Portfolio Strategy Report First Quarter Things to Keep an Eye on...

Transcription

1 BMO ETF Portfolio Strategy Report First Quarter 2014 BMO EXCHANGE TRADED FUNDS Slowly Inching Towards Normalization 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 January 6, 2014, 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. After reneging on its hints of tapering back at the September Federal Open Markets Committee (FOMC) meeting, the U.S. Federal Reserve (Fed) finally came through by announcing its intention to scale back its monthly bond buying program. Unlike the asset wide sell-off we experienced in the summer months, however, equity markets continued to rally into the end of the year. Much of the equity market strength in the last several weeks was due to the tapering and hence a more hawkish monetary policy was already priced-in from the summer sell-off. The removal of stimulus was actually a sign of economic improvement, boosting investor confidence this time around. The movement in the Canadian yield curve since the Fed announcing No Taper in September has been notably different than its U.S. counterpart over the three months. Shorter term rates in Canada have actually fallen, whereas longer rates have been more steady (Chart A). Stateside, has been the opposite, the short-end has been extremely steady, given the Fed s pledge to keep rates low until 2015, but longer rates have been more volatile. (See the Changes to Portfolio Strategy section to see our fixed income positioning) The term structure in VIX 1 futures contracts, which we often mention, has been flattening out (Chart B). This implies investors expect less equity market volatility in the future. This is somewhat concerning for two reasons: firstly, this essentially means equity markets are priced for perfection, making unexpected headline risk more reactive when they occur and secondly, lower volatility will bait more and more investors to allocate to equities, which could lead bond yields to rise too quickly. In 2014, we expect interest rates to continue dictating the moves in assets. Macro-economic policy and therefore a top-down view will still be prominent. However, as the global economy continues to stabilize, more emphasis will be put on getting exposure to certain assets, sectors and factors, rather than just chasing broad beta. Since we expect intra-market correlation to ease, complementing passive/ systematic strategies with bottom up investing will also likely serve investors well as markets move to normalization. That s not to say that markets won t see headwinds in the new year. While the macro-economic backdrop has improved for the most part, the technical picture is looking overbought. Furthermore, the fundamentals in certain areas, while not overbought, are beginning to look a slightly more rich. In addition to markets being priced for perfection, we continue to believe there is an excess amount of leverage in the system, leaving markets extremely vulnerable should rates move up too quickly. 4.0% 3.5% Chart A: The Canadian Yield Curve 02/01/ /09/ Chart B: Market Expects Equity Volatility to Remain Low Yield (%) 3.0% 2.5% 2.0% VIX Futures Level % 12 Now Same Time Last Year 1.0% 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 12Y 15Y 20Y 25Y 30Y Term 10 Spot 1 M 2 M 3 M 4 M 5 M 6 M 7 M 8 M 9 M Contract Month Source: BMO Asset Management Inc., Chicago Board of Options Exchange (CBOE Holdings Inc.), Bloomberg

2 Portfolio Strategy Report First Quarter Things to Keep an Eye on... MSCI Europe/S&P 500 Composite Ratio Oct Oct MSCI Europe/S&P 500 Composite Ratio Oct Oct Oct Nov Nov Nov Nov Dec Dec Dec Dec Jan European equities, when looking at the larger cap Euro Stoxx 50 Index, have shown relative strength against U.S. equities over the last two quarters. The much broader MSCI Europe Index, which also include smaller cap securities, has also recently began to outperform the S&P 500 Composite Index. This has been due to a growing number of investors increasing their allocations to the area. From a pure economic policy standpoint, a case can be made for European equities, given the European Central Bank (ECB) and central banks in the surrounding area are rumoured to become more dovish. This is a stark contrast to the Fed s recent stance of tightening monetary policy. Recommendation: From a fundamental perspective, however, valuations haven t been that appealing with the current price-to-earnings (P/E) ratio of the MSCI Europe Index at 20.0x, while the S&P 500 Composite is currently at 17.3x. The higher valuations in Europe are due to lower earnings, a result of the weaker economic backdrop. Although we still favour U.S. equities, the momentum behind their European counterparts cannot be denied. We continue to keep a close eye on the region, waiting for the fundamental story to catch up to the technical underpinnings. Year over Year Gain (%) 25% 20% 15% 10% 5% 0% Exactly a year ago, we recommended investors increase their exposure to the U.S. dollar and hence elect to use non-currency hedged alternatives when investing in U.S. assets. We continue to stand by that view. With long rates in the U.S. rising relative to the same parts of the yield curve in Canada, the interest rate differential will likely widen, making the U.S. dollar relatively more appealing. In fact, with the Fed looking to raise rates while most other central banks look to stand pat, we favour the greenback in most currency crosses and view the U.S. dollar to be in the early stages of a bull-market. Recommendation: With a large portion of our strategy allocations in U.S. equities and credit, we continue to recommend using non-currency hedged options where available, particularly for longer term core holdings. For shorter term trades and tactical positioning, a currency hedge may be more optimal, as short-term currency movements are less predictable. -5% U.S. Dollar Index vs. Euro vs. Japanese Yen vs. British Pound vs. Canadian Dollar vs. Swedish Krona vs. Swiss Franc Gain Over Last 6 Months (%) 30% 25% 20% 15% 10% 5% 0% -5% Health Care Industrials Financials Cons Discr Info Tech Telecom Energy Cons Stap Materials Utility In our second quarter 2013 report, published in early April, we mentioned how the yield curves in both Canada and the U.S. were steepening on the long end. We mentioned how this would place pressure on yield oriented assets and investors should put more of an emphasis on cyclical oriented areas exposed to the economic recovery. Recommendation: Back in that April report titled The Steepening Effect, talks of Fed tapering were not yet mentioned nor speculated by the market. Now with the Fed confirming it will scale back its bond buying program, the need for cyclical assets are only more justified. In our second quarter report, we recommended an allocation to the BMO Equal Weight Industrial Index ETF (ZIN). Since that time, industrials have been the second best performing sector of the S&P/TSX Composite Index. We continue to recommend investors maintain exposure to this ETF in their portfolio strategy. In fact, as outlined in our Changes to Portfolio Strategy section on page 3, we have actually increased our weighting to ZIN by 1.0%.

