In this issue:

What’s New

♦ Bank of Canada hangs tight – for now – After surprising the markets with a 25 basis point cut to its key lending rate back in January, the Bank of Canada held steady at 0.75% last week. With oil prices appearing to have stabilized and GDP growth showing resilience, Stephen Poloz has gone on record saying he believes the January cut is sufficient protection against the economic slowdown, at least for now. However, with energy prices expected to remain low, and the economy and housing markets slowing in some regions, further cuts may be warranted in the next few months. Stay tuned!

♦ Fewer Canadian contributed to RRSPs – While fewer Canadians contributed to their RRSP this year, those who did contributed on average, about $200 more. This according to a recent study done by the BMO Financial Group, which showed that 57% of Canadians contributed before the March 2 deadline, down from 65% in 2014. When asked why they didn’t make a contribution this year, 38% of respondents cited a lack of funds as the key reason, a quarter said they had higher priority expenses, and more than 20% were taking advantage of other investments such as a TFSA for their savings. Another reason that some may not have contributed is they find the prospect of coming up with a few thousand dollars at the end of the year challenging. A great way around that is to make monthly contributions into your RRSP, making it a less daunting task. Still, with nearly 60% contributing, it is a fairly positive story.

 

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ETF RECOMMENDED LIST REVIEW


Bank of Canada shocks markets by cutting rates? No material change to investment outlook

By Dave Paterson, CFA

When we did our last review of the ETF Recommended List in December, the thing that had everybody’s attention was the precipitous drop in oil prices and the effect it was expected to have on the Canadian economy. At that time, oil was trading in the $66 range, and has since continued its decline, touching a low of $44.45 at the end of January. It has since gained a bit of ground and shown some signs of stabilizing, closing February 28 at just under $50.

Clearly this drop has spooked many, including the Bank of Canada Governor Stephen Poloz who cut the Bank’s key overnight lending rate by 25 basis points in January. He said this was an insurance policy against the potential fallout from economic slowdown expected thanks to lower oil. While that may be the official line, many market participants saw this more as a way to lower the value of the Canadian dollar in an effort to boost sagging exports.

While this move was surprising, it really hasn’t done much to change my investment outlook. I still favour equities over fixed income. Within equities, I favour the U.S. over Canada or Europe.

Where my outlook has changed slightly is that I have improved my short-term outlook on fixed income to NEUTRAL from UNDERWEIGHT. However, this is only a temporary change in stance and will move to UNDERWEIGHT again as we are able to gain more clarity around the economic and interest rate picture.

I had been favouring short term and higher yielding bonds because I was worried that a higher, more index like duration stance would hurt returns with flat or rising rates. Now, with downward pressure on rates, taking more duration risk in the short term may be justified. This is only for the very near term, and a more defensive positioning will be warranted soon.

Within the equity space, even with the higher valuation levels, I continue to favour the U.S. over the other regions. It is not so much a case that the U.S. is a great place to invest, but more that the other regions are facing headwinds.

In Canada, oil will likely be the key driver of the markets, with spillover to the financials, particularly the banks which are expected to struggle under the weight of lower interest revenues, less merger & acquisition activity, and potentially higher loan loss reserves. Combined, energy and financials make up more than half the index, so without a material rebound in the oil price, it will be difficult for the TSX to generate outsized gains. Further, I expect that volatility will continue to be on the upswing.

In Europe, with the recent Greece crisis kicked further down the road, the focus can again return to the underperforming economies. The European Central Bank continues to talk about stimulus packages, and eventually one will stick. Valuations are the most attractive of any of the developed markets, but until there is a sustained recovery, I expect higher levels of volatility. For those with an above average appetite for risk, you may want to consider adding to Europe, but it is a risky play right now.

Asia continues to struggle, with China posting its slowest growth rates in decades. The central bank stepped in, cutting interest rates in an effort to spur the economy. China is a key driver not only to Asia, but also Europe and the emerging markets. As long as China continues to struggle, so too will those regions. As with Europe, I expect things will turn around in the medium term, but am expecting higher than normal volatility while things work through.

My current investment outlook is:

   
Underweight
Neutral
Overweight
Cash
X
Bonds
X
  Government
X
  Corporate
X
  High Yield
X
  Global Bonds
X
  Real Return Bonds
X
Equities
X
  Canada
X
  U.S.
X
  International
X
  Emerging Markets
X

Following are the changes to the ETF Recommended List.

ETFs Added to the List

BMO MSCI EAFE Index (C$ Hedged) ETF (TSX: ZDM) – This ETF is designed to replicate the performance, net of fees of the MSCI EAFE Index, with 100% of the currency exposure hedged back to Canadian dollars. The MSCI EAFE Index is the pre-eminent benchmark of international equities, investing in approximately 1,000 large and mid-cap stocks in developed markets around the world, excluding Canada and the U.S. It covers approximately 85% of the outstanding, free float adjusted market cap. I am adding this ETF to replace the iShares MSCI EAFE Index (C$ Hedged) ETF (TSX: CPD). ZDM provides virtually identical investment exposure, but does so at a lower cost, without sacrificing liquidity. The maximum management fee of ZDM is 20 basis points, which is 30 bps lower than XIN. One key difference is XIN invests in the U.S. traded iShares MSCI EAFE Index (NYSE: EFA), which fully replicates the index, while ZDM may use a sampling methodology. A downside to the sampling methodology is there may be a higher tracking error. This higher tracking error is more than made up for with slightly higher returns and a lower cost. Based on those factors, I believe this switch will be beneficial to investors.

ETFs Removed from the List

iShares S&P/TSX Canadian Preferred Share Index ETF (TSX: CPD) – With the Bank of Canada cutting its overnight lending rate, the outlook for the preferred share market in Canada turned somewhat negative. To understand why this is the case, we need to look at the makeup of the S&P/TSX Preferred Share Index, which this ETF seeks to replicate. Approximately two thirds of the index is fixed reset preferred shares, 30% is in perpetual preferred shares, and the rest a mix of floating rate and retractable preferreds.

Fixed reset preferreds pay a set dividend for a set time, usually five years. After this initial period, the dividend is reset at a new level that is based on a formula that often uses the Government of Canada five-year bond yield as its benchmark. With the recent rate cut, the yield on the Canada five year has taken a fall, currently hovering around 91 basis points (March 4), down substantially from the end of the year. If we do see additional cuts as many expect, yields are likely to fall even further.

Investors now fear that the dividends on the fixed resets will be set at much lower levels, making them much less appealing from a yield standpoint. With the ETF very concentrated in fixed resets, I am not comfortable with the near-term risk, and will be avoiding this ETF until we get a clearer direction on rates, and the new dividend levels. Investors looking to invest in preferreds may want to consider individual issues or some of the more actively managed preferred share mutual funds rather than this in the near term.

iShares MSCI EAFE Index (C$ Hedged) ETF (TSX: XIN) – I removed this from the Recommended List because I believe that ZDM provides a lower cost way to access the same investment exposure. The maximum management fee for XIN is 50 basis points, while ZDM is 0.20%. In a case where two investments offer a similar risk reward profile, I believe the lower cost option is the best choice.

