BMO ETF Portfolio Strategy Report

Transcription

1 BMO ETF Portfolio Strategy Report A New Year, and More Market Resolutions 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 4, 213, unless otherwise indicated. First Quarter 213 BMO EXCHANGE TRADED FUNDS In this report, we highlight our strategic and tactical portfolio positioning strategies for the first quarter using various BMO Exchange Traded Funds. The fiscal cliff drama finally came to an end on New Year s day. A compromise deal was reached that prevented an end to spending cuts and an increase in taxes to the middle class. The House of Representatives voted to approve the fiscal cliff bill, which allows tax increases to individuals and households making US$4k and US$45k respectively. Over the quarter, the focus of investors will shift towards the already breached U.S. debt ceiling, giving Congress roughly two months to raise its legal borrowing limit. The Federal Reserve Board (Fed) announced a fourth round of quantitative easing 1 (QE4) at its December FOMC 2 meeting, to replace Operation Twist 3 which expired at the end of 212. This rendition of the monetary easing measure was given thresholds, allowing the Fed to keep rates low as long as unemployment remained above 6.5% and inflation expectations remained below 2.5%. The power transition in China was also completed over the quarter, paving the way for the country s new regime. While modernizing China s infrastructure will continue, it is unlikely it will occur at the same rapid pace of 29-2, potentially placing headwinds on commodity related sectors of the S&P/ TSX Composite Index (S&P/TSX). As a result, we continue to favour the lower beta trade for Canadian exposure. The failure of the S&P/TSX in following the 4.3% one day surge of the Shanghai Composite Index on December 14 may provide evidence for this thesis. With the growing middle class in emerging markets, the focus of their economic policies continues to shift towards consumer consumption and away from commodity intensive projects. Direct exposure in emerging market equities may therefore be more favourable than indirect exposure through Canadian equities. It is possible that the correlation between the S&P/TSX and emerging market equity stocks will decline in coming years, as developing nations have less of a demand for our base metal exports. Many investors have also started reallocating to emerging market equities, which could lead to tailwinds for the asset class. Although the European economies continue to remain in a malaise, there have been some positive developments. The OMT 4 programme has been a game changer over the short-term, as most European sovereign credit spreads remain well below their one-year averages. Certainly, European stocks can outperform in the first quarter of 213 and even throughout the year, however from a portfolio management context, returns in this area could come with heightened volatility, particularly since it is the region that is most likely to produce a tail-risk event 5. The post crisis era, has favoured more defensive-oriented investments with higher risk-adjusted returns. For that reason, we continue to avoid direct exposure to European stocks, despite the opportunities. Similar to the theme we highlighted back in 211, we believe multi-nationals provide indirect exposure to the European economy. Implied Probability (%) Market Becoming More Optimistic of a U.S. Recovery Source: Intrade U.S. Recession by 212 Year End U.S. Recession by 213 Year End Nov-29 Jan-2 Mar-2 May-2 Jul-2 Sep-2 Nov-2 Jan-211 Mar-211 May-211 Jul-211 Sep-211 Nov-211 Jan-212 Mar-212 May-212 Jul-212 Sep-212 Nov-212 Implied Probability (%)... and Less Pessimistic of a Euro Fallout Aug-2 Source: Intrade Oct-2 Any country to announce intention to drop Euro as currency Dec-2 Feb-211 Apr-211 Jun-211 Aug-211 Oct-211 Dec-211 Feb-212 Apr-212 Jun-212 Aug-212 Oct-212

