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Investor profile

  • Portfolio size: $100,000 and below
  • Tax status: taxable
  • Time horizon: over 15 years
  • Risk: moderate
  • Objective: growth

Benchmark

  • 20% Canadian equities (S&P/TSX Composite)
  • 20% U.S. equities (S&P 500)
  • 20% International equities (MSCI EAFE)
  • 40% Canadian bonds (DEX Universe)

Exchange traded funds (ETFs) that use embedded strategies are all the rage. Unlike their passive cousins that replicate traditional capitalization-weighted indices, and that have underpinned the growth of the worldwide ETF market to date, these active strategies seek to improve upon traditional index construction. Smart beta, high beta, equal weight, low volatility, fundamental and factor-based strategies, such as growth, value, and momentum, are all active “indexing” strategies.

Advisors looking to “add value” for clients with modest assets (less than $100,000), may find the promise of outperformance an intriguing option particularly if there is limited room to trade in these smaller portfolios. Does it make sense to use these active strategies and if so, which ones? Do active strategies improve returns and at what cost?

It is no surprise that the answer to all these questions is “it depends.” Some strategies are better at protecting capital in down markets while others are better at capitalizing on bull markets. Some help control risk related to individual companies or sectors and others help dampen volatility. Advisors can use other strategies to accomplish these same objectives, but time, effort and expense are variables in doing so.

The portfolios in Table 1 were designed to incorporate embedded strategies whenever possible, but we chose cap-weighted international and fixed income ETFs to contain costs. Table 2 shows the all capitalization-weighted equivalents for comparison.

Fixed Income

The short 2.7 year duration of the bond portion for all these portfolios, Vanguard Canadian Short-Term Corporate Bond Index (VSC), reflects a concern for rising interest rates sometime in the indeterminate future. An alternative approach would be to match the term of the bond portfolio with the investor’s time horizon. A long time span will involve more volatility but, getting capital back at the end of the period shouldn’t be a problem assuming reasonable credit quality. BMO and RBC both offer a series of target maturity bond ETFs that fit this approach. Laddered ETFs also make good sense with the prospect of rising rates. Our preference is a short 1–5 year ladder because of the extremely low current rate environment, and we prefer the extra yield of corporate bonds because credits are improving with albeit modest economic growth prospects. iShares 1–5 Year Laddered Corporate Bond (CBO), PowerShares 1–5 Year Investment Grade Corporate Bond (PSB) and RBC 1–5 Year Laddered Corporate Bond (RBO) ETFs are available for this choice. Although their track records are limited, other alternative fixed income ETFs, with terms to maturity just over 5 years, that have come to market recently are worthy of consideration for their yields. PowerShares Senior Loan (BKL) and First Trust Senior Loan (FSL) package floating rate (resetting every 30–55 days) debt obligations of companies are typically BB+ rated. As senior loans, they are collateralized against assets.

Fees

The all capitalization-weighted alternatives in Table 2 show fees that are lower for each strategy, as one would expect. What may be surprising is that the costs of the embedded-strategy portfolios were all under 0.30%, with a little help from international equities (VDU, 0.28%) and bonds (VSC, 0.15%). Inasmuch as these are mostly active strategies that can be compared with active mutual funds, the savings are substantial. The challenge for advisors is to determine if the relative advantage of including embedded strategy ETFs in a portfolio is worth the added ETF cost of 0.09% in each example.

Global Macro (embedded strategy)

Economic growth well below historical norms five years into a recovery and interest rates at 32-year lows underline the top down strategy for this portfolio. Dividends provide income and stability, so selecting dividend-driven ETFs makes sense for those who are a little defensive after a strong 2013, seek more current income, and fear the economy sliding back into recession or worse. In Canada, RBC Quant Canadian Dividend Leaders (RCD) and BMO Canadian Dividend (ZDV) both with 0.39% in fees and Vanguard Canadian High Dividend Yield Index (VDY), 0.30%, are available. U.S. choices trading in Canada include Vanguard U.S. Dividend Appreciation (VGG) with a 0.28% fee and others (see Table 3). A concomitant benefit may be lower volatility but one should recognize that securities underlying these products may be relatively overvalued because so much money has been seeking higher yields in recent years. Traditionally better dividend paying companies, such as utilities and tobacco companies, trade at a discount to the market multiple and are now at or above it. The price earnings ratio (P/E) for the S&P/TSX Composite Index, as represented by iShares (XIC), is 16.2 versus 17.7 for iShares Dividend Aristocrats (CDZ) for example. In the U.S., the Dow Jones Industrial Average has a P/E of 14.8 compared with 20.2 for the Dow Jones Utility Average. Because of these valuations, we deviated from our strongly held practice of selecting the lowest cost ETF available and opted for RCD. We like that the selection process examines the company’s prospects and ability to maintain and grow dividends into the future rather than the general practice of picking the highest dividend yielding securities in an index.

Emerging markets have underperformed recently because lack of economic momentum in China and the U.S. threatens their near-term prospects. For long term investors, however, this is an opportunity to accumulate a growth component. The iShares MSCI Emerging Markets Minimum Volatility Index Fund (XMM) selects lower volatility holdings from the MSCI Emerging Markets Index. Research has shown a reasonably good relationship between lower volatility and higher returns in both developed and emerging markets. An important characteristic is that this strategy should reduce draw downs in bear markets compared with the cap-weighted alternative. This contradicts the basic assumption that higher risk leads to higher returns. Our theory is that low volatility securities suffer less volatility drag, the phenomenon that explains the difference between compound (geometric) returns and simple daily (arithmetic) returns.

Exposure to Europe may be of interest for an associated reason. Still facing serious economic and social issues relating to the global financial crisis, Europe may offer relative value and exposure to continuing improvement: BMO MSCI Europe High Quality Hedged (ZEQ).

Core Satellite (embedded strategy)

A low volatility Canadian equity ETF was substituted for the dividend one used in the Global Macro portfolio. PowerShares TSX Composite Low Volatility Index (TLV) follows construction principles similar to XMM mentioned above and iShares MSCI Canada Minimum Volatility Index (XMV). A third low volatility alternative in Canada is the BMO Low Volatility Canadian Equity (ZLB) that uses a weighted beta scheme to determine holdings. Chart 1 shows the sector exposures of the BMO ZLB compared with PowerShares TLV. Large sector differences in Utilities, Oil and Gas, Consumer Discretionary, and Telecom illustrate the importance of studying the underlying holdings of all ETFs. Performance can vary significantly.