ETFs of Note

iShares Canadian Short Term Bond Index ETF (TSX: XSB) – With the Bank of Canada likely to cut their key overnight lending rate at least one more time, the near term outlook for fixed income investments has improved dramatically from just a few months ago. While the expectation of a cut has largely been built into the price of shorter-term bonds, there is still some potential for a little rally if it does happen. While some of the longer dated issues may benefit more from the rate cut, I continue to be defensive and favour shorter duration issues. This ETF focuses exclusively on Canadian investment grade bonds that have a maturity of less than five years. It has a duration of 2.79 years, which is significantly lower than the 7.56 year duration of the broader Canadian market. This remains my top pick for shorter-term bond exposure.

PowerShares Tactical Bond ETF (TSX: PTB) – I had originally recommended this as an alternative to the iShares Canadian Universe Bond Index ETF (TSX: XBB) because I believed the tactical approach would allow it to outpace XBB in a rising yield environment. I liked the fact it is a hybrid between an active and passive strategy, investing in a mix of fixed income ETFs offered through PowerShares and other ETF providers. Invesco’s Global Asset Allocation team examines the economic and market environment, and will tactically position the underlying holdings to best position the portfolio for their outlook. Now that the yield environment has changed, and rates are expected to move slightly lower, I would once again favour XBB over this offering for the near term. However, taking a more medium to long-term view, I believe PTB to be a solid choice for those looking for a diversified, one ticket fixed income ETF solution.

BMO Low Volatility Canadian Equity (TSX: ZLB) – While I had expected the low volatility strategies to outperform in down markets, I certainly was not expecting the recent stellar performance posted of late. This was the best performing Canadian equity ETF over the past three months, gaining 12.1%, handily outpacing the broader market. It invests in stocks that have shown the lowest beta for the past five years, from a universe of the 100 largest, most liquid names that trade in Canada. Because of its focus on low beta, it is concentrated in the more stable consumer names, utilities, and communications, while maintaining a significant underweight in financials, energy, and materials. This positioning explains the outperformance, as it was those sectors that were hit hardest. While I have been pleasantly surprised by the recent performance, it is not sustainable, and I expect it to moderate in the coming weeks and months. Given the run up, now is a great time to rebalance your portfolio, and consider taking some money off the table with this, and any other low vol ETFs you may hold.

iShares Core S&P 500 Index (CAD Hedged) ETF (TSX: XSP) – Despite the economic recovery underway south of the border, U.S. equities took a breather, with XSP dropping 3.2% in January and finishing the most recent three months with a modest 0.70% loss. In comparison, the average U.S. equity mutual fund gained 9.1% for the most recent three months. The key reason for this dramatic difference in performance is the fully hedged currency exposure of XSP. With the Canadian dollar continuing its slide against the U.S. greenback, those investments with unhedged U.S. dollar exposure saw an extra boost to their performance thanks to the currency. With the Canadian dollar expected to remain weak, and more downside possible, depending on the Bank of Canada, the fully hedged currency position may continue to act as a headwind. If you still want U.S. equity exposure and are comfortable with unhedged currency exposure, you should take a look at the iShares Core S&P 500 ETF (TSX: XUS). It offers the identical investment exposure, save for the currency hedging policy. While unhedged currency exposure has been a benefit of late, it can also be a detractor should we see the Canadian dollar bounce back. Regardless, XSP and XUS remain my top picks for U.S. equity ETFs for their diversified portfolios and low cost. If there is a market that lends itself to passive investing over active, it is the U.S., and these ETFs are the best way to play the space.

BMO Global Infrastructure ETF (TSX: ZGI) – One of the more compelling investment themes for the past few years has been rebuilding the world’s crumbling infrastructure. This ETF looks to capitalize on that by investing in companies that are involved in the development, ownership, or management of infrastructure assets such as energy, pipelines, bridges, airports and toll roads. It holds approximately 50 names, and not surprisingly, it is heavily concentrated in energy and utilities. It tracks the Dow Jones Brookfield Global Infrastructure North American Index, which means that the majority of the holdings are large, well-capitalized companies. A benefit to this is they tend to generate meaningful dividends for investors. At the end of January, the dividend yield of the underlying holdings was 3%, which is higher than the broader global equity market. It passes some of this along to investors through a regular quarterly dividend, which has been $0.145 per quarter for the past several quarters. I prefer this over the iShares Global Infrastructure ETF (TSX: CIF) because it has shown a more favourable risk/reward profile at a lower cost. One concern that I do have is the valuations of the underlying portfolio looking pretty stretched, which may result in a period of underperformance and higher than average volatility. However, investor demand for yield and momentum in the sector may provide support for many of the names in the ETF. Still, the medium term outlook for infrastructure remains strong, and ZGI is a great way to gain exposure. While historic volatility may have been lower than the broader equity markets, I would still treat this as a sector fund and limit exposure in a portfolio according to your risk tolerance.

ETF Recommended List

ETF
FIRST MENTION
3 mths ending Jan 31
RESULTS
(to Jan 31)
COMMENTS
ACTION
Fixed Income
PowerShares Tactical Bond ETF (PTB)
Sep-14
5.9%
6.6% (6 mth)
Good one ticket bond portfolio. Favour XBB now
Hold
PowerShares Senior Loan CAD Hedged ETF (BKL)
Dec-13
-0.7%
0.4% (1 Yr)
Fed looking to move likely in June. Hold for now
Hold
iShares 1-5 Year Laddered Corporate Bond (CBO)
Jul-12
2.7%
4.2% (1 Yr)
Favouring the more diversified XSB for near term
Hold
iShares DEX Universe Bond Index (XBB)
Dec-07
6.7%
5.7% (5 yr)
Remains best option for diversified bond holding
Hold
iShares Canadian Short Term Bond Index (XSB)
Aug-04
2.7%
3.8% (10 yr)
Outlook positive on expected BOC rate cuts
Buy
 
Income ETFs
BMO Monthly Income ETF (ZMI)
Nov-14
1.6%
1.6% (3 mth)
Distributions yield 3.6%. Some growth potential.
Hold
iShares Diversified Monthly Income Fund (XTR)
Aug-13
1.5%
7.3% (1 Yr.)
Offers modest growth potential with 6% yield
Hold
 
