Friday, 25 July 2014

Low Volatility ETF Update - Are they performing as advertized?

In 2012 we introduced the newly launched category of low volatility equity ETFs that promised more stability and equal or better returns in comparison to standard index funds with holdings selected and weighted by market capitalization. A couple of years have passed, so let's see how they are performing.

Comparison Table - Low Vol ETFs vs Cap-Weight Benchmarks
(click to enlarge table image)

Low Vol performance mostly lags Cap-Weight ...
The green cells in our comparison table above show where the Cap-Weight ETFs have done better than their Low Vol counterparts. The green cells outnumber the yellow cells showing Low Vol superiority. It is interesting how consistent is the pattern of returns. In every single equity market around the world, Cap-Weight has higher returns for the year ending June 30th. But the tide seems to have turned since the beginning of 2014 - most of the Low Vol ETFs have pulled ahead Year-To-Date (YTD).

... and the reason is that Cap-Weight should win in a strong bull market
As we noted in the original post (and as reiterated in this excellent National Bank Financial January 2013 analysis of Low Vol ETFs), the main drawback of Low Vol strategies is likely performance lag in strong upward markets. That is what has been happening - returns in every world market have been wonderful recently - 14% to 28% 1-year total returns in the various global equity markets. The Low Vol returns have been very good too, just not quite as good.

More evidence of how good things have been recently shows in the columns for Reward to Volatility (Sharpe) Ratio and Volatility (standard deviation of returns). Sharpe ratios are very high - compare the 1-year numbers ranging from 0.6 up to 4.6 versus the 10-year averages of 0.4 and 0.5. Historical long term Sharpe ratio figures across many equity markets cited in the 2012 Credit Suisse Global Investment Returns Yearbook (see Fig.4 on page 19) range from 0.1 to 0.7. We have been living in unusually good and stable times for the last few years. Volatility itself is also very low compared to past longer term averages. Equity volatility below 10 is well below the usual high-teen or greater long term average (see Tables 1 and 2 on page 22 of Credit Suisse). The result is that in several cases, the Cap-Weight ETF benchmarks actually display lower volatility than the Low Vol ETFs which are specifically designed to be lower volatility.

When markets go sour again, that will be the real test of Low Vol ETFs
It is perhaps obvious to say it but the current equity party will end - market volatility will return and large market drops will happen. There's no reason to think the history of markets will not be repeated and equities will not exhibit considerable volatility in future. The only thing we don't know is exactly when that will happen. That is when we will see how much the Low Vol ETFs limit the downside drop and the volatility, perhaps proving their worth with better risk-adjusted (higher Sharpe ratio) and total returns.

We investors must decide whether to wait another five or ten years for definitive proof to emerge to substantiate the benefits of actual ETFs that attempt to capture results shown in academic research and backtests. Waiting means possibly missing out on Low Vol benefits ... or missing out on Low Vol disappointment if they really do not pan out.

As far as what other investors are doing, so far, the net asset figures of the various ETFs in our table show that Low Vol has caught on mainly in the USA. In Canada, only BMO's low vol version has attracted substantial investor money.

Disclosure: This blogger owns shares of the BMO Low Volatility Canadian Equity ETF (TSX symbol: ZLB).

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 21 July 2014

Inflation Protection's Big Trade-off - Protection vs Returns

Friday the latest CPI inflation indicator for Canada showed a 2.4% rise. Inflation has been fairly low and quite stable for more than a decade now but the wary investor keeps the more distant past in mind when inflation ran amok and therefore factors an amount of "just-in-case" protection against any resurgence and surprise spikes of inflation.

As with many situations there is a trade-off - what works very well as protection often has low returns. Let's therefore have a look at the major asset classes to see how they respond to unexpected inflation.

Expected vs Unexpected Inflation - First, it's necessary to clarify that what's expected won't hurt so much, it's the unexpected that matters. With inflation running at around 2%, the expected returns and yields of various investments have that amount (as we noted in this recent post) incorporated into prices. It's the shock and surprise increases that take away real value which hurt investors.

