BMO ETF Portfolio Strategy Report

Transcription

1 BMO ETF Portfolio Strategy Report Fourth Quarter 2014 BMO EXCHANGE TRADED FUNDS In Search of Quality Alfred Lee, CFA, CMT, DMS Vice President, BMO ETFs Portfolio Manager & Investment Strategist BMO Asset Management Inc. 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 October 3, 2014, unless otherwise indicated. In this report, we highlight our strategic and tactical portfolio positioning strategies for the fourth quarter using various BMO Exchange Traded Funds. Our key strategy changes are outlined throughout the report and in our quarterly outlook on page six. Canadian equities have performed well year-to-date, with the 11.0% total return of the S&P/ TSX Composite Index outpacing the 8.1% total return of the S&P 500 Composite Index since the beginning of January (local currency terms). In spite of this, we continue to recommend an overweight to U.S. equities. We believe the U.S. will continue to lead the global economic recovery, placing upward pressure on its currency. A rising U.S. dollar would likely subject the commodity heavy Canadian equity market to a headwind. The U.S. Federal Reserve Board ( Fed ) is expected to keep its overnight rate at its current level until We expect the Fed to begin telegraphing this move in its Federal Open Markets Committee (FOMC) meetings before the end of In anticipation, the 10-year Treasury bond yield is trading 34 bps higher than its Canadian equivalent, a spread not seen since U.S. gross domestic product (GDP) recently came in at 4.6% (Chart A) annualized quarter over quarter, notably higher than the 4.2% on its last read. We don t envision that U.S. Treasury yields will move up significantly, as the overall rate environment should remain low on an absolute level. However, with investors earning slightly more yield from government bonds and should credit spread levels remain relatively even, a potential derisking in bond portfolios could occur. This could benefit higher quality issuers at the expense of noninvestment grade bonds, provided inflation levels remain low, not offsetting the pick-up in yields. With the Scottish referendum now in the past, the focus will now move to Catalonia. In addition to the Spanish community s fight for independence, potential political risk may also stem from the ongoing Ukraine and Russia conflict as well as the U.S. lead coalition against ISIS. With the threat of political uncertainty potentially leading to stock market volatility, we are avoiding the emerging markets, which tend to have a higher beta than traditional bonds. In addition, with the smaller cap Russell 2000 Index breaking down against the S&P 500 Composite Index (Chart B), we are focusing on higher quality large- and mid-cap names. Despite the potential threat of higher rates in the U.S., we expect rates to remain low overall. However, we expect some bond repositioning across the world, such as reducing duration and increasing emphasis on higher quality corporate bonds. As a result, the fixed income portion of a portfolio will likely contribute less yield, placing greater emphasis on dividend paying stocks to make up for the overall shortfall in portfolio yield Chart A: U.S. Economic Recovery Gaining Traction Chart B: Small Cap Stocks Breaking Down Mar Aug-2004 Jan Jun Nov-2005 GDP Annualized Q/Q Apr Sep-2006 Feb Jul Dec May Oct Mar Aug-2009 Jan Jun Nov-2010 Apr Sep-2011 Strong Rebound in GDP Feb Jul Dec May Oct Mar Oct-2007 Feb-2008 Russell 2000 Index/ S&P 500 Composite Index Ratio Jun-2008 Oct-2008 Feb-2009 Jun-2009 Oct-2009 Feb-2010 Jun-2010 Oct-2010 Feb-2011 Jun-2011 Oct-2011 Small caps beginning to break down versus larger caps Feb-2012 Jun-2012 Oct-2012 Feb-2013 Jun-2013 Oct-2013 Feb-2014 Jun-2014

2 Portfolio Strategy Report Fourth Quarter Things to Keep an Eye on... S&P/TSX Composite Index Sep-2011 Nov-2011 Jan-2012 Mar-2012 May-2012 Jul-2012 Sep-2012 Nov-2012 Equities and bonds have been correlated in 2014 Jan-2013 Mar-2013 May-2013 Jul-2013 S&P/TSX Composite Index FTSE/TMX Canada Universe Index Sep-2013 Nov-2013 Jan-2014 Mar-2014 May-2014 Jul-2014 Sep FTSE/TMX Canada Universe Index While our portfolio strategy has performed well year-to-date, it would be irrational to believe that this is the norm, considering the gains in both the equity and fixed income market. While the correlation between equities and bonds in an upwards market is positive, highly correlated assets during a downturn detracts from portfolio construction. We believe the strong performance in these asset classes has been partially due to a re-leveraging trade, with last year