Canadian Equity
BMO S&P/TSX Capped Composite ETF (ZCN)
Mar-15
NEW
NEW
Offers more attractive liquidity than XIC
Hold
BMO Low Volatility Canadian Equity ETF (ZLB)
Jan-13
12.1%
31.4% (1 Yr)
Low vol continues to outperform. Take profits
Hold
PowerShares FTSE RAFI Canadian Fundamental (PXC)
Jan-13
-0.7%
6.5% (1 Yr)
Energy and Financials weighed on performance
Hold
iShares S&P/TSX Completion Index (XMD)
Jan-12
-0.6%
5.5% (3 yr)
I continue to favour mid-caps over small caps
Hold
iShares S&P/TSX CDN Preferred Share (CPD)
Jun-09
-4.4%
3.0% (5 yr)
Outlook for prefs mixed at best.
Sell
iShares S&P/TSX Canadian Dividend Aristocrats (CDZ)
Sep-08
0.8%
11.6% (5 Yr)
All Cap dividend exposure. Growth potential
Hold
iShares Core S&P/TSX Capped Composite Index (XIC)
Dec-07
1.1%
8.6% (5 yr)
ZCN offers better spreads and lower premiums
Sell
Foreign Equity
BMO MSCI EAFE Index (C$ Hedged) (ZDM)
Mar-15
NEW
NEW
Offers lower cost than XIN
Hold
iShares International Fundamental Index (CIE)
Sep-14
7.2%
4.6 (6 mth)
Valuations look strong. Expect modest growth
Hold
iShares MSCI EAFE Minimum Volatility Index (XMI)
Aug-13
14.0%
26.5% (1 Yr.)
Low vol continues to outperform. Take profits
Hold
iShares MSCI EAFE Index (C$ Hedged) (XIN)
Jan-13
3.2%
12.6% (1 Yr)
Replacing with ZDM for lower cost structure
Sell
Vanguard MSCI U.S. Broad Mkt (C$ Hedged) (VUS)
Jan-13
-0.3%
12.5% (1 Yr)
All cap U.S. equity exposure.
Hold
iShares US Fundamental Index (CLU)
Mar-11
-1.3%
17.3% (3 Yr)
Valuations attractive, but earnings looks weaker
Hold
iShares Core S&P 500 Index (XSP)
Dec-07
-0.7%
14.9% (5 Yr)
Forward earnings estimates look strong
Buy
Specialty / Sector
BMO MSCI Emerging Markets (ZEM)
Sep-14
6.7%
6.3% (6 mth)
EM near term outlook cloudy. Long term solid
Hold
iShares Gold Bullion Fund ETF (CGL)
Oct-12
10.1%
3.4% (1 Yr)
India demand may provide some growth
Hold
BMO Equal Weight REITs Index ETF (ZRE)
Jul-12
4.8%
16.3% (1 Yr)
With yields lower, REITs look attractive near term
Hold
BMO Global Infrastructure (ZGI)
Jan-12
11.0%
24.9% (3 Yr)
Demand for yield supports infrastructure
Buy
iShares S&P/TSX Capped Financials Index (XFN)
Sep-09
-7.3%
10.33% (5 Yr)
Bank earnings under pressure. Take profits?
Hold
 
Note: Funds Highlighted in Green are Funds rated a Buy, while funds highlighted in Red are rated a Sell

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IMPRESSIVE QUARTER FOR THE COUCH POTATO PORTFOLIO

Rally in fixed income pushes portfolio sharply higher

After a disappointing showing last time around, the Couch Potato Portfolio bounced back nicely, gaining 2.8% for the three months ending January 31. This capped off a strong year that saw the portfolio rise by nearly 10%.

With the Bank of Canada surprising the markets with a 25 basis point cut to their key overnight lending rate in January, the iShares Canadian Universe Bond Index ETF (TSX: XBB) rose sharply, gaining more than 5% over the period. The only loser in the period was the iShares Core S&P 500 CAD Hedged ETF (TSX: XSP), which lost 0.6%. This was firmly in the bottom quartile of U.S. equity funds thanks to the fully hedged currency exposure. In comparison, the iShares Core S&P 500 ETF (TSX: XUS), which is identical except for the fact it does not hedge its currency, gained 5.7%.

Closer to home, Canadian equities faced massive headwinds thanks to the continued selloff in the oil sector, combined with weakness in financials. Still, the iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC) managed to eke out a very modest 1.0% gain.

Looking ahead, I am cautiously optimistic the portfolio can continue to produce modest gains, with fixed income likely leading the way in the short term. The Bank of Canada is widely expected to cut rates at least once, with a further 25 basis point cut possible in the spring. In this rate environment, the outlook for bonds is modestly positive.

Unfortunately we can’t say the same thing for equities where the outlook is mixed at best. Canadian equities are expected to face more headwinds as oil and energy are expected to see continued pressure on pricing while the global supply and demand situation sorts itself out. The price of oil will eventually recover, but many oil stocks have already factored that into share prices, limiting much of the upside in the near term. Financials are expected to struggle as lower interest revenue and weaker energy prices weigh on earnings. Combined, these two sectors make up nearly half of the index, which will make it difficult to see much in the way of gains in the near term.

U.S. equities remain a bright spot as the U.S. economy continues to show signs of improvement. While this is a positive, any drop in the value of the Canadian dollar will hurt the relative returns of XSP when compared with those investments that do not hedge currency.

The same holds true for the iShares MSCI EAFE CAD Hedged ETF (TSX: XIN) where currency exposure is also fully hedged. However, the outlook for EAFE stocks is considerably cloudier than it is for U.S. equities. If the latest quantitative easing package proposed by the European Central Bank gains the favour of markets, we may see a nice liquidity driven rally in European shares. However, if it fails to capture attention, European shares are expected to continue to languish. Asian stocks are also expected to be mixed, with China continuing to disappoint.

While I do like the simplistic appeal of the Couch Potato Portfolio, I believe that there are certain markets that lend themselves to a more active approach. A great example is Canadian equities, where there is significant concentration within three sectors; energy, financial and materials. A more active fund can provide better risk-adjusted returns than the index. I also believe that a well-managed global equity portfolio can provide much better downside protection than the indices.

Until recently, I have been favouring a more active approach for the fixed income sleeve for the portfolio. However, now that the upward pressure on interest rates, at least in Canada, has been lessened in the near term, I believe the passive approach may serve investors well.

For the next quarter or two, I would expect the Couch Potato Portfolio to outperform a more actively managed portfolio.

Here is the latest report on the Couch Potato Portfolio performance. Results are based on the closing prices as of January 31, 2015.

ETF
Shares Owned
Target Weight
Book Value
Market Value
Dividends Paid
Total Return since Inception
XBB
140
40%
$ 4,019.40
$ 4,597.51
$ 1,136.79
42.67%
XIC
140
30%
$ 3,015.30
$ 3,257.46
$ 502.78
24.71%
XSP
82
15%
$ 1,489.94
$ 1,885.01
$ 148.56
36.49%
XIN
55
15%
$ 1,500.40
$ 1,260.57
$ 180.66
-3.94%
 
Totals
100%
$10,025.04
$11,000.56
$ 1,968.80
29.37%

mfumar15img01

 

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TD RETIREMENT PORTFOLIOS

Unique option strategy helps protect portfolios in periods of volatility.

With market volatility on the upswing, many are looking at new and innovative ways to help reduce the risk they take in their portfolios. One such product that has gained a lot of attention has been the TD Retirement Portfolios, which are the TD Retirement Conservative Portfolio, and the TD Retirement Balanced Portfolio. Combined, these funds have attracted nearly $2.5 billion in assets, and have consistently been at or near the top of the list of TD’s top selling funds.

At the core, these are simply conservatively managed balanced funds, with a focus on risk management. They invest in a mix of cash, bonds and equities, allowing the manager some flexibility to shift the asset mix around based on market expectations.

 
TD Retirement Conservative Portfolio
TD Retirement Balanced Portfolio
Neutral Mix
Range
Neutral Mix
Range
Cash
5%
0% – 20%
5%
0% – 20%
Fixed Income
30%
15% – 45%
30%
15% – 45%
Equities
10%
0% – 25%
25%
10% – 40%
Option Strategy
55%
40% – 70%
40%
25% – 55%
Source: TD Asset Management

Where these portfolios set themselves apart is through the use of an options based strategy that is designed to provide downside protection, while still allowing for capital growth. The funds invest in the TD Risk Reduction Pool. In very simple terms, this pool is using a “collar” options strategy that consists of three parts; an ETF that replicates the S&P 500, covered call options, and protective put options.