Macro-Economic Volatility and Supply Shock Inflation vs "Great Moderation" Inflation - It probably has not seemed so to those suffering through rising prices, but the nature of inflation has differed in the 1990s and 2000s from the decades of the 1970s and 80s. The less volatile business cycles of more recent times, termed the Great Moderation, have entailed a different kind of inflation. In the 1970s, inflation arose more from supply shocks, in the form of big oil price increases, and at times when the economy struggled, while in the more recent period inflation has risen in tandem with good economic growth. That, according to the research paper Inflation-Hedging Portfolios: Economic Regimes Matter (on SSRN) by Marie Grière and Ombretta Signori, has meant that the best protection against inflation has changed, as we note below.

Short-term vs Long Term - The final key distinction is that the type of investment that responds well and quickly to a surprise inflation leap may not do as well as another over many years.

Asset Classes - How they respond to inflation

a) Cash - Except for a short few months of typical lag before rates adjust, cash investments like T-Bills and money-market funds will rise with inflation, no matter what the economic regime. The bad news is the trade-off that returns on cash short- and long-term are low and, as Brière and Signori point out, the return on a long-term investment in cash stands a fair risk of falling shy of full inflation-matching. BlackRock's review Are Hedging Properties Inflated? notes how central bank policies like ones in place at present may mean negative overall real returns for cash.

b) Nominal Bonds (Government 10+ year) - Bonds do not usually offer inflation protection. On the contrary, in the short term bonds suffer losses through price reductions. However, with longer holding periods extending out more and more years, bonds progressively recover. During the years of the Great Moderation, Grière and Sognori even found nominal bonds to be a good long-run inflation hedge, whereas in the earlier opposite economic environment, nominal bonds were a bad choice for inflation compensation. This brings to the fore a key issue for investors - will the Bank of Canada (and other central banks) continue to maintain their credibility and the belief of investors that inflation will not be allowed to run rampant? If inflation is consistently contained, nominal bonds will do fine as inflation protection. The advantage of nominal bonds over inflation-indexed bonds of similar duration is slightly higher yields.

c) Inflation-Indexed (Real Return) Bonds - Such bonds, called Real Return Bonds in Canada and TIPS in the USA, offer explicit inflation hedging by the built-in mechanism to increase interest and principal in lockstep with a measure of inflation, in Canada that being the CPI. Any and every inflation rise, whether expected or unexpected, feeds automatically into the bonds' returns three months after the actual CPI results. The downside is that net real returns after taking away the inflation-matching portion are very low.

d) Equities (Broad market cap-weight index) - Equities are hurt by unexpected inflation in the short term and especially so when inflation is of the supply shock variety, as the 1970s oil price shocks so well demonstrated when stocks had negative total returns while CPI rose significantly (e.g. see this chart of the USA's S&P 500 index). In the long term, the ability of businesses to cope with inflation by passing through price increases to make up for inflation has enabled gradual, though sometimes not full recovery depending on the period as BlackRock show. The Credit Suisse Global Investment Returns Yearbook for 2012, which examined the inflation-fighting performance of various asset classes, summarized equities as "not particularly good inflation hedges". On the other hand, equities offer the best long-term historical returns record.

e) Real Estate - This asset class is a very poor short-term inflation hedge but an effective long term hedge (see all our reference studies linked in this post), with returns similar to equities.

f) Gold and Precious Metals - In the short-term, gold has been found to be a very good hedge for unexpected inflation but only erratically in certain periods, and is a weak hedge for overall inflation in the long term. It is an asset that produces no income and its long term return from capital appreciation only is very low as the Credit Suisse Yearbook data shows. It's hedging value is probably more related to financial and currency collapse than inflation.

g) Commodities - There appears to be consensus that commodities offer excellent short-run inflation hedging according to an IMF paper of 2011 Inflation Hedging for Long Term Investors by Alexander Attié and Shaun Roache. BlackRock ranks commodities as the best short-term inflation hedge of all the asset types. This conclusion applies to broad commodity indices as individual commodities are not effective. The protection offered by commodities erodes over time till at more than five years, there is no benefit. Worst for the long term, commodities have exhibited negative real returns far short of inflation as the graph below copied from the Attié and Roache paper shows where the dark black line of commodities lies below CPI inflation.
(click to enlarge image)

