BMO ETF Portfolio Strategy Report

Transcription

1 BMO ETF Portfolio Strategy Report First Quarter 2015 BMO EXCHANGE TRADED FUNDS A Diverging Landscape Alfred Lee, CFA, CMT, DMS Vice President, BMO ETFs Portfolio Manager & Investment Strategist BMO Asset Management Inc. alfred.lee@bmo.com In this report: Recent Developments...1 Things to Keep an Eye on...2 Changes to the Portfolio Strategy...3 Stats and Portfolio Holdings...4 Portfolio Characteristics...5 The Good, the Bad, and the Ugly...6 All prices or returns as of market close on January 9, 2015, unless otherwise indicated. In this report, we highlight our strategic and tactical portfolio positioning strategies for the first quarter using various BMO Exchange Traded Funds. Our key strategy changes are outlined throughout the report and in our quarterly outlook on page six. Whether the U.S. Federal Reserve ( Fed ) will finally raise its overnight lending rate in 2015 will be one of the major focal points later in the year. In the wake of an encouraging U.S. jobs report and its unemployment recently falling to 5.7%, there is a growing possibility that the Fed will tighten its monetary policy at some point. Barring a major global economic slowdown, we anticipate a rate hike in the second half of the year. However, with no signs of inflation, we expect the Fed rate to remain low with the rate an eighth or quarter point higher at year s end. Although we expect the U.S. central bank to become more hawkish, economic data out of Europe and Asia has shown signs of waning momentum. For example, the Purchasing Manager s Index (PMI) for both the Euro-zone and Asia have been trending lower. In addition, slowing inflation has become a concern in both areas. This may prompt the central banks to intervene, likely benefiting the defensive oriented assets and dividend paying stocks of the area. Economic growth will likely increasingly diverge, with the U.S. shouldering global growth, but the rate of overall global economic expansion may slow. The varying monetary policies of different regions, however, should create asset allocation opportunities. In addition to diverging interest rates, falling crude prices may create a further divide between various economies. If the Organization of Petroleum Exporting Countries (OPEC) continues to refrain from cutting production, depressed oil prices could be an ongoing headwind for oil exporting countries, especially for higher cost producers such as Canada. We expect this imbalance to be corrected at some point in 2015, particularly with some OPEC members already calling to cut production. Uncertain energy prices and diverging yields between various sovereign bonds should be catalysts that lead to growing opportunities for asset and sector allocation strategies. Due to these two factors, we expect correlations between different asset classes to continue to decline, as we saw in 2014 (Chart A). Consequently, alpha generation through top down strategies should become more rewarding as the year progresses. With slower economic growth in certain areas, lower energy prices and slower velocity of money, deflationary pressures may arise in some economies. In addition to asset and sector allocation, a well-constructed portfolio should consider exposure to specific market factors (such as low volatility or dividends) and currency exposure (hedged or unhedged) depending of the respective region. Higher beta stocks, which have fared well in the U.S. over the last 30-months, seem to be losing momentum. Similar to other regions, lower beta stocks seem to be gaining relative strength over the broad S&P 500 Composite Index (Chart B). Should the U.S. Federal Reserve take a more hawkish tone, we expect a further tailwind behind lower beta stocks in the U.S. Chart A: Lower Intra-Market Correlations Chart B: U.S. Low Beta Stocks beginning to Outperform S&P 500 Composite Correlation to Global Equities U.S. Equities Canadian Equities 2014 Since 2008 Recession Last 10 Years Global Bonds Gold Commodities U.S. High Yield Bonds Emerging International Market Equities ZLU.U/S&P 500 Composite Ratio Mar Apr May-2013 BMO US Low Volatilty ETF -U.S. Dollar (ZLU.U) / S&P 500 Composite Jun Jul Aug-2013 Sep-2013 Oct Nov-2013 Dec-2013 Jan Feb-2014 Mar Apr May-2014 Low Volatility Stocks in the U.S. gaining momentum vs. S&P 500 Composite Jun Jul Aug-2014 Sep-2014 Oct Nov-2014 Dec-2014