The pool will invest nearly all of its assets in the ETF, providing the equity exposure. Next, they will sell covered call options. A covered call option allows the buyer the right to buy a stock or ETF at a predetermined price at a time in the future. The set price is referred to as the “strike price”. When the fund sells these call options, it generates premium income, which can then be used to purchase protective put options, which provides the pool with its downside protection.

While a call option allows the purchaser to buy a stock or ETF at a set price at a future time, a put option allows the purchaser to sell a stock or ETF at a predetermined price in the future. So, when the price of the stock or ETF falls below the strike price, the value of the put increases, offsetting the drop in the underlying stock or ETF, and protecting the value of the portfolio.

For every dollar of ETF exposure, TD will purchase a dollar of put option protection. The covered call strategy is more tactical in its approach, and the amount of call options sold will be dependent on their outlook. When they see more upside in the markets, fewer options will be written, allowing for higher growth potential. When they see flat or a falling environment, they may write more calls to generate the extra premium income.

While the downside protection is a nice feature, it comes with a cost, which is the upside participation you give up. In the event there is a sharp rally, the pool will be forced to sell its ETFs to the call option holders at the strike price, thereby capping the growth until more ETFs can be purchased. Covered calls generate additional income for the pool, which is used to buy the downside put protection.

Performance is tough to measure with these funds for a few reasons. The first, obviously, is that with about a year and a half of returns, there really isn’t sufficient data on which to do a meaningful analysis. Second, given the option strategy used, the focus of the funds is really more on delivering modest returns with less risk. Judging by absolute and relative returns may not be the most appropriate. Finally, because of the way mutual funds are categorized in Canada, these funds get lumped in with Global Equity Balanced Funds, which is a bit misleading when looking at the peer group.

Looking at the performance to the end of January, we see that performance has been disappointing on an absolute basis.

Funds
1 Mth
3 Mth
6 Mth
1 Yr.
TD Retirement Conservative Portfolio
1.25%
2.85%
3.71%
6.91%
TD Retirement Balanced Portfolio
2.79%
4.46%
5.79%
9.57%
Benchmarks
1 Mth
3 Mth
6 Mth
1 Yr.
Fundata Global Fixed Income Balanced Idx
4.25%
4.88%
4.28%
8.49%
Fundata Global Neutral Balanced Index
8.68%
11.37%
13.91%
18.36%
Fundata Global Equity Balanced Index
8.40%
11.27%
14.10%
20.06%
Source: Fundata

However, if I look at their volatility profile, they have been less volatile and offered stronger downside protection than what a more typical balanced fund has experienced in the same period. They have behaved as advertised in volatile times.

To their credit, TD has done a great job at positioning these funds as potentially suitable for investors who have just entered, or are just about to enter retirement. They may also be appropriate for very conservative investors looking for the potential for some growth, but are more worried about significant losses. Beyond that, I struggle to find an investor for whom these funds may be appropriate. In almost all cases where an investor has a medium to long term time horizon and average risk tolerance, a more traditional balanced fund or well-diversified portfolio may be more appropriate.

Bottom Line:

These are indeed very interesting products. They use a unique approach and could potentially serve a need for more conservative investors.

My fear is that many don’t fully understand the tradeoffs the funds have made for the benefit of the strong downside protection, namely lower gains in rising markets. This could result in many disappointed investors down the road, when they see that their returns may lag a more traditional balanced fund over the long term. Considering all factors, I remain cautious on these funds.

 

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PORTFOLIO STRATEGY – WHEN IS A GOOD TIME TO INVEST?

Studies show it?s more about ?time in the markets? rather than timing the markets

With valuations reaching the higher end of their historic ranges, many are wondering if a repeat of the 2000 tech bubble, the 2008, the credit crunch, or the more recent 2011 swoon are likely.

To be clear, I have no idea if a correction is on the way. Equity valuations are high, but nowhere near where they were in 2000 and 2007. Also, when you compare equities to the risk reward profile of other asset classes, the higher valuations may be partially justified. That is not to say a correction is unlikely, but barring something completely unforeseen, I wouldn’t expect a repeat of 2008.

Whenever I make any investment decision, I carefully weigh the risks involved. Whether it is choosing a particular investment, or deciding when to buy/sell, it is important to understand the odds you face and the probability of your choice being successful.

There are two things that I always look at when evaluating an investment’s suitability- the investor’s risk tolerance and time horizon. It is tough to separate these two as, more often than not, they are quite related. The main reason for that is any investment may be very unpredictable over a shorter period of time, whereas returns have tended to be fairly consistent over longer periods.

The chart below shows the range of returns experienced by the S&P/TSX Composite Index, including reinvested dividends, over a number of rolling periods, between January 1980 and January 2015. The yellow line shows the average return for each rolling period, the green line shows the best return, and the red line is the worst return.

mfumar15img02
Source: Fundata, Bloomberg

Over all time periods, the average annualized return for an investor was 9.3%. As you can see, the range of returns varies greatly depending on the length of time a person was invested. For rolling one-year periods, the best return was 87% and the worst was -40%. That is a range of more than 126%.

Looking at longer holding periods, we can see that the range of annualized returns tends to move more towards the average. At the five-year holding period, the best return was 28%, and the worst was -2%, for a range of 30%. Going out to the 20-year holding period, the range of potential returns is quite small, at only 5.4%, with the same average annualized return.

In fact, if an investor had been able to hold their investment for at least six years, they would have made money in every case. Even an investor who bought in October 2007, just before the world started falling apart in 2008, would have realized an annualized gain of 3%.

The point is that if you have a reasonably long time horizon, it is more important that you be invested, rather than trying to perfectly time the buy and sell of your investment.

To demonstrate, let’s go back to 2007/2008. The market peaked in May 2008. If you had been invested at that time, and held your investment to the end of January 2015, a $10,000 investment would be worth $12,165, working out to an annualized gain of 3%.

Now, let’s assume you timed it perfectly, selling out at the peak in May 2008, and buying back in February 2009, the market trough. Your $10,000 investment would be worth more than $21,470, an annualized gain of more than 12%. While that is impressive, it is also extremely unlikely. I remember February 2009. The mood was dismal and nobody wanted to invest in equities. Many continued to run for the exits, even after suffering massive losses. It would have taken extreme courage and conviction to buy back in, not to mention incredible luck in perfectly picking the bottom.

The reality is nobody can consistently pick the perfect time to sell and buy back in. Most have a tendency to sell out at or near the bottom, and then wait far too long to buy back in. If you would have sold out in February 2009, as many did, and then wait until early 2010 to get back into the markets, your initial $10,000 investment would now be worth $8,241, or an annualized loss of nearly 3%. Had you waited longer, your losses would have been magnified.

mfumar15img03

Source: Fundata

Bottom Line:

Timing the market is an extremely difficult thing to do. There are very few, if any, who can do it perfectly all the time. The consequences of getting it wrong are often much worse than if you take a buy and hold approach, assuming you have a time horizon of at least seven years. In the overwhelming majority of cases, it is more prudent to buy and hold a portfolio of quality investments, rather than trying to perfectly pick the top or bottom of a market cycle. In other words, it is more about “time in the markets” rather than timing the markets.