Given 1) the variable hedging performance of the various asset classes, 2) the difficulties in knowing when inflation surprises are set to arrive (no kidding!) and what type of economic regime and inflation drivers there will be and 3) the need to gain higher returns than simply keep up with inflation, the sensible thing to do for the investor with a long time horizon would seem to us to include some of each asset, to maintain a diversified portfolio that will cope with all the eventualities. Rebalancing to the target asset allocation will take into account the effects of inflation reactions as well as the many other effects affecting asset values such as real interest rates, changing perceptions of riskiness and foreign currency swings.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Saturday, 12 July 2014

Dogs of the Dow and the TSX - Are they nasty or nice investing pets?

It's now the dog days of summer, so it's a good time to write about an investing theory referring to dogs that seems to have worked pretty well since it was first put forward by Michael O'Higgins in his 1991 book Beating the Dow.

The theory is called the Dogs of the Dow. The method is ultra-simple: once a year, take the list of the 30 stocks in the Dow Jones Industrial Average, sort them by dividend yield, and buy an equal amount of the ten highest yielding stocks. Hold them for a year and then the following year, sell the stocks no longer in the top ten and buy the replacements. By convention the buying and selling is done on January 1st, though there is nothing to prevent anyone from starting at any time during the year.

The popularity of the strategy has even led to the creation of a dedicated Dogs of the Dow website, where the 2014 January 1st list of Dogs is shown in blue. For someone buying today, a stock screener such as with the DJIA index selected, will list all its components, which can then be sorted by yield.

The logic and rationale of the Dogs method is that the dividend yield indicates stocks which are out of favour, usually only temporarily. Dividend yield is defined as dividends over current stock price so the yield of a stock rises when price declines i.e. the stock falls out of favour. Thus, the Dogs strategy is often described as a simple, crude strategy for identifying Value stocks.

Performance - Up-to-date total return data seems difficult to find, but up to 2011 the Dogs strategy performed the same as the overall DJIA with a 10.8% average over the preceding 20 years according to Dogs of the Dow. Since then, the Dogs have edged ahead, judging by the price in blue in the chart below of the sole ETN that tracks the Dogs, the Deutsche Bank AG ELEMENTS Dogs of the Dow Total Return Index Note (NYSE: DOD, MER 0.75%) compared to the red line of the DJIA.
(click image to enlarge)

Criticisms and caveats:
  • Equal weighting of selected Dogs while the DJIA is price-weighted gives the Dogs an unfair advantage (see Wikipedia write-up and Forbes article) i.e. the performance comes from the weighting not the stock selection
  • Dividends alone are no longer a good test of fundamental value (e.g. this article in Barron's magazine) due to a rising rate of share buybacks; instead something like shareholder yield (net of share buybacks minus issuance plus dividends) would be more appropriate
  • Lack of diversification of the Dogs as a portfolio due to the small number of stocks and accidental sector concentrations
Dogs of the TSX
The same idea has been applied in Canada on stocks in the TSX 60 Index, though with some modifications by the originator of the Canadian version Dave Stanley, like the exclusion of deliberately high-yielding income trusts and former trusts (as described in the Beating the TSX Finiki article and as discussed in this thread on the Financial Wisdom Forum), to ensure a similar focus on blue chip, large cap stocks.

Up to 2011, the Dogs of the TSX did even better than the Dow original, beating the TSX 60 Index by more than 2% per year on average between 1987 and 2011 (according to Finiki, citing a 2012 Canadian MoneySaver article).

Current List of TSX Dogs:
Using the superb Stock Rover screener, we extracted all the high yielding larger cap stocks on the TSX, then filtered out all stocks that are not included (rows highlighted in pale yellow) in the TSX 60 Index, as well as any income trusts and former income trusts (rows in tan) not already excluded to come up with the table below. The white rows are the TSX Dogs as of July 11.
(click to enlarge)

The rules of selecting the Dogs are not set in stone. It's an active strategy, not a passive one and we investors can change what we want.  Some of the companies may be in the doghouse for good reason. Norm Rothery of Stingy Investor has just published in MoneySense his list of Top Dogs of the TSX, filtering out stocks where the dividend may be in danger, as indicated by dividends that exceed earnings. Notice how TransAlta (TSX: TA), top of the list above with highest yield, got dropped, no surprise given its negative earnings. Some investors might consider TransAlta a good buy as a turnaround candidate but others, who want only to buy high quality blue chip companies and their dividends, may well want to exclude TA, which is not even a very large cap company.