2 Portfolio Strategy Report First Quarter Things to Keep an Eye on... Brent Crude (US$/barrel) Mar/2013 Apr/2013 May/2013 Jun/2013 Brent Crude Moving Average (50-Day) 10-Year Average Jul/2013 Aug/2013 Sep/2013 Oct/2013 Nov/2013 Dec/2013 Jan/2014 Feb/2014 Mar/2014 Current discount vs. 10-Year Average Apr/2014 May/2014 Jun/2014 Jul/2014 Aug/2014 Sep/2014 Oct/2014 Nov/2014 Dec/2014 Since mid-june of 2014, oil (Brent Crude) prices have fallen 56.4% to US$50.11/barrel. While this has been a detractor from the equity markets of commodity exporting countries, the positive is that this has been supply side driven, rather than being a result of falling demand. Momentum indicators have suggested crude prices have been oversold for weeks. Should OPEC decide to curb supply, oil prices can quickly rally to more normalized levels. The greater question, however, is how long OPEC is willing and able to sustain lower oil prices. Recommendation: Sustained lower oil prices would continue to benefit our portfolio strategy, as we have been underweight the energy sector. Should oil prices rebound, our strategy would likely surrender some outperformance. Rather than utilizing core exposures to obtain energy exposure, we recommend investors instead consider tactical positions of energy ETFs, such as the BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO). By doing so, the position could be efficiently removed from the portfolio mix, whether or not a bounce-back in oil prices transpires. Food and Energy Prices (y/y % change) Dec/2009 Mar/2010 Jun/2010 Sep/2010 Dec/2010 Mar/2011 Jun/2011 Sep/2011 Dec/2011 Food Prices (y/y % change) Energy Prices (y/y % change) Euro Household Consumption (y/y % change) Mar/2012 Jun/2012 Sep/2012 Dec/2012 Mar/2013 Jun/2013 Sep/2013 Dec/2013 Mar/2014 Jun/2014 Sep/ Euro Household Consumption (y/y % change) One advantage of lower energy prices is that it acts as a fiscal stimulus, allowing consumers to have more disposable income. European equities, to which we have increased our allocation in the last year should benefit. When looking at recent trends of year-over-year (y/y) Euro-zone spending growth in relation to energy prices, a negative correlation is exhibited. This suggests that as energy prices decline, European consumers tend to have more disposable income to spend on necessities and goods. Recommendation: Several quarters ago, we added the BMO MSCI Europe High Quality Hedged to CAD Index ETF (ZEQ) to our portfolio strategy. Its combined 47.5% in both the consumer discretionary and consumer staple sectors should fare well should oil prices remain depressed. At the same time, it could make a long-term holding for a portfolio regardless of the outcome in crude prices, as the ETF screens for higher quality companies using metrics such as high return on equity (ROE) and stable year- over- year earnings. As the monetary policy of the European Central Bank (ECB) will likely remain accommodative, the currency hedge will mitigate any potential weakness of the underlying currency of the European stocks. CDX High Yield Spread 430 CDX HY 5-Year Spread Jan/2014 Feb/2014 Mar/2014 Apr/2014 May/2014 Jun/2014 Jul/2014 Aug/2014 Sep/2014 Oct/2014 Nov/2014 Dec/2014 Last quarter, we decreased our exposure to U.S. high yield bonds by reducing our position in the BMO High Yield U.S. Corporate Bond Hedged to CAD Index ETF (ZHY) by 3.0%. This decision was partially made based on the expectation of wider high yield credit spreads, as we anticipated a slowdown in the fourth quarter, which did materialize. The 3.0% allocation, we used to increase our position in the mid-term U.S. investment grade bonds, using the BMO Mid-Term US IG Corporate Bond Index ETF (ZIC). Over the fourth quarter, ZIC outperformed ZHY by 6.3% on a total return basis. Part of the outperformance however, did come from the U.S. dollar exposure of ZIC. Recommendation: Going forward, we do expect a higher and/or steeper U.S. treasury curve to be a slight headwind for U.S. high yield bonds. Higher rates in the U.S. could lead investors to de-risk a bond portfolio as higher coupons could be derived from higher quality bonds. We do continue to see investment grade bonds to be a sweet spot, should the U.S. Federal Reserve tighten monetary policy. However, the recent widening of the High Yield spreads as indicated by the High Yield CDX spread, presents some potential to tighten ahead. To reduce U.S. duration risk however, the BMO Floating Rate High Yield ETF (ZFH) can be used.