2 2 Things to Keep an Eye on... USDCAD Exchange Rate Nov-25 Source: Bloomberg May-26 Nov-26 May-27 Nov-27 May-28 Nov-28 May-29 Nov-29 May-2 S&P 5 Composite Index USD vs. CAD NOv-2 May-211 Nov-211 May-212 Nov S&P 5 Composite Index Despite the high debt to GDP ratio of the U.S., the U.S. s low interest rate policy will continue to encourage carry-trades, where investors borrow in U.S. dollars to fund purchases in riskier assets. During market sell-offs, the U.S. dollar rallies as carry-trade borrowings are paid back. For this reason, the greenback will likely remain inversely correlated to risk assets, making non-currency hedged U.S. equity ETFs less volatile over the long-run. Recommendation: We have recommended an overweight to U.S. equities since the end of 2. In that time, U.S. equity indices have outperformed and we continue to believe they provide the best risk-adjusted opportunities amongst broad based equity areas. We now recommend switching from the BMO S&P 5 Hedged to CAD Index ETF (ZUE) to the non-currency hedged exposure to U.S. equities through the BMO S&P 5 Index ETF (ZSP) as a way to lower overall portfolio volatility. Yield (%) Source: Bloomberg Cummulative Total Return (%) Oct-211 Source: Bloomberg Nov-211 Jun-1989 Jan-199 Aug-199 Mar-1991 Oct-1991 May-1992 Dec-1992 Jul-1993 Feb-1994 Apr-1995 Nov-1995 Jun-1996 Jan-1997 Aug-1997 Mar-1998 BMO Low Volatility Canadian Equity ETF (ZLB) S&P/TSX Composite Index Dec-211 Jan-212 Feb-212 Mar-212 Oct-1998 May-1999 Dec-1999 Jul-2 Feb-21 Sep-21 Apr-22 Apr Year Government of Canada Yield May-212 Jun-212 Aug-212 Yield can get lower, but little downside left Nov-22 Jun-23 Jan-24 Aug-24 Mar-25 Oct-25 May-26 Dec-26 Jul-27 Feb-28 Sep-28 Apr-29 Nov-29 Jun-2 Jan-211 Aug-211 Mar-212 Oct-212 Sept-212 Oct-212 NOv-212 The Fed s recent announcement of QE4 likely means a prolonged period of low interest rates. This will partially dictate the Bank of Canada s monetary policy, which will cause yielding assets to continue outperforming growth related investments. A quicker than expected North American recovery, however, could place upward pressure on interest rates. With yields at historic lows, investors should also look for interest rate protection in rate sensitive yielding investments. Recommendation: Preferred shares have been in high demand given their tax efficient yield and low volatility attributes. With the risk of rising rates, albeit low, we recommend rate reset preferred shares, which provide better protection to rising rates than straight perpetual preferred shares. Investors can obtain diversified exposure to a portfolio of rate resets through the BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR). As previously mentioned in this report, we believe commodity related sectors of the S&P/TSX may continue to face heightened volatility with emerging markets being less reliant on reflationary policies. Our core position in Canadian equities, the BMO Low Volatility Canadian Equity ETF (ZLB) has significantly outperformed the S&P/TSX. Since the launch of ZLB on October 27, 211, its 17.5% total return has easily outpaced the 4.3% total return of the S&P/TSX over the same time period. Recommendation: Outside periods of unconventional monetary policy, particularly quantitative easing, lower beta trades have outperformed those of a more cyclical or higher beta nature. Our 9.% position in ZLB has been one of our most efficient equity exposures, offering high risk-adjusted returns. We recommend defensive oriented ETFs over traditional market-cap weighted ETFs for broad based Canadian equity exposure.

3 3 Changes to the Portfolio Strategy: Asset Allocation: With continued geo-political risk stemming from a number of regions, in addition to continued macro-economic headwinds, asset allocation remains important in the portfolio construction process. Our strategy for the first quarter of 213 remains predominantly defensive in the equity portion of our portfolio, with targeted positions in key cyclical areas for growth opportunities. Our view remains that higher yielding non-canadian credit plays will continue to provide better risk-adjusted returns than certain areas in equities. Fixed Income: Our strategy for fixed income remains unchanged for the first quarter of 213. The BMO Aggregate Bond Index ETF (ZAG) provides low cost exposure to the broad Canadian bond universe, while more targeted fixed income ETFs provide a further tilt toward our preferred duration and credit exposure. We continue to favour corporate bonds as a slowly strengthening Canadian economy could result in a tightening of corporate spreads. With interest rate futures currently pricing in a zero probability of rates increasing by.25% or more in the next six-months, we recommend overweighting mid-term corporate bonds for higher yield. Until rates look close to rising, we continue to recommend the BMO Mid-Corporate Bond Index ETF (ZCM) as a tactical tilt in the fixed income portion of our portfolio. Equities: The underlying macro-economic backdrop in the U.S. continues to improve. Economic data in unemployment and housing in the U.S. has shown signs of improvement. We remain positive on U.S. equities, but are switching our.