Other differences between our list above and Rothery's probably arise because his list came from data as of June 30th. Two on his list - Telus (TSX: T) and Power Corporation (TSX: POW) - are 11th and 12th in line in the Stock Rover screen. Market prices are always changing.

The resulting Dogs looks less like ones that will bite you and more like faithful companions. Most of the current Dogs have shown up in our previous posts of centenarian companies (National Bank, CIBC, BCE and Bank of Montreal and blue chips (as well as the centenarians, Potash Corp, Rogers, Shaw) or dependable utilities (Fortis).

Other variations of the Dogs selection method are also possible e.g.:
  • Relax the exclusion of (former) income trusts, especially now that it has been several years since the 2011 trust conversion deadline and excessive payouts would most likely have had to be reigned in. For example, Canada's largest REIT Riocan (TSX: REI.UN) has a high yield which is still well under its earnings, as our table above shows. Global Securities writes about such an apparently successful implementation of this Dogs variation.
  • Allow in large caps that the TSX 60 excludes, like Power Financial (TSX: PWF), Great West Life (TSX: GWO) and IGM Financial (TSX: IGM)
Due to the lack of diversification / the high sector concentration (4 out of 10, or 40% on an equal investment basis, are in Communication Services, with none in Industrials or Consumer stocks and only 10% each in Energy and Materials), we would not think it advisable to put all a Canadian equity allocation into this strategy. However it does offer a way to identify stocks that currently offer higher dividends at a reasonable price and to establish long term positions in high quality companies.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Tuesday, 8 July 2014

Long Term Return Expectations for USA and Rest of World - the Current Outlook

Last week we laid out what by historical standards are the modest future long term returns investors can expect from Canadian stocks and bonds. Since most Canadian investors also include an allocation to equities of the USA and other countries, this week we'll review the indicators of their likely future returns over the next 10+ years.

US Equities

Method 1 - Current Dividend Yield + Dividend Growth
The idea is the same as that in our post about Canadian stocks but since US companies make heavy use of stock buybacks (see this Credit Suisse article) to return money to shareholders instead of dividends, we'll adopt the modification that takes account of buybacks and new share issuance to derive Shareholder Yield. Patrick O'Shaughnessy at Millenial Invest recently explained Shareholder Yield and graphed its historical actual values for the US equity market, which currently looks to be just under 4% - we'll use 3.9%.

Then we add potential dividend growth based on growth of the overall US economy. Forecasts of long term US GDP growth vary from the Conference Board's Global Outlook of about 2% as an average of the two periods from 2014-19 and 2020-25, to the US Federal Reserve's 2.2 to 2.4% cited by Rick Ferri back in January. We multiply those GDP forecasts by the 0.6 proportion that flows through on average to shareholders (as we reported in our original post on future return expectations, research shows that GDP growth gets diluted and does not translate into as much shareholder return) to get a range of 1.2% to 1.4% annual dividend growth.

Result: A reasonably attractive, at least compared to what CAPE tells us below, total US real annual equity return estimate of 3.9 + 1.2/1.4 = 5.1 to 5.3%

Method 2 - Shiller's Cyclically-Adjusted Price Earnings (CAPE) Ratio
Yale professor Robert Shiller found that a P/E that adjusts earnings for inflation and averages over the past ten years smooths out economic cycles in calculating a Price/Earnings ratio for the US stock market. The adjusted P/E or CAPE gives a good indicator of probable future long term stock returns. The higher the CAPE the lower the future returns. Clifford Asness of AQR Capital explains the ratio in more detail and defends its usefulness in An Old Friend: The Stock Market’s Shiller P/E.