3 Portfolio Strategy Report First Quarter Changes to Portfolio Strategy Asset Allocation: As mentioned in our last report, we expected a correction in the equity and credit markets in the final quarter of Our portfolio strategy added some significant outperformance relative to our benchmark over the quarter as a result of some of the recent changes we made. In addition to our ongoing overweight to the U.S. and our underweight to energy, our decision to reduce exposure to U.S. high yield bonds last quarter, has been a positive for downside protection. We expect a more hawkish environment in the U.S., whereas monetary conditions will likely remain status quo or more relaxed in other areas. A growing divide in interest rates would not only have ramifications on the bond markets, but also would affect other asset classes given the inter-market relationships. Overall, we remain content with our asset allocation mix, as we are still more bullish on equities and credit. However, we are making adjustments within the asset classes to better position our portfolio for both short and longer-term opportunities. Fixed Income: Interest rate futures have implied a greater possibility of a rate change (both higher and lower) from the Bank of Canada (BoC) by the end of With the BoC governor, preferring a lower Canadian dollar, we see a rate hike this year to be unlikely. Unless we experience sustained lower oil prices, which will eventually impact Canada s gross domestic product (GDP), we don t expect a lower overnight rate in Canada either. As the year progresses, we would look to possibly take duration risk in Canadian bonds, while taking less duration risk with our U.S. fixed income exposure. For the meantime, we are leaving our allocation to investment grade fixed income unchanged. We would keep an eye on the trend of the spread between Canadian and U.S. 10-year bond yield. Should a Federal Reserve rate hike become more imminent, we would look to reduce U.S. duration exposure, while increasing our exposure to the mid-part ( the belly ) of the yield curve in Canada. Equities: As mentioned previously, we envision a greater divergence in monetary policy going forward. We expect this to lead to a greater divergence in regional asset performance. Economic data outside of the U.S. has shown signs of weakness, which will likely prevent central banks in Europe and Asia from tightening monetary policy. This should continue to place buying pressure on yield in these areas. As a result, we are initiating a 6.0% position in the BMO International Dividend ETF (ZDI). The lack of sector diversification has been beneficial for the Canadian equity market over the last decade, with its three main sectors performing well. However, with greater uncertainty in energy and opportunities arising in other global equity markets, we are looking to increase our global diversification. Although we are still positive on Canadian dividends, we are reducing our position in the BMO Canadian Dividend ETF (ZDV) by 4.0% to partially fund our new allocation in ZDI. Higher beta equity strategies have performed well in the U.S. since mid-2012, but have recently begun to lose momentum. On the other hand, lower beta U.S. equity strategies, have been gaining strength relative to the S&P 500 Composite Index. In addition, with equity market volatility, as indicated by the CBOE/S&P Implied Volatility Index (VIX) rising, we are eliminating our 5.0% position in the BMO S&P 500 Index ETF (ZSP), in favour of the BMO U.S. Low Volatility ETF (ZLU). We believe oil prices can fall further from current levels. However, the majority of the drop in Brent prices has likely already occurred. Although, it is difficult to determine how long oil prices could remain depressed, it should also be noted that the current price of crude is trading at a notable discount to its 10-year average. As previously mentioned, a tactical position in the BMO S&P/TSX Equal Weight Oil & Gas Index ETF (ZEO) can be used to gain exposure to large cap