% exposure in the BMO S&P 5 Index Hedged to CAD (ZUE) to an 8.% position in the non-currency hedged BMO S&P 5 Index (ZSP), as the currency exposure of the U.S. dollar will provide us with an inverse correlation to risk assets. We have pared back our exposure to U.S. equities by 2.%, as we have increased our exposure to emerging markets. We are slightly decreasing our exposure to the BMO Covered Call Canadian Banks (ZWB). Overall, the Canadian banks are more stable than their global counterparts, but have gone on a considerable run since early June. Consequently we are decreasing our position in ZWB by a slight 1.%. Our position in preferred shares also provides us with exposure to the Canadian banks, but higher up the capital structure. Although financials remains our largest sector overweight, Canadian banks account for a small position of this allocation. The Shanghai Composite Index, an emerging market laggard in terms of equity performance over the last two years, had a one day gain of 4.3% on stronger manufacturing data. Lower inflation in many emerging market countries, may allow for more accommodative monetary policy. Should we get a soft-landing in China, this will be positive for the broader emerging market countries. Though Chinese stocks may face headwinds, there are attractive opportunities in the broader emerging market equities. We are initiating a small position of 3.% in the BMO Emerging Market Equity Index ETF (ZEM). The fourth quarter of the year has historically been a seasonal strong period for technology stocks. However, tech stocks continue to run up against headwinds. While the longer-term potential for technology stocks remain positive, from a tactical perspective, we our eliminating our 3.% position in the BMO Nasdaq- Hedged to CAD Index ETF (ZQQ) as its underlying index, the Nasdaq- Index, registered a double-top formation, which usually precedes a short-term sell-off. Non-traditional/Alternative: Preferred shares have many characteristics that are beneficial to a portfolio, such as non-correlated returns to bonds and equities, tax efficient yield and lower volatility compared to bonds. As mentioned on the previous page, we prefer rate resets given they are less sensitive to rising interest rates. We are initiating a 5.% position in the BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR). In addition to being a portfolio of only rate resets, the portfolio utilizes a laddered approach, where the portfolio is divided in five equal term buckets, organized by reset year. The laddered structure allows an equal portion of the portfolio to reset to the current interest rate environment each calendar year, providing an additional layer of protection against rising rates. We continue to like gold given the ongoing expansionary monetary policy and lower relative interest rates in the U.S. However, the seasonality for gold tends to be the most significant in the last two quarters of the year. Consequently, we are trimming our position in the BMO Precious Metals Commodity Index ETF (ZCP) by 2.% to 5.%, still leaving us with a sizable position. Sell/Trim Ticker (%) Buy/Add Ticker (%) BMO S&P 5 Hedged to CAD Index ETF ZUE -.% BMO S&P 5 Index ETF ZSP 8.% BMO Nasdaq- Hedged to CAD Index ETF ZQQ -3.% BMO Emerging Markets Index ETF ZEM 3.% BMO Covered Call Canadian Banks ETF ZWB -1.% BMO Laddered Preferred Share Index ETF ZPR 5.% BMO Precious Metals Commodity Index ETF ZCP -2.% Total -16.% Total 16.%

4 4 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 (%) 9-Day Vol Volatility Contribution ZAG BMO Aggregate Bond Index ETF Debt Core $ % 21.% % 3.3% 1.14 ZCM BMO Mid Corporate Bond Index ETF Debt Tactical $ % 12.% % 4.4% 1.32 Total Fixed Income 33.% 14.7% Equities ZLB BMO Low Volatility Canadian Equity ETF Equity Core $ % 9.% % 2.3%.34 ZDV BMO Canadian Dividend ETF Equity Core $ % 9.% 7.9.3% 4.4%.56 ZSP BMO S&P 5 Index ETF Equity Core $ % 8.% % 2.2%.2 ZEM BMO Emerging Market Equity Index ETF Equity Core $ % 3.% % 1.6%.13 ZUB BMO Equal Weight U.S. Banks Hedged to C$ ETF Equity Tactical $ % 3.% % 1.5%.7 ZWB BMO Covered Call Banks ETF Equity Tactical $ % 3.% % 5.7%.83 ZRE BMO Equal Weight REITs Index ETF Equity Tactical $2.6.55% 5.% % 4.7%.52 ZEO BMO S&P/TSX Equal Weight Oil & Gas Index ETF Equity Tactical $ % 3.% % 2.7%.19 Total Equity 43.% 62.% Non-Traditional/Hybrids ZHY BMO High Yield U.S. Corp Bond Hedged to C$ Index ETF Debt Tactical $ % 7.5% % 6.7% 1.3 ZEF BMO Emerging Market Bond Hedged to C$ Index ETF Debt Tactical $ % 5.5% % 4.6% 1.1 ZPR BMO S&P/TSX Laddered Preferred Index ETF Equity Tactical $ % 5.