s spike in interest rates, which likely caused some margin calls. We don t expect the easy returns so far this year to continue. Recommendation: We are content with the defensive positioning of our strategy as we anticipate a correction at some point and have performed well on an absolute basis. We continue to advocate equity exposure outside of Canada, with an overweight to the U.S. While on the bond side of the portfolio, we continue to favour overweighting exposure to both Canadian and U.S credit. Our defensive positioning and overweight to U.S. equities fared well in September as the S&P/TSX Composite Index sold off. As mentioned, we believe a steady U.S. dollar should be a headwind for Canadian equities. S&P 500 Composite Sep-2000 Sep-2001 Sep-2002 Sep-2003 Sep-2004 Sep-2005 Sep-2006 Sep-2007 Sep-2008 Sep-2009 S&P 500 Composite Index USDCAD Cross Sep-2010 Sep-2011 Sep-2012 Sep-2013 Sep USD/CAD Ex-rate Not too long ago, the weakness of the U.S. dollar was used as a gauge of risk appetite. When the U.S. dollar fell in relation to a risk currency like the Canadian dollar, it would imply that investors desired exposure to risk assets. When the greenback gained, it was an indication that investors were risk averse. The strong gains of the U.S. dollar during the credit crisis provides a good example, as the U.S. dollar gained against most currencies with investors searching for a liquid and safe asset. Recommendation: Since early 2011, this inverse relationship with the U.S. dollar and risk assets has broken down, largely a result of the U.S. becoming the driver to the current global economic recovery. Should the Fed start telegraphing its move to higher rates in 2015, we expect the U.S. Treasury yield curve to steepen more than other sovereign term structures, leading to a higher U.S. dollar. Conversely, should the global economic recovery stall, the U.S. dollar would likely also outperform as investors again search for a safe-haven. Since late 2012, we have recommended to have our U.S. asset exposure non-currency hedged CDX HY Spread U.S. high yield bonds have performed well over the past five years. This shouldn t come as a surprise, given the wide option-adjusted spread (OAS) traded back at the height of the recession presented significant spread compression opportunities. Furthermore, the fundamental strength of the high yield bond universe has drastically improved with defaults at historical lows. The credit spread between high yield and U.S. Treasury bonds has not only recently reached a post-recession low, but has also become more volatile Recommendation: Overall, we remain positive on U.S. high yield bonds, particularly given the strengthening credit environment. However, if rates on Treasury bonds do eventually rise, this would allow investors to pick-up some additional yield from less risky government bonds. Investors dialing down risk could potentially have an impact on U.S. high yield bonds. Feb-2009 Aug-2009 Feb-2010 Aug-2010 Feb-2011 Aug-2011 Feb-2012 Aug-2012 Feb-2013 Aug-2013 Feb-2014 Aug-2014

3 Portfolio Strategy Report Fourth Quarter Changes to Portfolio Strategy Asset Allocation: The U.S. Federal Reserve has pledged to keep its overnight rate at current levels until We expect that its intent to raise rates next year will be telegraphed to the market in advance. With U.S. unemployment drifting lower, it would be no surprise to us if the U.S. central bank outlines how they expect to raise rates before the end of the calendar year. Similar to last year, where the bond market overreacted well in advance of the Fed s actual announcement of tapering, we expect treasury yields to react in anticipation of a rate hike. Heading into the final quarter of the year, we are not making any drastic changes to our asset allocation mix, as we have already reduced our exposure to interest rate risk. In addition to the risk of higher rates sometime in 2015, technical indicators would suggest that equity markets are overbought in the short-term. Although we believe the long-term bull-market to be intact, the run up in assets this year has partially been due to a re-leveraging of the markets, to which fair value, in our opinion, has already been reached. As a result, we believe the defensive stance of our strategy to be well positioned should that shortterm correction materialize. For long-term outperformance, managing downside risk is more critical than capturing all of the upside, in our strategy. Fixed Income: The risk of rising rates continues to be the imminent threat to the fixed income market. Economic data clearly indicates that the