energy related companies. The companies in the ETF are Canadian, which tend to be higher cost producers and have a higher beta to oil, potentially outperforming if and when oil prices bounce back to higher levels. Moreover, the recent decline in the Canadian energy sector has made yields more attractive with the current portfolio yield of ZEO at 4.0%. Non-Traditional: Although we are currently leaving the duration risk of the investment grade portion of our portfolio strategy unchanged, we are reducing the duration risk of our high yield exposure. With the high yield credit spread trending wider in the last half year, we believe stronger U.S. economic data will eventually lead this trend to reverse. To maintain our exposure to U.S. high yield bonds, while eliminating our duration exposure, we are switching our 3.5% position in the BMO High Yield U.S. Corporate Bond Hedged to C$ Index ETF (ZHY) for the BMO Floating Rate High Yield ETF (ZFH). Sell/Trim Ticker (%) Buy/Add Ticker (%) BMO S&P/TSX Equal Weight Industrials Index ETF ZIN 5.0% BMO S&P/TSX Equal Weight Oil & Gas Index ETF ZEO 3.0% BMO Canadian Dividend ETF ZDV 4.0% BMO International Dividend ETF ZDI 6.0% BMO S&P 500 Index ETF ZSP 5.0% BMO U.S. Low Volatility U.S. Equity ETF ZLU 5.0% BMO High Yield U.S. Corporate Bond Hedged to C$ Index ETF ZHY 3.5% BMO Floating Rate High Yield ETF ZFH 3.5% Total 17.5% Total 17.5%

4 Portfolio Strategy Report First Quarter Stats and Portfolio Holdings Investment Objective and Strategy: The strategy involves tactically allocating to multiple asset-classes and geographical areas to achieve long-term capital appreciation and total return by investing primarily in exchange traded funds (ETFs). Ticker ETF Name Position Price MER Fixed Income Weight (%) 90-Day Vol Volatility Contribution ZDB BMO DISCOUNT BOND INDEX ETF Debt Core $ % 14.0% % 2.5% 0.69 ZIC BMO MID-TERM U.S. IG CORPORATE BOND INDEX ETF Debt Tactical $ % 10.0% % 3.4% 0.39 ZCS BMO SHORT CORPORATE BOND INDEX ETF Debt Tactical $ % 9.0% % 2.0% 0.83 ZST BMO ULTRA SHORT-TERM BOND INDEX ETF Debt Tactical $ % 3.0% % 2.0% 1.01 Total Fixed Income 36.0% 15.8% Equities ZLB BMO LOW VOLATILITY CANADIAN EQUITY ETF Equity Core $ % 8.5% % 2.9% 0.27 ZDV BMO CANADIAN DIVIDEND ETF Equity Core $ % 5.0% % 4.6% 0.29 ZLU BMO LOW VOLATILITY U.S. EQUITY ETF Equity Core $ % 5.0% % 2.0% 0.16 ZDY BMO U.S. DIVIDEND ETF Equity Core $ % 11.0% % 3.8% 0.29 ZDI BMO INTERNATIONAL DIVIDEND ETF Equity Core $ % 6.0% % 4.2% 0.27 ZEQ BMO MSCI EUROPE HIGH QUALITY HEDGED TO CAD ETF Equity Tactical $ % 7.0% % 3.3% 0.21 ZWB BMO COVERED CALL BANKS ETF Equity Tactical $ % 3.0% % 6.0% 0.45 ZEO BMO S&P/TSX EQUAL WEIGHT OIL & GAS INDEX ETF Equity Tactical $ % 3.0% % 2.3% 0.07 ZWA BMO COVERED CALL DOW JONES INDUSTRIAL AVERAGE HEDGED TO C$ ETF Equity Tactical $ % 3.0% % 6.2% 0.51 ZUB BMO Equal Weight U.S. Banks Hedged to C$ ETF Equity Tactical $ % 4.0% % 1.6% 0.08 Total Equity 55.5% 80.5% Non-Traditional/Hybrids ZFH BMO FLOATING RATE HIGH YIELD ETF Equity Tactical $ % 3.5% % 5.0% 0.71 ZPR BMO S&P/TSX LADDERED PREFERRED INDEX ETF Debt Tactical $ % 5.0% % 4.8% 1.86 Total Alternatives 8.5% 3.6% Total Cash 0.0% % 1.0% Portfolio 0.31% 100.0% % 3.3% 0.90 Yield (%)* Yield/ Vol Ticker Top Holdings Weight ZDB BMO DISCOUNT BOND INDEX ETF 14.0% ZDY BMO U.S. DIVIDEND ETF 11.0% ZIC BMO MID-TERM U.S. IG CORPORATE BOND INDEX ETF 10.0% ZCS BMO SHORT CORPORATE BOND INDEX ETF 9.0% ZLB BMO LOW VOLATILITY CANADIAN EQUITY ETF 8.5% ZEQ BMO MSCI EUROPE HIGH QUALITY HEDGED TO CAD ETF 7.0% ZDI BMO INTERNATIONAL DIVIDEND ETF 6.0% ZDV BMO CANADIAN DIVIDEND ETF 5.0% ZLU BMO LOW VOLATILITY U.S. EQUITY ETF 5.0% ZPR BMO S&P/TSX LADDERED PREFERRED INDEX ETF 5.0% ZUB BMO EQUAL WEIGHT U.S. BANKS HEDGED TO C$ ETF 4.0% ZFH BMO FLOATING RATE HIGH YIELD ETF 3.5% ZST BMO ULTRA SHORT-TERM BOND INDEX ETF 3.0% ZWB BMO COVERED CALL BANKS ETF 3.0% ZEO BMO S&P/TSX EQUAL WEIGHT OIL & GAS INDEX ETF 3.0% ZWA BMO COVERED CALL DOW JONES INDUSTRIAL AVER- AGE HEDGED TO C$ ETF 3.0% Non-Traditional (11.5%) Equities (55.5%) Fixed Income (33.0%) Core 49.5% Tactical 50.5% *Yield calculations for bonds is based on yield to maturity, which includes coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity and for equities it is based on the most recent annualized income received divided by the market value of the investments. **Cash is based off the 3-quarter Canadian Dealer Offered Rate (CDOR).

