-ended the yield curve with the long end flatting in reaction. Bond yields have also shown signs of weakening every time headlines suggest that the Republican administration in the U.S. will suffer roadblocks for reflationary or pro-growth policies. However, the Fed cited improved economic conditions to support its rate hike decision, and in light of that stance, our portfolios are adopting lower duration exposure than the broad benchmark. Long bonds should suffer in a rising rate environment, but if markets react negatively then a flattening yield curve will have the opposite effect — depending on which scenario investors judge more likely, and coupled with a thorough review of their risk tolerance, investors should either maintain their benchmark exposure or use short-term or floating rate fixed income tools to prepare for the long-awaited rising rate environment.

TOP PICKS

HORIZONS ACTIVE FLOATING RATE BOND ETF (HFR.TO)
This ETF consists of an actively-managed portfolio of investment-grade Canadian corporate bonds, but with a duration risk-mitigating overlay: the managers at Fiera use a series of plain vanilla, fixed-for-floating interest rate swaps to convert the payments to floating rate. As a result, the NAV of this ETF should not suffer rate-hike induced declines, like most (but not all) other bond ETFs or single bond holdings. HFR pays an indicative distribution yield of two per cent after fees, and its price rises and falls with movements in the Canadian corporate credit spread. While we certainly consider this ETF to be riskier than cash, we use it in our model portfolios to bring down duration while keeping yield respectable, with the proviso that HFR can suffer drawdowns from time to time.

BMO S&P/TSX CAPPED COMPOSITE INDEX ETF (ZCN.TO)
ZCN is almost identical to past pick XIC, and all of the broad Canadian equity ETFs offered by iShares, Vanguard, and BMO charge extremely low expense ratios of six basis points. ZCN tracks the S&P/TSX Composite Index, which our strategists have noted is now valued more favourably than the S&P 500.

ISHARES MSCI EUROPE IMI INDEX ETF (CAD-HEDGED) (XEH.TO)
There are at least 16 ways to buy European equity in ETF format in Canada, with various flavours of factor strategies, dividend products, or quantitative active management. Many of these are compelling and suggest avenues for future research and investment. But when it comes to instant, fast, low-cost access to a region or theme, we turn to liquid, cap-weighted benchmark tracking ETFs like XEH, which tracks the MSCI Europe “Investable Market Index.” XEH is a currency-hedged wrap of XEU, and through its sub-holding, it offers exposure to over 1000 European stocks including mid-cap and small-cap companies. We opted for the currency-hedged version in this case to limit volatility induced by the British Pound (25 per cent of the portfolio's currency exposure), as well as to protect from reversals against the euro’s recent upticks.