U.S. economy has improved dramatically since the depth of the recession. Its current monetary policy is therefore overly dovish, from our perspective. Consequently, we have significantly shortened our duration over the last year in anticipation of higher rates, albeit our decision to do so has been early. From a duration perspective, we remain content with our overall fixed income strategy. On the credit side of our strategy, we want to increase our exposure to investment grade U.S. corporate bonds (moving up in quality). Should U.S. Treasury rates rise next year, some investors may reduce risk as they can pick up some extra yield given a steeper treasury curve. This would likely have an impact on non-investment grade bonds, as investors may not have to overweight risk in order to generate higher yields. U.S. investment grade bonds may therefore be the sweet spot, providing a higher yield than government bonds but less risk than high yield debt. High grade corporate bonds in the U.S. may benefit from both higher inflows and credit spread tightening from the treasury side. We are increasing our weighting in the BMO Mid-Term U.S. IG Corporate Bond Index ETF (ZIC) by 3.0% as result. Equities: Equity markets have reacted to talks of reduced monetary stimulus in a very different manner in the last two years. With improving economic data, such as lower unemployment and a more stable real estate market in the U.S., higher interest rates at this point of the recovery is seen as a vote of confidence in the economic expansion. This should benefit more cyclical industries. In the last year, we have transitioned our strategy to more economically sensitive areas and reduced our exposure to interest rate sensitive sectors such as utilities and real estate investment trusts (REITs). We believe our equity strategy to be well positioned, even if it remains slightly defensive. Non-Traditional: Overall, U.S. high yield bonds remain attractive for many reasons. The default rates remain near all-time lows and from a portfolio construction standpoint, the asset class provides diversification properties to both traditional equities and bonds. However, with the high yield option adjusted spread (OAS) near post-recession lows and becoming more volatile, we believe there is the threat that spreads may widen out. Thus, we are reducing our position in the BMO High Yield U.S. Corporate Bond Hedged to CAD Index ETF (ZHY) by 3.0%. Sell/Trim Ticker (%) Buy/Add Ticker (%) BMO High Yield US Corporate Bond Hedged to CAD Index ETF ZHY 3.0% BMO Mid-Term US IG Corporate Bond Index ETF ZIC 3.0% Total 3.0% Total 3.0%

4 Portfolio Strategy Report Fourth 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% 0.85 ZIC BMO MID-TERM U.S. IG CORPORATE BOND INDEX ETF Debt Tactical $ % 10.0% % 3.4% 0.61 ZCS BMO SHORT CORPORATE BOND INDEX ETF Debt Tactical $ % 9.0% % 2.0% 0.90 ZST BMO ULTRA SHORT-TERM BOND INDEX ETF Debt Tactical $ % 3.0% % 2.0% 1.01 Total Fixed Income 36.0% 17.0% Equities ZLB BMO LOW VOLATILITY CANADIAN EQUITY ETF Equity Core $ % 8.5% % 2.9% 0.39 ZDV BMO CANADIAN DIVIDEND ETF Equity Core $ % 9.0% % 4.6% 0.55 ZSP BMO S&P 500 INDEX ETF Equity Core $ % 5.0% % 2.0% 0.18 ZDY BMO U.S. DIVIDEND ETF Equity Core $ % 11.0% % 3.8% 0.37 ZEQ BMO MSCI EUROPE HIGH QUALITY HEDGED TO CAD ETF Equity Tactical $ % 7.0% % 3.3% 0.27 ZWB BMO COVERED CALL BANKS ETF Equity Tactical $ % 3.0% % 6.0% 0.67 ZIN BMO S&P/TSX EQUAL WEIGHT INDUSTRIALS INDEX ETF Equity Tactical $ % 5.0% % 2.3% 0.19 ZWA BMO COVERED CALL DOW JONES INDUSTRIAL AVERAGE HEDGED TO C$ ETF Equity Tactical $ % 3.0% % 6.2% 0.72 ZUB BMO EQUAL WEIGHT U.S. BANKS HEDGED TO C$ ETF Equity Tactical $ % 4.0% % 1.6% 0.12 Total Equity 55.5% 77.6% Non-Traditional/Hybrids ZHY BMO HIGH YIELD U.S. CORP BOND HEDGED TO C$ INDEX ETF Debt Tactical $ % 3.5% % 5.0% 0.68 ZPR BMO S&P/TSX LADDERED PREFERRED INDEX ETF Equity Tactical $ % 5.0% % 4.8% 1.86 Total Alternatives 8.5% 5.4% Total Cash 0.0% % 1.3% Portfolio 0.32% 100.0% % 3.3% 0.46 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% ZDV BMO CANADIAN DIVIDEND ETF 9.0% ZLB BMO LOW VOLATILITY CANADIAN EQUITY ETF 8.5% ZEQ BMO MSCI EUROPE HIGH QUALITY HEDGED TO CAD ETF 7.0% ZSP BMO S&P 500 INDEX ETF 5.0% ZIN BMO S&P/TSX EQUAL WEIGHT INDUSTRIALS INDEX 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% ZHY BMO HIGH YIELD U.S. CORP BOND HEDGED TO C$ INDEX ETF 3.5% ZST BMO ULTRA SHORT-TERM BOND INDEX ETF 3.0% ZWB BMO COVERED CALL BANKS ETF 3.0% ZWA BMO COVERED CALL DOW JONES INDUSTRIAL AVERAGE HEDGED TO C$ ETF 3.0% Non-Traditional (11.5%) Equities (55.5%) Fixed Income (33.0%) Core 47.5% Tactical 