3 Portfolio Strategy Report First Quarter Changes to Portfolio Strategy Asset Allocation: For some time, we ve stated that asset allocation starts with the fixed income portion of an investor s portfolio. Given the expected directional move of interest rates, we continue to hold this belief, notwithstanding our long-term bullish view on equities. With a steeper yield curve and longer rates becoming more volatile, investors will be forced to shorten the duration of their bond exposure. Though shorter term bonds are less volatile, they also yield less, leaving investors looking to other asset classes to make up the shortfall. As rates rise and economic conditions strengthen, credit-related areas will become more appealing than government bonds. While we have been recommending investors increase their exposure to corporate bonds and high yield debt, we acknowledge that this exposes investors to a widening of credit spreads should the economic recovery lose momentum. As we have reduced our weighting in government bonds and increased the cyclicality of our equities over the last year, we have to have allocations to well selected areas that provide downside protection. From an asset allocation perspective, we remain overweight equities and underweight bonds and commodities. For the quarter, we are content with our allocation mix and tactical positioning within those assets as we have generated alpha. However, there are some minor adjustments needed in our portfolio positioning. Fixed Income: Over the last year, we have notably reduced the duration of our portfolio strategy. At this point, we intend to further increase our exposure to the short-end (or reduce our duration) with Canadian bonds. We are therefore allocating 3.0% in the BMO Ultra Short-Term Bond ETF (ZST), an ETF consisting of bonds maturing in less than one year. This ETF may also be supplemented with short term, higher yielding areas and floating rate instruments to supplement yield and help protect against rising rates respectively. This ETF has a duration of between 0.25 and 0.75, which not only brings down the duration of the portfolio strategy, but also increases its liquidity profile and protection in a rising interest rate environment. To fund the position in ZST, we will decrease our position in the BMO Aggregate Bond Index ETF (ZAG) by 3.0%, bringing its weight down to 14.0%. We continue to see ZAG as a core position, supplemented by other tactical positions in fixed income related areas. To make up for the yield short-fall in the fixed income portion of our portfolio, we have utilized covered call strategies to enhance the yield of our overall portfolio strategy. Over the last three years, we have remained overweight in U.S. equities and continue to hold that view. However, as the global economic recovery looks to gain momentum, multi-national companies exposed to various different economic regions will likely benefit. We are thus adding a 3.0% position in the BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF (ZWA) with its underlying portfolio of blue-chip names having global exposure and its covered call overlay, helping to supplement global exposure and yield in our overall portfolio strategy, respectively. As previously mentioned, our exposure to the Canadian industrial sector through our BMO Equal Weight Industrial Index ETF (ZIN), has fared well as economic data has improved. With the technical picture in this sector improving and the macro-economic backdrop looking favorable, as Canadian railway airline and machinery companies likely benefiting from a U.S. recovery due to increased trade activity, we will add an additional 1.0% to ZIN. Alternative/Hybrids: We are increasing our position in the BMO High Yield U.S. Corporate Bond Hedged to C$ Index ETF (ZHY) by 1.0% to 6.5% of the portfolio, as we anticipate further spread compression in this area. With the economic outlook gradually improving in the U.S., the business environment will be more favourable for non-investment grade companies. Furthermore, the default rate for high yield bonds remain low, averaging 2.6% over the last ten years. We are decreasing our position in our BMO Laddered Preferred Index ETF (ZPR) by 2.0% bringing it to 5.0% of the portfolio strategy. This is not to say that we are no longer favouring rate reset preferred shares, to the contrary, our outlook on rate reset preferred shares is favourable, but we are reducing our position to fund other adds/buys in our portfolio strategy. With a number of individual preferred shares very likely to be redeemed in 2014, that money will likely flow into existing and new issues, potentially causing the price in preferred shares to rise. Equities: Several quarters ago, we reduced our position in the BMO Equal Weight REIT Index ETF (ZRE). At that time, we were reluctant to eliminate the entire position, given we believed its sell-off was irrational. Now that the price action in real estate investment trusts (REITs) have normalized, we view this as a better exit point. We are thus eliminating our remaining 3.0% position in ZRE and although we believe REITs are well capitalized, at this time, we prefer increased exposure to credit and cyclical oriented assets. Sell/Trim Ticker (%) Buy/Add Ticker (%) BMO Aggregate Bond Index ETF ZAG 3.0% BMO Ultra Short-Term Bond ETF ZST 3.0% BMO Equal Weight REIT Index ETF ZRE 3.0% BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF ZWA 3.0% BMO Laddered Preferred Share Index ETF ZPR 2.0% BMO Equal Weight Industrials Index ETF ZIN 1.0% BMO High Yield U.S. Corporate Bond Hedged to C% Index ETF ZHY 1.0% Total 8.0% Total 8.0%