% % 4.4% 1.7 ZCP BMO Precious Metals Commodities Index ETF Commodity Tactical $ % 5.% %.%. Total Non-Traditional/Hybrids 23.% 23.2% Total Cash Tactical 1.%.9.1% 1.3% Portfolio.37%.% 6.9.% 3.6%.52 Yield (%)* Yield/ Vol *Note: Bond yields are based off of yield to maturity. **Cash is based off of 3-month Canadian Dealer Offered Rate (CDOR) Ticker Top Holdings Weight ZAG BMO Aggregate Bond Index ETF 21.% ZCM BMO Mid Corporate Bond Index ETF 12.% ZLB BMO Low Volatility Canadian Equity ETF 9.% ZDV BMO Canadian Dividend ETF 9.% ZSP BMO S&P 5 Index ETF 8.% ZHY BMO High Yield U.S. Corp Bond Hedged to C$ INDEX ETF 7.5% ZEF BMO Emerging Market Bond Hedged to C$ Index ETF 5.5% ZRE BMO Equal Weight REITs Index ETF 5.% ZPR BMO S&P/TSX Laddered Preferred Index ETF 5.% ZCP BMO Precious Metals Commodities Index ETF 5.% ZEM BMO Emerging Market Equity Index ETF 3.% ZUB BMO Equal Weight U.S. Banks Hedged to C$ ETF 3.% ZWB BMO Covered Call Banks ETF 3.% ZEO BMO S&P/TSX Equal Weight Oil & Gas Index ETF 3.% Cash 1.% Cash (1.%) Non-Traditional (23.%) Equities (43.%) Fixed Income (33.%) Core 5.% Tactical 5.%

5 5 Portfolio Characteristics Regional Breakdown (Overall Portfolio) Canada 67.% United States 18.5% Emerging Markets 8.5% Commodities 5.% Cash 1.% *Regional Breakdown includes equities, fixed income and alternative sleeves. Equity Sector Breakdown Financials 4.5% Energy 18.% Materials 2.3% Telecommunication Services 4.6% Industrials 3.5% Consumer Discretionary 7.8% Information Technology 5.5% Consumer Staples 7.1% Utilities 7.% Health Care 3.7% Fixed Income Breakdown Federal 2.% Provincial 13.5% Investment Grade Corporate 39.% Non-Investment Grade Corporate 16.5% Emerging Markets 11.% Weighted Average Term 8.8 Weighted Average Duration 6.3 Weighted Average Coupon 5.2% Weighted Average Current Yield 4.6% Weighted Average Yield to Maturity 3.3% 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 6 The Good, the Bad, and the Ugly First Quarter 213 Outlook: The Santa Claus rally looks to carry its momentum into the new year. Fundamentals remain attractive and the global macro-economic picture continues to show signs of improvement. Investors will likely become more optimistic over the first quarter, as the technical underpinnings of risk assets gather momentum. With the U.S. running up against its debt ceiling and with other potential sources of tail-risk in the global economy, the market may become exposed to a repricing of risk later in the first quarter. We have increased the cyclicality of our strategy, but our core remains defensive as risk premia in equities remains low. Global-Macro/Geo-Political Fundamental Technical Good A fiscal cliff resolution paves the way for a short-term risk rally. The European Central Bank s (ECB) OMT programme has been a game changer in stabilizing sovereign debt yields in the Eurozone. U.S. housing, ground-zero to the 28 financial crisis, continues to improve. China is beginning to show signs of a manufacturing turnaround which would benefit the global economy. U.S. high yield credit spreads has lagged the CBOE/S&P Implied Correlation Index (VIX) suggesting an investor preference for noninvestment grade corporate bonds over equities. Fundamentals continue to remain attractive with 8 of the GICS sectors in the TSX trading below their -year price-to-earnings (P/E) averages. Sentiment has notably improved compared to the beginning of Q The technical underpinnings of the market have improved. Market breadth was encouraging in the fourth quarter and risk assets have gained positive momentum. Liquidity remains favourable for risk assets. December Purchasing Managers Index (PMI) numbers for the U.S. and a number of Asian and European countries improved. Bad Rising turmoil in the Middle East could disrupt commodity prices, stunting the economic recovery in the developed world. Monetary policy and unconventional policies have become less effective, with risk assets rallying for shorter durations with each installment of quantitative easing. A number of Canadian banks were downgraded by credit rating agency Standard and Poor s. Canadian energy stocks still trade at a premium to their global U.S. counterparts. The S&P/TSX Energy Index is trading at a current P/E of 19.8x, notably higher than the 11.9x and.9x current P/E of the S&P 5 Energy Index and MSCI ACWI Energy Index respectively. Gold lost its positive momentum at the end of 212. However, monetary policy continues to be positive for the hard assets. Intra-market correlation and market volatility remains highly correlated, severely limiting the effects of single asset class diversification. Investors should consider moving from traditional 6/4 (Equity/Fixed Income) portfolios to multiasset portfolios, which include non-traditional assets. Resistance of the S&P 5 Composite Index is at 1475 and 29 for the Nasdaq-. A failure to break above these levels could spell headwinds for U.S. equities. Presidential cycle would be a negative for stocks, but the improving macro-economic picture will be more important. With the S&P 5 Composite trading near its recent high, a Fibonacci retracement to 61.8% would be close to a 5.