The best ways to own Canadian banks

Editor’s note: this is an updated version of an article published in September 2012.

Canada has long been known as a country of natural resources: oil, rocks and trees. Following the 2008–2009 global financial crisis, banks were added to the list. Whether bank executives exercised more effective risk management or regulators held tighter control over capital ratios does not matter; Canadian banks rode through the worst banking collapse since the Great Depression relatively unscathed.

In 2012, a consortium of banks acquired 80% of TMX Group, which owns the country’s largest stock market, the Toronto Stock Exchange. This unprecedented vertical control of capital market access by Canada’s most powerful financial institutions led me at the time to observe that the banks were too critical to the country’s well-being to fail. Taxpayers could be asked to bail out the banks from any serious threats, meaning that their credit ratings were effectively as good as the Government of Canada’s.

Owning bank shares made sense even before the TMX acquisition. As banks transitioned from their traditional spread business—borrowing from depositors at low rates and lending at higher ones—and expanded into consumer finance (e.g., consumer loans and credit cards) and wealth management, it was evident they commanded dominant market share and pricing power. Indeed, as stated in CSA Consultation Papers 81-408 and 81-407, banks now control 43% of mutual fund assets under management and more than two-thirds of mutual fund distribution in Canada. Further, 80% of mutual fund owners with portfolios smaller than $100,000 bought those funds from banks.

Bank stocks have been dividend engines, paying out about 45% of cap-weighted earnings (see Table 1). Yields of between 3.56% and 4.42% look attractive compared with a broader market yield of 2.16% for the S&P/TSX 60 (as at April 2017).

Selecting bank stocks used to be easy because they all performed similarly. Since their dominant spread businesses were highly correlated, they tended to move together as interest rates rose and fell. This has changed significantly over the past 20 years, with business and geographical expansion. Some banks have a larger proportional loan exposure to domestic residential mortgages (CM), some to auto loans (TD), others to the energy sector (CM, NA) and yet others to foreign markets (BNS). Investors must either choose carefully or obtain diversified exposure through ETFs (see Table 2).

Bank exposure among sector ETFs ranges from 43.2% (HEF) to 135.2% (HFU). (Disclosure: my firm provides model portfolios to Horizons ETFs.) Horizons Betapro Capped Financials (HFU) is a leveraged ETF that targets two times the daily return of the underlying Capped Financials Index, and has a 67.6% bank weight (multiplied by two, that’s 135.2%). During periods of low volatility, an investor can hold a half position in this instrument and get full exposure, freeing capital to buy other diversifying assets. Avoid this vehicle when volatility is high.

The derivatives-based Horizon ETFs in Table 2 use forward contracts to get exposure to the underlying index performance, so some counterparty risk is involved. All are total return structures that do not have distributions, making them tax-efficient.

The ETFs with the highest bank exposure (ZEB, ZWB and CIC) display somewhat higher yields than broader-based financial sector ones like XFN and CEW. The BMO Covered Call Canadian Banks ETF (ZWB), in particular, demonstrates a higher distribution, a characteristic of a covered call strategy. But higher yields come at the obvious cost of limited diversification, since the bank-focused ETFs only track six firms. In rapidly rising markets, ZWB also has less potential upside because writing at or near out-of-the-money calls changes the risk-reward characteristics of the portfolio, which is meant to offer modestly higher distributions and some downside protection as a trade-off against forgoing some upside. Covered calls are ideal in a sideways or gradually advancing market.

Enhanced income ETFs like HEF and FIE select constituents specifically to boost yield, so their higher yields are no surprise. They are also more diversified.

Broad Canadian market indexes like the S&P/TSX 60 and FTSE Canada offer more than 30% bank exposure with broad diversification (see Table 3). These ETFs benefit from significantly lower costs and better diversification, and have higher valuations, as indicated by their higher price-earnings ratios.

Caveat

The last meaningful Canadian housing downturn occurred in 1990. This event threatened the value of the collateral underlying the banks’ mortgage portfolios, and bank stocks took three years to recover, though their dividends remained solid throughout. Since then, all banks have worked to diversify their business exposures.

Owning the banks is a good way to capture solid yields and participate in dominant businesses while getting some small revenge for the fees and service frustrations we all encounter. But when the housing market suffers as the result of higher interest rates or overexuberance in key markets like Vancouver and Toronto, banks will not go unscathed. These ETFs may provide good shorting opportunities in that case.

Table 1: Owning the banks via direct exposure

Table 2: Owning the banks via sector ETFs

Table 3: Owning the banks via broad-market ETFs

Mark Yamada is President of PÜR Investing Inc., a software development firm. Disclosure: PÜR Investing Inc. provides risk-based model portfolios to Horizons ETFs.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.