 

Return to the table of contents…

In this issue:

What’s New

♦ Bank of Canada hangs tight – for now – After surprising the markets with a 25 basis point cut to its key lending rate back in January, the Bank of Canada held steady at 0.75% last week. With oil prices appearing to have stabilized and GDP growth showing resilience, Stephen Poloz has gone on record saying he believes the January cut is sufficient protection against the economic slowdown, at least for now. However, with energy prices expected to remain low, and the economy and housing markets slowing in some regions, further cuts may be warranted in the next few months. Stay tuned!

♦ Fewer Canadian contributed to RRSPs – While fewer Canadians contributed to their RRSP this year, those who did contributed on average, about $200 more. This according to a recent study done by the BMO Financial Group, which showed that 57% of Canadians contributed before the March 2 deadline, down from 65% in 2014. When asked why they didn’t make a contribution this year, 38% of respondents cited a lack of funds as the key reason, a quarter said they had higher priority expenses, and more than 20% were taking advantage of other investments such as a TFSA for their savings. Another reason that some may not have contributed is they find the prospect of coming up with a few thousand dollars at the end of the year challenging. A great way around that is to make monthly contributions into your RRSP, making it a less daunting task. Still, with nearly 60% contributing, it is a fairly positive story.

 

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ETF RECOMMENDED LIST REVIEW


Bank of Canada shocks markets by cutting rates? No material change to investment outlook

By Dave Paterson, CFA

When we did our last review of the ETF Recommended List in December, the thing that had everybody’s attention was the precipitous drop in oil prices and the effect it was expected to have on the Canadian economy. At that time, oil was trading in the $66 range, and has since continued its decline, touching a low of $44.45 at the end of January. It has since gained a bit of ground and shown some signs of stabilizing, closing February 28 at just under $50.

Clearly this drop has spooked many, including the Bank of Canada Governor Stephen Poloz who cut the Bank’s key overnight lending rate by 25 basis points in January. He said this was an insurance policy against the potential fallout from economic slowdown expected thanks to lower oil. While that may be the official line, many market participants saw this more as a way to lower the value of the Canadian dollar in an effort to boost sagging exports.

While this move was surprising, it really hasn’t done much to change my investment outlook. I still favour equities over fixed income. Within equities, I favour the U.S. over Canada or Europe.

Where my outlook has changed slightly is that I have improved my short-term outlook on fixed income to NEUTRAL from UNDERWEIGHT. However, this is only a temporary change in stance and will move to UNDERWEIGHT again as we are able to gain more clarity around the economic and interest rate picture.

I had been favouring short term and higher yielding bonds because I was worried that a higher, more index like duration stance would hurt returns with flat or rising rates. Now, with downward pressure on rates, taking more duration risk in the short term may be justified. This is only for the very near term, and a more defensive positioning will be warranted soon.

Within the equity space, even with the higher valuation levels, I continue to favour the U.S. over the other regions. It is not so much a case that the U.S. is a great place to invest, but more that the other regions are facing headwinds.

In Canada, oil will likely be the key driver of the markets, with spillover to the financials, particularly the banks which are expected to struggle under the weight of lower interest revenues, less merger & acquisition activity, and potentially higher loan loss reserves. Combined, energy and financials make up more than half the index, so without a material rebound in the oil price, it will be difficult for the TSX to generate outsized gains. Further, I expect that volatility will continue to be on the upswing.

In Europe, with the recent Greece crisis kicked further down the road, the focus can again return to the underperforming economies. The European Central Bank continues to talk about stimulus packages, and eventually one will stick. Valuations are the most attractive of any of the developed markets, but until there is a sustained recovery, I expect higher levels of volatility. For those with an above average appetite for risk, you may want to consider adding to Europe, but it is a risky play right now.

Asia continues to struggle, with China posting its slowest growth rates in decades. The central bank stepped in, cutting interest rates in an effort to spur the economy. China is a key driver not only to Asia, but also Europe and the emerging markets. As long as China continues to struggle, so too will those regions. As with Europe, I expect things will turn around in the medium term, but am expecting higher than normal volatility while things work through.

My current investment outlook is:

   
Underweight
Neutral
Overweight
Cash
X
Bonds
X
  Government
X
  Corporate
X
  High Yield
X
  Global Bonds
X
  Real Return Bonds
X
Equities
X
  Canada
X
  U.S.
X
  International
X
  Emerging Markets
X

Following are the changes to the ETF Recommended List.

ETFs Added to the List

BMO MSCI EAFE Index (C$ Hedged) ETF (TSX: ZDM) – This ETF is designed to replicate the performance, net of fees of the MSCI EAFE Index, with 100% of the currency exposure hedged back to Canadian dollars. The MSCI EAFE Index is the pre-eminent benchmark of international equities, investing in approximately 1,000 large and mid-cap stocks in developed markets around the world, excluding Canada and the U.S. It covers approximately 85% of the outstanding, free float adjusted market cap. I am adding this ETF to replace the iShares MSCI EAFE Index (C$ Hedged) ETF (TSX: CPD). ZDM provides virtually identical investment exposure, but does so at a lower cost, without sacrificing liquidity. The maximum management fee of ZDM is 20 basis points, which is 30 bps lower than XIN. One key difference is XIN invests in the U.S. traded iShares MSCI EAFE Index (NYSE: EFA), which fully replicates the index, while ZDM may use a sampling methodology. A downside to the sampling methodology is there may be a higher tracking error. This higher tracking error is more than made up for with slightly higher returns and a lower cost. Based on those factors, I believe this switch will be beneficial to investors.

ETFs Removed from the List

iShares S&P/TSX Canadian Preferred Share Index ETF (TSX: CPD) – With the Bank of Canada cutting its overnight lending rate, the outlook for the preferred share market in Canada turned somewhat negative. To understand why this is the case, we need to look at the makeup of the S&P/TSX Preferred Share Index, which this ETF seeks to replicate. Approximately two thirds of the index is fixed reset preferred shares, 30% is in perpetual preferred shares, and the rest a mix of floating rate and retractable preferreds.

Fixed reset preferreds pay a set dividend for a set time, usually five years. After this initial period, the dividend is reset at a new level that is based on a formula that often uses the Government of Canada five-year bond yield as its benchmark. With the recent rate cut, the yield on the Canada five year has taken a fall, currently hovering around 91 basis points (March 4), down substantially from the end of the year. If we do see additional cuts as many expect, yields are likely to fall even further.

Investors now fear that the dividends on the fixed resets will be set at much lower levels, making them much less appealing from a yield standpoint. With the ETF very concentrated in fixed resets, I am not comfortable with the near-term risk, and will be avoiding this ETF until we get a clearer direction on rates, and the new dividend levels. Investors looking to invest in preferreds may want to consider individual issues or some of the more actively managed preferred share mutual funds rather than this in the near term.

iShares MSCI EAFE Index (C$ Hedged) ETF (TSX: XIN) – I removed this from the Recommended List because I believe that ZDM provides a lower cost way to access the same investment exposure. The maximum management fee for XIN is 50 basis points, while ZDM is 0.20%. In a case where two investments offer a similar risk reward profile, I believe the lower cost option is the best choice.