The CAPE is now over 26, which is very high by historical standards, as this chart from Guru Focus shows. Note the tiny implied future annual return, a mere +0.6%!
(click to enlarge image)

The following chart from a post at the Blakeley Group shows what happened to subsequent S&P 500 returns at various CAPE levels through the past 114 years.

However, the relationship between CAPE and US equity returns has a fair degree of variability - all is not deterministically and rigidly fore-ordained. Asness includes a table showing that for CAPE over 25, subsequent annualized 10-years have ranged over a worst case of -6.1% to a best of +6.3%.

Method 3 - Ratio of Total Market Cap to GDP
This is apparently Warren Buffett's method of assessing whether the US market is over- or under-valued. As calculated by Guru Focus, it currently shows the US market to be significantly over-valued. Consequently the expected future return for US equities is a paltry 1%.

We would have hoped for closer agreement between the three methods but that's the situation. US equity real returns will be muted but there seems to be a high degree of uncertainty with a plausible range from 0.6% to 5.3%.

For those who wish to look at nominal returns including US inflation, simply add the Federal Reserve Bank of Cleveland's current 10-year inflation forecast of 1.8% to the real return figures above.

Developed and Emerging Market Country Equities
CAPE works about as well for other developed country markets as for the US, but less reliably for Emerging market countries, according to this 2012 paper by Joachim Klement. The Shiller P/E for Europe has been rising but is still low in relative historical terms as seen in the charts on MrMarket.EU and in this presentation by Henderson Global Investors. The latter two papers do not translate the low CAPE numbers into projected returns but Klement does and his projections, though two years old, may still be useful, especially for emerging markets which have gone sideways since 2012. His projections are for five years only. The annual compound real return for emerging markets he projects at 5.8%. For developed markets the projection in 2012 was 5.7% annual real growth, but we have seen gains of over 23% in the last year alone so a current projection will not be as high.

Guru Focus uses a method similar to the dividends plus dividend growth formula we have used above, but it explicitly adjusts for reversion to the mean of the ratio of market cap to GDP. By this method, of the 19 major countries in the table of CAPE-based return expectations on Guru Focusevery single country, both developed and emerging market, is estimated to have future returns significantly above the USA's (see chart below). Emerging markets have very high projected returns. Incidentally, we note that the Guru Focus estimate for Canada is 3.9%, which fits within the bound of other estimates we wrote about last week.
A Canadian investor should look to maintain, or establish if not already there, an allocation in the portfolio to developed country and emerging market equities. The USA offers less promise of reward those markets.

Caveat: A Canadian investor's return on foreign assets will be affected by moves of the Canadian dollar versus the currency of the foreign country equities. Though such moves tend to even out in the very long run for investors who maintain and regularly rebalance their asset allocation, as we discuss here and here, over longer periods such as ten years or more, returns may raised or reduced by foreign exchange moves. Forecasting foreign exchange shifts is too uncertain to be worth trying.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Saturday, 28 June 2014

Long Term Stock and Bond Return Expectations for Canada - the Current Outlook

A view of probable future returns is essential for individuals to develop realistic planning assumptions for retirement savings growth. Two years ago we wrote about the prospects for long term returns (10 years or more) of the Canadian stock market, the S&P/TSX Composite Index. Our estimate then was an average compound real after-inflation return of 4.2% per year.

The last two years have seen undeniably outstanding stock market growth - almost 32% in price gains alone (leaving aside another yearly 2.5% or so of dividends) as the Yahoo Finance chart below shows. It's time for an update look forward, which we'll also expand by looking at probable bond market returns and inflation.

Stock Returns

Method #1 - First, we'll apply the same method as we did two years ago:

Future Return = Current Dividend Yield + Estimated Growth Rate of Dividends

Current Dividend Yield - The current S&P/TSX Composite dividend yield (the current annualized sum of dividends being paid by the 245 stocks in the index divided by the current stock prices in proportion to the market cap size of the companies) is not easily found. It is not unfortunately not published by the index providers so the individual investor must use an approximation, as Globe columnist John Heinzl described in How to find index yields. The answer is to use the yield on an ETF that tracks the index, such as the iShares S&P/TSX Capped Composite Index ETF (TSX symbol: XIC). Both the Trailing Yield and the Distribution Yield round out to the same 2.4% and the recently lowered MER is now down to a paltry 0.05% so we'll use a Current Dividend Yield of 2.4%.