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 ZAG BMO AGGREGATE BOND INDEX ETF Debt Core $ % 14.0% % 2.1% 0.53 ZIC BMO MID-TERM U.S. IG CORPORATE BOND INDEX ETF Debt Tactical $ % 7.0% % 2.8% 0.75 ZCS BMO SHORT CORPORATE BOND INDEX ETF Debt Tactical $ % 9.0% % 2.9% 1.36 ZST BMO ULTRA SHORT-TERM BOND INDEX ETF Debt Tactical $ % 3.0% % 1.6% 3.29 Total Fixed Income 33.0% 14.7% Equities ZLB BMO LOW VOLATILITY CANADIAN EQUITY ETF Equity Core $ % 8.5% % 2.8% 0.45 ZDV BMO CANADIAN DIVIDEND ETF Equity Core $ % 9.0% % 5.6% 0.70 ZSP BMO S&P 500 INDEX ETF Equity Core $ % 8.0% % 2.2% 0.19 ZDY BMO U.S. DIVIDEND ETF Equity Core $ % 11.0% % 2.3% 0.22 ZEM BMO MSCI EMERGING MARKET INDEX ETF Equity Core $ % 3.0% % 2.1% 0.12 ZWB BMO COVERED CALL BANKS ETF Equity Tactical $ % 3.0% % 6.4% 0.77 ZIN BMO S&P/TSX EQUAL WEIGHT INDUSTRIALS INDEX ETF Equity Tactical $ % 5.0% % 2.9% 0.24 ZWA BMO COVERED CALL DOW JONES INDUSTRIAL AVERAGE HEDGED TO C$ ETF Debt Tactical $ % 3.0% % 5.4% 0.68 ZUB BMO EQUAL WEIGHT U.S. BANKS HEDGED TO C$ ETF Debt Tactical $ % 4.0% % 4.3% 0.30 Total Equity 54.5% 79.2% Non-Traditional/Hybrids ZHY BMO HIGH YIELD U.S. CORP BOND HEDGED TO C$ INDEX ETF Debt Tactical $ % 6.5% % 5.4% 1.22 ZPR BMO S&P/TSX LADDERED PREFERRED INDEX ETF Equity Tactical $ % 5.0% % 4.4% 1.70 Total Alternatives 11.5% 6.0% Total Cash Tactical 1.0% % 1.3% Portfolio 0.34% 100.0% % 3.3% 0.47 Yield (%)* Yield/ Vol Ticker Top Holdings Weight ZAG BMO AGGREGATE BOND INDEX ETF 14.0% ZDY BMO U.S. DIVIDEND ETF 11.0% 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% ZSP BMO S&P 500 INDEX ETF 8.0% ZIC BMO MID-TERM U.S. IG CORPORATE BOND INDEX ETF 7.0% ZHY BMO HIGH YIELD U.S. CORP BOND HEDGED TO C$ INDEX ETF 6.5% 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% ZST BMO ULTRA SHORT-TERM BOND INDEX ETF 3.0% ZEM BMO MSCI EMERGING MARKET 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% Cash 1.0% Cash (1%) Non-Traditional (11.5%) Equities (54.5%) Fixed Income (33%) Core 53.5% Tactical 46.5% *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-month Canadian Dealer Offered Rate (CDOR).