ETFs of Note

iShares Canadian Short Term Bond Index ETF (TSX: XSB) – With the Bank of Canada likely to cut their key overnight lending rate at least one more time, the near term outlook for fixed income investments has improved dramatically from just a few months ago. While the expectation of a cut has largely been built into the price of shorter-term bonds, there is still some potential for a little rally if it does happen. While some of the longer dated issues may benefit more from the rate cut, I continue to be defensive and favour shorter duration issues. This ETF focuses exclusively on Canadian investment grade bonds that have a maturity of less than five years. It has a duration of 2.79 years, which is significantly lower than the 7.56 year duration of the broader Canadian market. This remains my top pick for shorter-term bond exposure.

PowerShares Tactical Bond ETF (TSX: PTB) – I had originally recommended this as an alternative to the iShares Canadian Universe Bond Index ETF (TSX: XBB) because I believed the tactical approach would allow it to outpace XBB in a rising yield environment. I liked the fact it is a hybrid between an active and passive strategy, investing in a mix of fixed income ETFs offered through PowerShares and other ETF providers. Invesco’s Global Asset Allocation team examines the economic and market environment, and will tactically position the underlying holdings to best position the portfolio for their outlook. Now that the yield environment has changed, and rates are expected to move slightly lower, I would once again favour XBB over this offering for the near term. However, taking a more medium to long-term view, I believe PTB to be a solid choice for those looking for a diversified, one ticket fixed income ETF solution.

BMO Low Volatility Canadian Equity (TSX: ZLB) – While I had expected the low volatility strategies to outperform in down markets, I certainly was not expecting the recent stellar performance posted of late. This was the best performing Canadian equity ETF over the past three months, gaining 12.1%, handily outpacing the broader market. It invests in stocks that have shown the lowest beta for the past five years, from a universe of the 100 largest, most liquid names that trade in Canada. Because of its focus on low beta, it is concentrated in the more stable consumer names, utilities, and communications, while maintaining a significant underweight in financials, energy, and materials. This positioning explains the outperformance, as it was those sectors that were hit hardest. While I have been pleasantly surprised by the recent performance, it is not sustainable, and I expect it to moderate in the coming weeks and months. Given the run up, now is a great time to rebalance your portfolio, and consider taking some money off the table with this, and any other low vol ETFs you may hold.

iShares Core S&P 500 Index (CAD Hedged) ETF (TSX: XSP) – Despite the economic recovery underway south of the border, U.S. equities took a breather, with XSP dropping 3.2% in January and finishing the most recent three months with a modest 0.70% loss. In comparison, the average U.S. equity mutual fund gained 9.1% for the most recent three months. The key reason for this dramatic difference in performance is the fully hedged currency exposure of XSP. With the Canadian dollar continuing its slide against the U.S. greenback, those investments with unhedged U.S. dollar exposure saw an extra boost to their performance thanks to the currency. With the Canadian dollar expected to remain weak, and more downside possible, depending on the Bank of Canada, the fully hedged currency position may continue to act as a headwind. If you still want U.S. equity exposure and are comfortable with unhedged currency exposure, you should take a look at the iShares Core S&P 500 ETF (TSX: XUS). It offers the identical investment exposure, save for the currency hedging policy. While unhedged currency exposure has been a benefit of late, it can also be a detractor should we see the Canadian dollar bounce back. Regardless, XSP and XUS remain my top picks for U.S. equity ETFs for their diversified portfolios and low cost. If there is a market that lends itself to passive investing over active, it is the U.S., and these ETFs are the best way to play the space.

BMO Global Infrastructure ETF (TSX: ZGI) – One of the more compelling investment themes for the past few years has been rebuilding the world’s crumbling infrastructure. This ETF looks to capitalize on that by investing in companies that are involved in the development, ownership, or management of infrastructure assets such as energy, pipelines, bridges, airports and toll roads. It holds approximately 50 names, and not surprisingly, it is heavily concentrated in energy and utilities. It tracks the Dow Jones Brookfield Global Infrastructure North American Index, which means that the majority of the holdings are large, well-capitalized companies. A benefit to this is they tend to generate meaningful dividends for investors. At the end of January, the dividend yield of the underlying holdings was 3%, which is higher than the broader global equity market. It passes some of this along to investors through a regular quarterly dividend, which has been $0.145 per quarter for the past several quarters. I prefer this over the iShares Global Infrastructure ETF (TSX: CIF) because it has shown a more favourable risk/reward profile at a lower cost. One concern that I do have is the valuations of the underlying portfolio looking pretty stretched, which may result in a period of underperformance and higher than average volatility. However, investor demand for yield and momentum in the sector may provide support for many of the names in the ETF. Still, the medium term outlook for infrastructure remains strong, and ZGI is a great way to gain exposure. While historic volatility may have been lower than the broader equity markets, I would still treat this as a sector fund and limit exposure in a portfolio according to your risk tolerance.

ETF Recommended List

ETF
FIRST MENTION
3 mths ending Jan 31
RESULTS
(to Jan 31)
COMMENTS
ACTION
Fixed Income
PowerShares Tactical Bond ETF (PTB)
Sep-14
5.9%
6.6% (6 mth)
Good one ticket bond portfolio. Favour XBB now
Hold
PowerShares Senior Loan CAD Hedged ETF (BKL)
Dec-13
-0.7%
0.4% (1 Yr)
Fed looking to move likely in June. Hold for now
Hold
iShares 1-5 Year Laddered Corporate Bond (CBO)
Jul-12
2.7%
4.2% (1 Yr)
Favouring the more diversified XSB for near term
Hold
iShares DEX Universe Bond Index (XBB)
Dec-07
6.7%
5.7% (5 yr)
Remains best option for diversified bond holding
Hold
iShares Canadian Short Term Bond Index (XSB)
Aug-04
2.7%
3.8% (10 yr)
Outlook positive on expected BOC rate cuts
Buy
 
Income ETFs
BMO Monthly Income ETF (ZMI)
Nov-14
1.6%
1.6% (3 mth)
Distributions yield 3.6%. Some growth potential.
Hold
iShares Diversified Monthly Income Fund (XTR)
Aug-13
1.5%
7.3% (1 Yr.)
Offers modest growth potential with 6% yield
Hold
 