5 Portfolio Strategy Report First Quarter Portfolio Characteristics Regional Breakdown (Overall Portfolio) Canada 50.5% United States 36.5% Europe 11.9% Asia 1.1% *Regional Breakdown includes equities, fixed income and alternative sleeves. Equity Sector Breakdown Financials 23.2% Health Care 7.5% Industrials 7.2% Information Technology 4.9% Materials 4.7% Telecommunication Services 4.8% Utilities 10.3% Consumer Discretionary 10.3% Consumer Staples 13.0% Energy 14.1% Fixed Income Breakdown Federal 13.6% Provincial 11.7% Investment Grade Corporate 71.3% Non-Investment Grade Corporate 3.5% Weighted Average Term 6.05 Weighted Average Duration 4.74 Weighted Average Coupon 3.4% Weighted Average Current Yield 3.3% Weighted Average Yield to Maturity 2.6% Weighted Average Current Yield: The market value weighted average coupon divided by the weighted average market price of bonds. Weighted Average Yield to Maturity: The market value weighted average yield to maturity includes the coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity. Weighted Average Duration: The market value weighted average duration of underlying bonds divided by the weighted average market price of the underlying bonds. Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates.

6 Portfolio Strategy Report First Quarter The Good, the Bad, and the Ugly Conclusion: We expect a diverging economic landscape to materialize as the varying pace of recovery between major regions will become increasingly prevalent. The monetary policy of key central banks will become uneven as a result, leading to greater opportunities in asset allocation. These conditions will be beneficial for multi-asset strategies and portfolios utilizing targeted styles and factor exposures. Our ongoing concern remains the excess leverage in the financial markets. The NYSE Margin Debt Index, which we often quote in this report, has now trended below its 12-month average. Should it significantly break below this average, a deleveraging process could occur, where current margin levels exceed pre-2008 levels. Consequently, our equity exposure, particularly in the U.S. has now become more defensively positioned. Global-Macro/Geo-Political Fundamental Technical U.S. initial jobless claim continues to trend lower. Its current levels are lows not seen since prerecession. The new highs of the S&P 500 Composite Index have been met with higher earnings per share (EPS). We continue to expect correlations between and within asset classes to drift lower. This is a positive for multi-asset strategies. The U.S. unemployment rate also continues to tick down from its high of 9.93% in 2009 to its current 5.7%. The 12.9x current price-to-earnings (P/E) of the S&P 500 Energy Index is 28.7% discount to the broad S&P 500 Composite Index. On a relative basis, gold has surged versus oil prices. Good The University of Michigan Consumer Sentiment Index has gained to 93.6, a post-recession high. Leading Economic Indicator (LEI) a combination of 10 economic data points, shows the Euro area gaining momentum. More accommodative monetary policy from the central banks of Asia Pacific could be supportive for the dividend paying companies of the region. Lower energy prices could be the required catalyst to European equities which have a good representation to consumer relate sectors. Bad Industrial Production in areas outside of the U.S. are showing weakness. China and some major European economies are lower year over year growth and Brazil and Russia were negative. The slump in crude prices will put pressure on the GDP of oil exporting countries, which may trickle into other areas of the global