5 Portfolio Strategy Report First Quarter Portfolio Characteristics Regional Breakdown (Overall Portfolio) Canada 56.5% United States 39.5% Emerging Markets 3.0% Cash 1.0% *Regional Breakdown includes equities, fixed income and alternative sleeves. Equity Sector Breakdown Financials 25.5% Health Care 4.4% Industrials 14.9% Information Technology 8.4% Materials 3.6% Telecommunication Services 5.1% Utilities 8.2% Consumer Discretionary 9.2% Consumer Staples 8.3% Energy 12.2% Fixed Income Breakdown Federal 14.0% Provincial 10.6% Investment Grade Corporate 45.7% Non-Investment Grade Corporate 29.7% Weighted Average Term 6.3 Weighted Average Duration 4.5 Weighted Average Coupon 4.3% Weighted Average Current Yield 4.0% Weighted Average Yield to Maturity 3.0% 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: Although the Fed finally came through in announcing the tapering of their Large Scale Asset Purchase (LSAP) program, we believe much of the rise in yields were already priced into the market. With the Fed pledging to low rates until 2015, shorter term rates should be less volatile. Higher long-term rates, however, should be seen as a positive sign as it provides both investor confidence and evidence that the economy is normalizing. This should bode well for equities, especially for cyclical areas tied to the U.S. economy. We still believe yield oriented areas should fare well in the coming year, however, investors will have to be increasingly selective in these assets as the year progresses. We believe dividend related areas should fare better than pure defensive yield oriented areas as they tend to be less interest rate sensitive and provide the opportunity for capital gains. With interest rate sensitivity being one of the major key themes in 2014, investors will have to look to generate more yield on the short-end of the yield curve and make up for this short-fall in portfolio yield with solutions such as covered call overlays. Global-Macro/Geo-Political Fundamental Technical Good Higher long-term rates should be seen as a positive for the global economy, rather than the negative it is made out to be. The U.S. unemployment rate continues to tick down from its high of 9.93% in 2009 to the 7.3% where it stands now. Industrial production in China, the world s second largest economy, is back on the rise. Leading Economic Indicator (LEI) a combination of 10 economic data points, shows the Euro area gaining momentum. Relative valuations for North American stocks still look attractive compared to their global counterparts. The MSCI North American Index has a 17.3x P/E ratio compared to the 18.8x of the MSCI World Index. For investors interested in emerging markets, the Asia Pacific and Latin American regions also look attractive, with the MSCI AC Asia Pacific Index and the MSCI EM Latin America Index trading at a P/E ratio of 13.9x and 15.4x respectively. Inter-market and intra-market correlations have drifted lower, making it easier for investors to generate alpha in their portfolios. Bad Labour force participation rates continue to drift lower in Canada. A colder winter could slow productivity and economic growth in Canada and Northern parts of the U.S. Initial jobless claims in the U.S. came in higher than expected, but these numbers tend to be volatile. Although monetary policy is supportive for European equities, the valuations are still rich on European equities. Although not grossly over valued, equity valuations are getting quite rich. The MSCI World Index is trading at a 18.8x P/E ratio, which is higher than its 17.0x ten-year average. The CBOE/S&P Implied Volatility Index (VIX) continues to remain low, only crossing above the 20 level twice in While a positive, this could also mean than there is perfection priced into the market. Inter-market ratios all favour equities, which could lead rates to move higher, faster than anticipated. Canadian household debt levels remain at highs, making the economy vulnerable to higher interest rates. Margin debt levels, continues to rise to all-time highs. While we keep mentioning it, it shows much of this rally has been built on leverage. Ugly The 30-year yield in the U.S. continues to move up. It s important yields in this area don t rise t0o quickly to avert putting a halt on the U.S. housing recovery.

7 Portfolio Strategy Report First Quarter Footnotes 1 CBOE/S&P Implied Volatility Index is based on the options of the S&P 500 constituents. It is commonly used to gauge market sentiment. The term structure of VIX futures, shows the market s expectation for market volatility in the future. 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 trade-marks of S&P Opco, 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. 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). 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.