Canadian Equity
BMO S&P/TSX Capped Composite ETF (ZCN)
Mar-15
NEW
NEW
Offers more attractive liquidity than XIC
Hold
BMO Low Volatility Canadian Equity ETF (ZLB)
Jan-13
12.1%
31.4% (1 Yr)
Low vol continues to outperform. Take profits
Hold
PowerShares FTSE RAFI Canadian Fundamental (PXC)
Jan-13
-0.7%
6.5% (1 Yr)
Energy and Financials weighed on performance
Hold
iShares S&P/TSX Completion Index (XMD)
Jan-12
-0.6%
5.5% (3 yr)
I continue to favour mid-caps over small caps
Hold
iShares S&P/TSX CDN Preferred Share (CPD)
Jun-09
-4.4%
3.0% (5 yr)
Outlook for prefs mixed at best.
Sell
iShares S&P/TSX Canadian Dividend Aristocrats (CDZ)
Sep-08
0.8%
11.6% (5 Yr)
All Cap dividend exposure. Growth potential
Hold
iShares Core S&P/TSX Capped Composite Index (XIC)
Dec-07
1.1%
8.6% (5 yr)
ZCN offers better spreads and lower premiums
Sell
Foreign Equity
BMO MSCI EAFE Index (C$ Hedged) (ZDM)
Mar-15
NEW
NEW
Offers lower cost than XIN
Hold
iShares International Fundamental Index (CIE)
Sep-14
7.2%
4.6 (6 mth)
Valuations look strong. Expect modest growth
Hold
iShares MSCI EAFE Minimum Volatility Index (XMI)
Aug-13
14.0%
26.5% (1 Yr.)
Low vol continues to outperform. Take profits
Hold
iShares MSCI EAFE Index (C$ Hedged) (XIN)
Jan-13
3.2%
12.6% (1 Yr)
Replacing with ZDM for lower cost structure
Sell
Vanguard MSCI U.S. Broad Mkt (C$ Hedged) (VUS)
Jan-13
-0.3%
12.5% (1 Yr)
All cap U.S. equity exposure.
Hold
iShares US Fundamental Index (CLU)
Mar-11
-1.3%
17.3% (3 Yr)
Valuations attractive, but earnings looks weaker
Hold
iShares Core S&P 500 Index (XSP)
Dec-07
-0.7%
14.9% (5 Yr)
Forward earnings estimates look strong
Buy
Specialty / Sector
BMO MSCI Emerging Markets (ZEM)
Sep-14
6.7%
6.3% (6 mth)
EM near term outlook cloudy. Long term solid
Hold
iShares Gold Bullion Fund ETF (CGL)
Oct-12
10.1%
3.4% (1 Yr)
India demand may provide some growth
Hold
BMO Equal Weight REITs Index ETF (ZRE)
Jul-12
4.8%
16.3% (1 Yr)
With yields lower, REITs look attractive near term
Hold
BMO Global Infrastructure (ZGI)
Jan-12
11.0%
24.9% (3 Yr)
Demand for yield supports infrastructure
Buy
iShares S&P/TSX Capped Financials Index (XFN)
Sep-09
-7.3%
10.33% (5 Yr)
Bank earnings under pressure. Take profits?
Hold
 
Note: Funds Highlighted in Green are Funds rated a Buy, while funds highlighted in Red are rated a Sell

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Rally in fixed income pushes portfolio sharply higher

After a disappointing showing last time around, the Couch Potato Portfolio bounced back nicely, gaining 2.8% for the three months ending January 31. This capped off a strong year that saw the portfolio rise by nearly 10%.

With the Bank of Canada surprising the markets with a 25 basis point cut to their key overnight lending rate in January, the iShares Canadian Universe Bond Index ETF (TSX: XBB) rose sharply, gaining more than 5% over the period. The only loser in the period was the iShares Core S&P 500 CAD Hedged ETF (TSX: XSP), which lost 0.6%. This was firmly in the bottom quartile of U.S. equity funds thanks to the fully hedged currency exposure. In comparison, the iShares Core S&P 500 ETF (TSX: XUS), which is identical except for the fact it does not hedge its currency, gained 5.7%.

Closer to home, Canadian equities faced massive headwinds thanks to the continued selloff in the oil sector, combined with weakness in financials. Still, the iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC) managed to eke out a very modest 1.0% gain.

Looking ahead, I am cautiously optimistic the portfolio can continue to produce modest gains, with fixed income likely leading the way in the short term. The Bank of Canada is widely expected to cut rates at least once, with a further 25 basis point cut possible in the spring. In this rate environment, the outlook for bonds is modestly positive.

Unfortunately we can’t say the same thing for equities where the outlook is mixed at best. Canadian equities are expected to face more headwinds as oil and energy are expected to see continued pressure on pricing while the global supply and demand situation sorts itself out. The price of oil will eventually recover, but many oil stocks have already factored that into share prices, limiting much of the upside in the near term. Financials are expected to struggle as lower interest revenue and weaker energy prices weigh on earnings. Combined, these two sectors make up nearly half of the index, which will make it difficult to see much in the way of gains in the near term.

U.S. equities remain a bright spot as the U.S. economy continues to show signs of improvement. While this is a positive, any drop in the value of the Canadian dollar will hurt the relative returns of XSP when compared with those investments that do not hedge currency.

The same holds true for the iShares MSCI EAFE CAD Hedged ETF (TSX: XIN) where currency exposure is also fully hedged. However, the outlook for EAFE stocks is considerably cloudier than it is for U.S. equities. If the latest quantitative easing package proposed by the European Central Bank gains the favour of markets, we may see a nice liquidity driven rally in European shares. However, if it fails to capture attention, European shares are expected to continue to languish. Asian stocks are also expected to be mixed, with China continuing to disappoint.

While I do like the simplistic appeal of the Couch Potato Portfolio, I believe that there are certain markets that lend themselves to a more active approach. A great example is Canadian equities, where there is significant concentration within three sectors; energy, financial and materials. A more active fund can provide better risk-adjusted returns than the index. I also believe that a well-managed global equity portfolio can provide much better downside protection than the indices.

Until recently, I have been favouring a more active approach for the fixed income sleeve for the portfolio. However, now that the upward pressure on interest rates, at least in Canada, has been lessened in the near term, I believe the passive approach may serve investors well.

For the next quarter or two, I would expect the Couch Potato Portfolio to outperform a more actively managed portfolio.

Here is the latest report on the Couch Potato Portfolio performance. Results are based on the closing prices as of January 31, 2015.

ETF
Shares Owned
Target Weight
Book Value
Market Value
Dividends Paid
Total Return since Inception
XBB
140
40%
$ 4,019.40
$ 4,597.51
$ 1,136.79
42.67%
XIC
140
30%
$ 3,015.30
$ 3,257.46
$ 502.78
24.71%
XSP
82
15%
$ 1,489.94
$ 1,885.01
$ 148.56
36.49%
XIN
55
15%
$ 1,500.40
$ 1,260.57
$ 180.66
-3.94%
 
Totals
100%
$10,025.04
$11,000.56
$ 1,968.80
29.37%

mfumar15img01

 

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Unique option strategy helps protect portfolios in periods of volatility.

With market volatility on the upswing, many are looking at new and innovative ways to help reduce the risk they take in their portfolios. One such product that has gained a lot of attention has been the TD Retirement Portfolios, which are the TD Retirement Conservative Portfolio, and the TD Retirement Balanced Portfolio. Combined, these funds have attracted nearly $2.5 billion in assets, and have consistently been at or near the top of the list of TD’s top selling funds.

At the core, these are simply conservatively managed balanced funds, with a focus on risk management. They invest in a mix of cash, bonds and equities, allowing the manager some flexibility to shift the asset mix around based on market expectations.

 
TD Retirement Conservative Portfolio
TD Retirement Balanced Portfolio
Neutral Mix
Range
Neutral Mix
Range
Cash
5%
0% – 20%
5%
0% – 20%
Fixed Income
30%
15% – 45%
30%
15% – 45%
Equities
10%
0% – 25%
25%
10% – 40%
Option Strategy
55%
40% – 70%
40%
25% – 55%
Source: TD Asset Management

Where these portfolios set themselves apart is through the use of an options based strategy that is designed to provide downside protection, while still allowing for capital growth. The funds invest in the TD Risk Reduction Pool. In very simple terms, this pool is using a “collar” options strategy that consists of three parts; an ETF that replicates the S&P 500, covered call options, and protective put options.