52.5% *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 Fourth Quarter Portfolio Characteristics Regional Breakdown (Overall Portfolio) Canada 56.5% United States 36.5% Europe 7.0% *Regional Breakdown includes equities, fixed income and alternative sleeves. Equity Sector Breakdown Financials 23.8% Health Care 7.1% Industrials 15.2% Information Technology 6.2% Materials 3.7% Telecommunication Services 4.2% Utilities 7.6% Consumer Discretionary 9.8% Consumer Staples 11.2% Energy 11.3% Fixed Income Breakdown Federal 13.1% Provincial 10.9% Investment Grade Corporate 67.2% Non-Investment Grade Corporate 8.9% Weighted Average Term 6.2 Weighted Average Duration 5.1 Weighted Average Coupon 3.6% Weighted Average Current Yield 3.4% Weighted Average Yield to Maturity 2.7% 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 Fourth Quarter The Good, the Bad, and the Ugly Conclusion: We believe the main inflection point on the horizon is the Fed s move to a higher overnight rate sometime in As mentioned in our report last quarter, the U.S. Central Bank will likely begin to telegraph this move later this year. With the shift in the yield curve relatively flat in the last several months, it is likely that the bond market hasn t yet priced in the impact. Accordingly, we believe U.S. Treasury yields will soon rise, with the term structure becoming steeper. Continued strong data out of the U.S., particularly in employment, will encourage the move. The likely initial reaction is some deleveraging across most assets, which is why we continue to prefer taking a defense stance in our strategy. Markets will likely normalize, as we envision rates to remain low on an absolute level. With a steeper yield curve, we expect equities to outperform bonds, a stronger U.S. dollar, headwinds in commodities and a de-risking of lower quality, higher yield assets. Global-Macro/Geo-Political Fundamental Technical Good U.S. GDP remains strong and unemployment has moved lower. Strengthening U.S. economic data will increase the Fed s likelihood in raising rates. U.S. Empire State Manufacturing continues to tick up. This implies improving sentiment in business conditions. On a price to cash flow basis, North American stocks appear inexpensive. The 10.7x P/CF ratio of the MSCI North America Index is well below the 19.3x pre-recession high. For bargain hunters, emerging market equities look relatively cheap. The MSCI Emerging Market Index has a P/E ratio of 12.5x, a 5.8% discount to its 10-year average. Investors should note however, a rising U.S. dollar may be a negative for emerging market equities. Relative strength of lower beta stocks has gained against the broad market. We recommend reducing beta, as we expect a market correction in near term. The recent break out in the U.S. dollar makes it overbought, but we expect it to remain strong over the long-term as the Fed looks to raise rates in near future. Bad With, low inflation, a strong U.S. dollar, gold prices look to head lower, unless political risk breaks out. Unemployment in Canada is flat at 7.0%. Momentum in improvement has stalled in last two years. The S&P/TSX Composite Index has seen its earnings multiple expand 13.7% year/year. We believe commodity headwinds will now cause its multiple to contract. Many broad market equity indices are above its respective 10-year averages now. Further price gains should be met with earnings expansion to be justified. Recent spike in the U.S. Dollar Index was a major headwind for Canadian stocks. We continue to be overweight U.S. equities as we expect the greenback to remain strong. Upward momentum in the S&P 500 Composite Index looks to be weakening. A consolidation would be healthy. Ugly Political risk continues to mount in a number of geographic regions. Russia/Ukraine, the Middle East, North Korea are ongoing issues. Protests in Hong Kong are now another concern. The MSCI Europe Index currently has a P/E ratio of 19.6x. This is a 14.1% premium to its 10-year average. Given the uneven recovery in Europe, investing in quality will be the key. Longer term indicators show a breakdown in the Russell 2000 Index. While small cap U.S. stocks look short-term oversold, gains should be used as selling opportunities to move into larger cap higher quality stocks. Leverage is an ongoing concern. The Fed raising rates will likely lead to some deleveraging until the market normalizes.

7 Portfolio Strategy Report fourth Quarter Visit bmo.com/etfs or contact Client Services at Sign-up today for market-driven investment strategies using BMO ETFs at bmo.com/etfs 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.