Estimated Growth Rate of Dividends - A declining working age population and slower population growth in Canada cause forecasters to predict markedly lower economic long term growth rates, as in the chart below from BMO Capital Markets recent publication Long Term Outlook: Destiny Dictated by Demography? (and similarly elsewhere e.g. this report from the OECD where table 4.1 estimates a likely 1.2% per capita GDP annual growth rate)

Taking the OECD figure of 1.2% times the 0.6 proportion that actually flows through to the shareholder (see our previous post and its links as to why all the growth isn't gained by the investor) gives us 1.2% x 0.6 = 0.7% in real future growth rate of dividends.

Thus our total is 2.4% + 0.7% = 3.1% future estimated real long term Canadian stock returns

It is perhaps not surprising that the estimate would be much lower today than two years ago, given the large gains since then, far above the projected average at that time and the long run historic averages.

Method #2 - For comparison, we'll add another method, described in Jay Ritters' paper Economic growth and equity returns, namely the earnings yield, or Earnings / Price.

According to the data for XIC on the iShares website, its P/E is currently 17.6. Turing that upside down gives us E/P, or 1/17.6 = 5.7%. But the ratio should use the past 10-year average of earnings according to Ritter, to smooth out economic booms and busts, not just the current earnings number embodied in the 17.6. Again the data for Canada is hard to to obtain for the individual investor. A rough estimation can be obtained using the TSX earnings figures taken at various points over the last twelve years by in his evaluation of whether the TSX is fairly valued. The average Earnings since 2005 over the current TSX Price (Index Value) of 15,000 gives an E/P of 4.7%. That number is still too high since the Earnings for each year have not been adjusted downwards for inflation but it gives an upper bound on the probable value.

Another comparison is the projection in the BMO Capital Markets paper, which is 7.0 (before inflation). Taking away 2% for inflation, for example using the figure derived below and which BMO also estimates, that would give a net return of 5.0%. Finally, using yet another method (and higher growth assumptions), InvestorsFriend estimated at the beginning of June based on a lower TSX index value of 14,375, that the TSX Composite would return about 7% annually, which gives the same 5% after inflation.

Our conclusion: over the next ten years, it is reasonable to assume that Canadian stocks are poised to deliver from 3% up to 5% real total return.

Bond Returns
The future return for bonds is simpler to estimate and much more certain. As we have written about previously here and here, bond duration tells us how long we need to stay invested in order to attain, within fairly narrow variation, the yield to maturity of the bond or a bond ETF at the time of purchase. Thus, if we take a bond ETF with long duration of 10 years or more, we know almost exactly what the total return, before inflation, will  be.

Take an average with a third each of the BMO Long Federal Bond Index ETF (TSX: ZFL) with a 14.84 years duration and a yield to maturity of 2.79%, the BMO Long Corporate Bond Index ETF (TSX: ZLC) of 12.85 years duration and 4.34% yield to maturity and BMO Long Provincial Bond Index ETF (TSX: ZPL) of 14.21 duration and 3.69% yield to maturity. That gives a future bond return of 3.6% before inflation, or 1.6% after inflation of 2%.

BMO's estimate for bond returns over the next ten years is 4%, or 2% net of inflation.

The best forecast of inflation is the difference between the yield on long term Government of Canada ordinary bonds (2.82% as of June 25) and long term real return bonds (0.78%), which automatically adjust for inflation. These figures from the Bank of Canada webpage with daily updated values for both types show almost exactly a 2.0% (2.82 - 0.78 = 2.04) difference between the two. 2% also happens to be the policy target rate for inflation set by the Bank of Canada. The market rates set by supply and demand obviously believe the Bank of Canada can and will achieve 2% on average. Thus our estimate of 2.0% inflation for the long term.

