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David Stephenson, director ETF strategy and development, CIBC Asset Management.
As inflation persists, how can ETFs be used to soften the blow? The war in Ukraine and inflation have been major drivers of market returns this year. U.S. and Canadian inflation data show price increases hovering near 40-year highs. Canadian inflation peaked at 8.1% in June and has declined for three straight months to 6.9% currently, but is still very high to the Bank of Canada targeted 2%, which has led to a steep and fast tightening cycle.
A major concern by investors is this rapid increase in rates could tip the economy into a recession. The outcome investors are currently debating is the soft or a hard landing with fixed income and equity markets both having challenging years. In the ETF industry, less than 10% of ETFs have had positive year-to-date performance. In this type of macro environment, ETFs have provided a great tool for investors to deliver specific portfolio outcomes, especially considering the product choices available, trading flexibility, and how investors can slice and dice the market both on the fixed income and equity side of portfolios.
As inflation has become top of mind for investors, a proven inflation hedge is to invest in parts of the market most impacted, areas where ETFs are available, such as energy, commodities, and thematic exposure, such as infrastructure.
What strategies are most optimal in the current market? We are in a fundamentally different market environment from the one we’ve seen over the last decade, driven by higher inflation, tighter monetary policy, and elevated geopolitical risk. The key for investors is to focus on what they control, such as the longer-term benefits of global diversification, disciplined behaviour, and staying focused on their unique financial goals and asset mix.
Having said that, ETFs have made top-down and cross-market investing more accessible by providing tools and allowing investors to incorporate dynamic strategies in their portfolio management processes and response to shifting risk and return opportunities. A good example of that is that many investors are incorporating some form of inflation protection into their portfolios to focus on equities. Sectors that have benefited include energy, real estate, and infrastructure.
Infrastructure investments can serve as a diversified source of return, and many assets have an explicit link to inflation through regulations or contracts, and have the ability to pass on increases to consumers. We’ve also seen examples of this in the consumer staple sector, grocery stores in particular, where consumers are feeling the pinch of higher prices.
The other concern in this current market environment is the possibility of a recession given the significant interest rate increases we’ve seen so far year to date. Many investors have been combining passive beta exposure and active risk. For example, a directional tilt in favour of defensive sectors, such as utilities and consumer staples. Many of these companies have benefited from higher inflation. And looking at the S&P/TSX Composite sector performance year to date as of October 21st, energy and consumer staples are the best performers and the only sectors with positive returns. ETFs make it very easy to express active use, either using passive exposures or actively managed strategies.
What types of products are investors asking for in this environment? Interestingly, despite the market volatility this year, flows into ETFs have totalled approximately 26 billion as of mid-October and have been relatively balanced between equity and fixed income. The main story has been a flight to safety and fixed income, but investors are still adding Canadian, U.S., and international equities to their portfolios as well.
We like low-volatility dividend ETFs in this market. They have performed relatively well year to date and offer downside protection and a smoother return profile, so they’re doing what they’ve been designed to do. As well, during volatile periods, dividends typically contribute a larger share of total return. Combined, these two strategies can potentially provide investors with a yield premium to the broader market, lower overall portfolio volatility, and can mitigate downside risk.
We also think there are opportunities globally, given the market sell-off to diversify, within both passive and active, but in particular for active managers that focus on companies offering attractive valuations and growth prospects. As often has been the case historically, unusually high volatility leads to a high spread in valuations, which has been a good environment to add value via stock picking.