% drop. Ugly The U.S. has once again breached its debt ceiling. Should political jockeying continue, a repeat of the 211 U.S. Treasury downgrade crisis could occur. With interest rates already bottomed and noncoventional policies less responsive, central banks may lack sufficient measures should financial markets experience a significant sell-off. Higher beta and more cyclical trades still have lower risk-adjusted returns than lower beta, more defensive plays as equity risk premia remains low. Canadian stocks have remained in a holding pattern for the last year and a half. Less infrastructure building in the emerging markets and U.S. becoming more energy independent may lead the S&P/TSX to face continued headwinds.

7 7 Footnotes 1 Quantitative easing: An unconventional monetary policy used by some central banks when traditional measures have not produced the desired effect. Money supply is typically increased in an effort to promote increased lending and liquidity. 2 Federal Open Market Committee (FOMC): A committee within the U.S. Federal Reserve that is in charge of determining monetary policy for the country. It makes key decisions on interest rates, money supply and unconventional monetary measures through open market operations. 3 Operation Twist: A program initiated by the U.S. Federal Reserve (Fed) to push down long-term rates by reinvesting the proceeds of selling short-term U.S. Treasuries in issues of longer maturity. By doing so, the Fed aims to stimulate the economy by lowering long-term borrowing costs by flattening the yield curve. 4 Outright Monetary Transactions: A European Central bank program, which enables them to purchase sovereign bonds issued by European member states in the secondary market. 5 Tail-risk: The risk of an outlier or improbable event occurring. Statistically, the event is said to be three standard deviations away from the mean under a normally distributed curve. Visit bmo.com/etfs or contact your financial advisor to find out more on BMO ETFs. The Dow Jones Industrial Average SM is a product of Dow Jones Opco, LLC, ( Dow Jones Opco ), a subsidiary of S&P Dow Jones Indices LLC and has been licensed for use. Dow Jones and Dow Jones Industrial Average SM are service marks of Dow Jones Trademark Holdings, LLC ( Dow Jones ) and have been licensed to Dow Jones Opco for use for certain purposes. BMO ETFs based on Dow Jones indexes are not sponsored, endorsed, sold or promoted by Dow Jones Opco, Dow Jones or their respective affiliates, and Dow Jones Opco, Dow Jones and their respective affiliates make no representation regarding the advisability of trading in such product(s). S&P and S&P 5 are trade-marks of Standard and Poor s Financial Services LLC and TSX is a trade-mark of TSX Inc. These and other associated trade-marks and/or service marks have been licensed for use by BMO Asset Management Inc. None of the BMO ETFs are sponsored, endorsed, sold or promoted by any of its aforementioned trade-mark owners and the related index providers or their respective affiliates or their third party licensors and these entities make no representation, warranty or condition regarding the advisability of buying, selling or holding units in the BMO ETFs. Nasdaq, OMX, NASDAQ OMX, Nasdaq-, and Nasdaq- Index, are registered trademarks of The NASDAQ OMX Group, Inc. (which with its affiliates is referred to as the Corporations ) and are licensed for use by BMO Asset Management Inc. The BMO Nasdaq Equity Hedged to CAD Index ETF has not been passed on by the Corporations as to its legality or suitability and is not issued, endorsed, sold, or promoted by the Corporations. THE CORPORATIONS MAKE NO WARRANTIES AND BEAR NO LIABILITY WITH RESPECT TO The BMO Nasdaq Equity Hedged to CAD Index ETF. 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 changes frequently and past performance may not be repeated. BMO (M-bar roundel symbol) is registered trade-marks of Bank of Montreal, used under licence. 12/12-16