Wishes, and estimates, don't always come true
It is necessary to keep in mind, as we noted two years ago, that for stock returns, and for inflation, the relationships driving forecasts are not deterministic and there can be considerable variability in actual outcome. It might be a lot more, or a lot less.

A future below historical averages
A 50-50 portfolio of Canadian stocks and bonds would thus produce a blended annual nominal total return of 4.3% to 5.3% and a real return of 2.3% to 3.3%.  That's less than the averages from 1900 to 2013 reported in the Credit Suisse Global Investment Returns Yearbook 2014 for Canada of 5.7% real stock return and 2.1% bond return, or 3.9% in a 50-50 mix. Over a long period that 0.6 to 1.6% gap would make a significant difference. The implication is that investors need to save more to build the same size retirement fund, or take longer to do it and then, in retirement, can withdraw at a lower rate than the 4% rule which worked in the past.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 23 June 2014

Canadian Preferred Share ETF Comparison - Attractive Income but Some Caveats

Why consider preferred shares?
Preferred shares offer the Canadian investor steady income in the form of tax-advantaged (when held within a taxable non-registered account) eligible dividends. The dividends are usually greater than interest income even before taxes for debt of comparable credit rating and term. With interest rates being so chronically low these days, that can be appealing.

Preferred dividends have claim to company profits after bonds, so there is extra credit risk. On the other hand, compared to common share dividends, preferred dividends have prior claim, though the offsetting downside is that preferred shares do not have the opportunity for capital growth like common shares. Preferred shares stand in the middle between common shares and debt and are generally considered an income investment (see Blackmont Capital's primer on preferred shares, linked to by's preferred share page, which delves into some of the pros and cons in more detail).

Why an ETF?
ETFs devoted to preferred shares offer a convenient way to invest. One purchase can create a permanent low maintenance holding that contains a widely diversified assortment of individual securities, lowering risk of exposure to individual companies. There's no need to rebalance or reinvest when securities are called, no need to figure out which individual securities to buy or sell, it is all done within the ETF by the managers.

There are currently five ETFs focused on Canadian preferreds. We leave aside US-based offerings since foreign preferred dividends are treated as ordinary income on Canadian taxes and lose their tax advantage. All offer fairly similar expense ratios around 0.5% per year. There are however some fairly marked differences between the funds in their mix of types of preferred share holdings and consequently sensitivity to interest rate changes.

The ETFs
  • Horizons Active Floating Rate Preferred Share ETF (TSX: HFP) - an actively managed ETF where managers apply their judgement, targeting short-term income while keeping value stable despite interest rate change effects; still tiny at $22 million in assets since October 2013 start-up; MER 0.62%
  • iShares S&P/TSX Canadian Preferred Share Index ETF (TSX symbol: CPD) - oldest (2007 inception) and largest in assets at $1.3 billion; strategy is to passively track the overall preferred share market; MER 0.50%
  • BMO S&P/TSX Laddered Preferred Share Index ETF (TSX: ZPR) - second largest fund at $1.0 billion assets, has been catching up quickly to CPD since 2012 inception; invests in a 5-year ladder of preferreds that reset rates. Lowest MER at 0.45%
  • Horizons Active Preferred Share ETF (TSX: HPR) - another actively managed fund "to provide dividend income while preserving capital"; highest MER at 0.64%
  • PowerShares Canadian Preferred Share Index (TSX: PPS) - founded in 2011 but changed its index in May this year to target lower recent volatility and higher dividends whereas before it screened only on liquidity, resulting in a huge shift to a heavy weight in fixed rate perpetual preferreds; MER 0.51%

Diversification and credit risk - trading off sector concentration vs credit rating
As our comparison table above shows, all funds have a substantial chunk (20% or more)  of holdings in in credit rating Pfd-3, which is below investment grade of Pfd-1 or Pfd-2. The fund with the most holdings below investment grade - ZPR at 32% - makes up for it by having a more even spread across sectors and a low concentration in the top 10. Another fund that is highly concentrated in banks and insurance companies - PPS, at 71% - makes up for that by the highest proportion of holdings in the top Pfd-1 credit rating at 11%. HFP has the most concentrated top 10 at 29% but a wide sector spread. There doesn't seem to be any ETF that is clearly superior to the others.