The pool will invest nearly all of its assets in the ETF, providing the equity exposure. Next, they will sell covered call options. A covered call option allows the buyer the right to buy a stock or ETF at a predetermined price at a time in the future. The set price is referred to as the “strike price”. When the fund sells these call options, it generates premium income, which can then be used to purchase protective put options, which provides the pool with its downside protection.

While a call option allows the purchaser to buy a stock or ETF at a set price at a future time, a put option allows the purchaser to sell a stock or ETF at a predetermined price in the future. So, when the price of the stock or ETF falls below the strike price, the value of the put increases, offsetting the drop in the underlying stock or ETF, and protecting the value of the portfolio.

For every dollar of ETF exposure, TD will purchase a dollar of put option protection. The covered call strategy is more tactical in its approach, and the amount of call options sold will be dependent on their outlook. When they see more upside in the markets, fewer options will be written, allowing for higher growth potential. When they see flat or a falling environment, they may write more calls to generate the extra premium income.

While the downside protection is a nice feature, it comes with a cost, which is the upside participation you give up. In the event there is a sharp rally, the pool will be forced to sell its ETFs to the call option holders at the strike price, thereby capping the growth until more ETFs can be purchased. Covered calls generate additional income for the pool, which is used to buy the downside put protection.

Performance is tough to measure with these funds for a few reasons. The first, obviously, is that with about a year and a half of returns, there really isn’t sufficient data on which to do a meaningful analysis. Second, given the option strategy used, the focus of the funds is really more on delivering modest returns with less risk. Judging by absolute and relative returns may not be the most appropriate. Finally, because of the way mutual funds are categorized in Canada, these funds get lumped in with Global Equity Balanced Funds, which is a bit misleading when looking at the peer group.

Looking at the performance to the end of January, we see that performance has been disappointing on an absolute basis.

Funds
1 Mth
3 Mth
6 Mth
1 Yr.
TD Retirement Conservative Portfolio
1.25%
2.85%
3.71%
6.91%
TD Retirement Balanced Portfolio
2.79%
4.46%
5.79%
9.57%
Benchmarks
1 Mth
3 Mth
6 Mth
1 Yr.
Fundata Global Fixed Income Balanced Idx
4.25%
4.88%
4.28%
8.49%
Fundata Global Neutral Balanced Index
8.68%
11.37%
13.91%
18.36%
Fundata Global Equity Balanced Index
8.40%
11.27%
14.10%
20.06%
Source: Fundata

However, if I look at their volatility profile, they have been less volatile and offered stronger downside protection than what a more typical balanced fund has experienced in the same period. They have behaved as advertised in volatile times.

To their credit, TD has done a great job at positioning these funds as potentially suitable for investors who have just entered, or are just about to enter retirement. They may also be appropriate for very conservative investors looking for the potential for some growth, but are more worried about significant losses. Beyond that, I struggle to find an investor for whom these funds may be appropriate. In almost all cases where an investor has a medium to long term time horizon and average risk tolerance, a more traditional balanced fund or well-diversified portfolio may be more appropriate.

Bottom Line:

These are indeed very interesting products. They use a unique approach and could potentially serve a need for more conservative investors.

My fear is that many don’t fully understand the tradeoffs the funds have made for the benefit of the strong downside protection, namely lower gains in rising markets. This could result in many disappointed investors down the road, when they see that their returns may lag a more traditional balanced fund over the long term. Considering all factors, I remain cautious on these funds.

 

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Studies show it?s more about ?time in the markets? rather than timing the markets

With valuations reaching the higher end of their historic ranges, many are wondering if a repeat of the 2000 tech bubble, the 2008, the credit crunch, or the more recent 2011 swoon are likely.

To be clear, I have no idea if a correction is on the way. Equity valuations are high, but nowhere near where they were in 2000 and 2007. Also, when you compare equities to the risk reward profile of other asset classes, the higher valuations may be partially justified. That is not to say a correction is unlikely, but barring something completely unforeseen, I wouldn’t expect a repeat of 2008.

Whenever I make any investment decision, I carefully weigh the risks involved. Whether it is choosing a particular investment, or deciding when to buy/sell, it is important to understand the odds you face and the probability of your choice being successful.

There are two things that I always look at when evaluating an investment’s suitability- the investor’s risk tolerance and time horizon. It is tough to separate these two as, more often than not, they are quite related. The main reason for that is any investment may be very unpredictable over a shorter period of time, whereas returns have tended to be fairly consistent over longer periods.

The chart below shows the range of returns experienced by the S&P/TSX Composite Index, including reinvested dividends, over a number of rolling periods, between January 1980 and January 2015. The yellow line shows the average return for each rolling period, the green line shows the best return, and the red line is the worst return.

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Source: Fundata, Bloomberg

Over all time periods, the average annualized return for an investor was 9.3%. As you can see, the range of returns varies greatly depending on the length of time a person was invested. For rolling one-year periods, the best return was 87% and the worst was -40%. That is a range of more than 126%.

Looking at longer holding periods, we can see that the range of annualized returns tends to move more towards the average. At the five-year holding period, the best return was 28%, and the worst was -2%, for a range of 30%. Going out to the 20-year holding period, the range of potential returns is quite small, at only 5.4%, with the same average annualized return.

In fact, if an investor had been able to hold their investment for at least six years, they would have made money in every case. Even an investor who bought in October 2007, just before the world started falling apart in 2008, would have realized an annualized gain of 3%.

The point is that if you have a reasonably long time horizon, it is more important that you be invested, rather than trying to perfectly time the buy and sell of your investment.

To demonstrate, let’s go back to 2007/2008. The market peaked in May 2008. If you had been invested at that time, and held your investment to the end of January 2015, a $10,000 investment would be worth $12,165, working out to an annualized gain of 3%.

Now, let’s assume you timed it perfectly, selling out at the peak in May 2008, and buying back in February 2009, the market trough. Your $10,000 investment would be worth more than $21,470, an annualized gain of more than 12%. While that is impressive, it is also extremely unlikely. I remember February 2009. The mood was dismal and nobody wanted to invest in equities. Many continued to run for the exits, even after suffering massive losses. It would have taken extreme courage and conviction to buy back in, not to mention incredible luck in perfectly picking the bottom.

The reality is nobody can consistently pick the perfect time to sell and buy back in. Most have a tendency to sell out at or near the bottom, and then wait far too long to buy back in. If you would have sold out in February 2009, as many did, and then wait until early 2010 to get back into the markets, your initial $10,000 investment would now be worth $8,241, or an annualized loss of nearly 3%. Had you waited longer, your losses would have been magnified.

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Source: Fundata

Bottom Line:

Timing the market is an extremely difficult thing to do. There are very few, if any, who can do it perfectly all the time. The consequences of getting it wrong are often much worse than if you take a buy and hold approach, assuming you have a time horizon of at least seven years. In the overwhelming majority of cases, it is more prudent to buy and hold a portfolio of quality investments, rather than trying to perfectly pick the top or bottom of a market cycle. In other words, it is more about “time in the markets” rather than timing the markets.

 

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