economy. Valuations on defensive oriented sectors such as utilities and telecoms continue to trade richer. The CBOE/S&P Implied Volatility Index (VIX) has spiked above 20 (its long-term average) three times in the last quarter. The more speculative CSI 300 Shanghai Shenzhen Index has surged relative to the Shanghai Composite Index. This potentially indicates a high degree of speculative investing. Eurozone y/y CPI (all items) has gone negative. China Export trade (y/y) have stabilized but remain well below pre-recession lows. We continue to be concerned about high household debt levels in Canada. Lower oil prices could negatively impact other parts of the economy, putting pressure on consumers. The Russian equity market has a current P/E of 4.4x. Although inexpensive, lower oil prices could place further headwinds on its market. The Margin Debt Index looks dangerously close to crossing below its 12-month average. A significant breach below would trigger a major deleveraging event. Ugly Industrial production in Japan (y/y) registered a -3.8% in its last reading. The S&P/TSX Composite Index has registered lower highs and lower lows. Commodity related currencies such as the Canadian dollar, Norwegian Krona and the Australian dollar have flat-lined relative to the U.S. dollar. Lower oil prices could cause interest rates to diverge, putting further downward pressure over the long-term.

7 Portfolio Strategy Report First Quarter Visit bmo.com/etfs or contact Client Services at S&P and S&P 500 are trademarks of Standard & Poor s Financial Services LLC ( S&P ) and TSX is a trademark of TSX Inc. These trademarks have been licensed for use by S&P Dow Jones Indices LLC and sublicensed to BMO Asset Management Inc. in connection with ZSP, ZIN and ZPR. ZSP, ZIN and ZPR are not sponsored, endorsed, sold or promoted by S&P Dow Jones LLC, S&P, TSX, or their respective affiliates and S&P Dow Jones Indices LLC, S&P, TSX and their affiliates make no representation regarding the advisability of trading or investing in such ETFs. The Dow Jones Industrial Average Index is a product of S&P Dow Jones Indices LLC and has been licensed for use by the BMO Asset Management Inc. Dow Jones, Dow Jones Industrial Average, and DJIA are registered trademarks of Dow Jones Trademark Holdings LLC ( Dow Jones ), and have been licensed to S&P Dow Jones Indices LLC and and sublicensed for use by BMO Asset Management Inc. in connection with ZWA. ZWA is not sponsored, endorsed, sold or promoted by S&P Dow Jones Indices LLC, Dow Jones, or their respective affiliates, and S&P Dow Jones Indices LLC, Dow Jones and their respective affiliates make no representation regarding the advisability of trading or investing in such ETF. The exchange traded funds referred to herein are not sponsored, endorsed or promoted by MSCI, and MSCI bears no liability with respect to any such exchange traded funds or any index on which such exchange traded funds are based. The prospectus contains more detailed description of the limited relationship MSCI has with BMO Asset Management Inc. and any related exchanged traded fund. This communication is intended for informational purposes only and is not, and should not be construed as, investment and/or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. BMO ETFs are managed and administered by BMO Asset Management Inc., an investment fund manager and portfolio manager, and separate legal entity from Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange traded funds. The indicated rates of return are the historical annual compound total returns including changes in prices and reinvestment of all distributions and do not take into account commission charges or income taxes payable by any unitholder that would have reduced returns. Please read the prospectus before investing. Exchange traded funds are not guaranteed, their value change frequently and past performance may not be repeated. BMO (M-bar roundel symbol) is registered trade-mark of Bank of Montreal, used under licence.