We note also that there has been a significant decline in the overall credit quality of CPD over the last six years as the comparison with statistics by James Hymas in a 2008 Canadian MoneySaver article shows. The proportion of the highest rated Pfd-1 holdings was 65% in October 2008 vs only 9% today. Many major bank issues got cut from Pfd-1 to Pfd-2. Pfd-3 holdings have also risen substantially. Many new issuers offering preferred shares, such as industrial companies, are below investment grade. Lower credit quality raises credit / default risk.

Interest rate risk exposure - the biggest differentiator
Four funds appear to be most exposed to changes in interest rates - CPD, PPS, ZPR and HPR - though it is hard to tell which is most exposed. The weighted average duration (which is a measure of sensitivity to interest rate change, the higher the number the greater the sensitivity) of their holdings at 5.2  for CPD and 6.3 for HPR are one indication. In comparison, the broad benchmark bond ETF from iShares (TSX:XBB) has a duration of 7.09 while a short-term bond fund - iShares' XSB -  has a duration of 2.87. Though Invesco does not provide a duration figure for PPS, we estimate that it will have a similar interest sensitivity by virtue of its large 45% component in perpetuals, which are by far the most sensitive type, as seen in the following chart from Scotia McLeod's Guide to Preferred Shares.

Horizons' HFP is the least sensitive to interest rates, with a duration of only 0.9, a reflection its policy to keep holdings in short-term resets and floating rate preferreds. BMO's ZPR theoretically should fit in between HFP and the others, with its strategy of holding preferreds that will reset rates in five or less years. But the price action of the various ETFs seen in the chart below contrasting ZLB vs the other preferred ETFs and XBB suggests that it behaves much like CPD. And HPR has been less volatile than CPD and ZPR - it looks as though the active management strategy of HPR "to preserve capital" has been effective.

Despite the higher duration of XBB, CPD and ZPR dropped more in 2013 when interest rates took their upward spike.

Attractive payouts and reasonable but volatile returns
An important lesson for investors is that preferred share ETFs can be quite volatile compared to bonds. In 2008-2009 during the credit crisis and the recovery, CPD took a big drop in 2008 with a 17.2% negative return and in 2009 with a 26.2% positive return while XBB toddled along smoothly at +6.1% and +5.0% respectively.

Our second comparison table below shows recent cash payout rates. Four of the ETFs are paying out 4.1 to 4.9% depending on which payout measure is used, while HFP is paying 2.1 (trailing 12 months) or 3.4% (current yield). That's attractive income compared to XBB's 3.2% distribution yield and 2.4% yield to maturity, especially when tax rates are taken into account (it can take $1.30 of pre-tax interest to equal the net after-tax of $1 of dividends in a taxable account, though this varies depending on the investor's tax bracket and province) and the fact that a good chunk of the preferred ETF payouts has been non-taxed Return of Capital.

However, not all is sweetness and light. Returns - which includes both dividends and capital gains/losses - have not been nearly so attractive in the short term. Three of the four (CPD, ZPR and PPS) that have been around long enough (at least a full year) to officially report returns show negative 1-year returns. The 2013 interest rate rise hurt capital values. In addition, the capital losses seen in the above price chart have caused the ETFs to have bad Return of Capital, merely giving investors their own money back. As a recent Raymond James Canadian Preferred Shares Report points out (see pages 2-3) many of the Reset preferreds are being and will be called in 2014 by the issuers and new issues will have lower dividend rates. The reality of the low interest rate environment is being absorbed and cash payouts have been falling.

It is very hard to predict exactly how an investment in these preferred ETFs will fare. There is such a mix of inter-acting factors that can affect eventual returns and future income / cash payouts - interest rates, most obviously, but also credit risk, call risk (likelihood of issues being redeemed prematurely, when it advantages the issuing company and not the investor), the required return differential between government debt and corporate preferreds, the variable mix of types of holdings within each ETF and the wide variety of special redemption or retraction features attached to the types of preferred shares. Finally, and ironically, to some extent the tail is wagging the dog - flows into or out of the ETFs themselves are so large that they affect the market for underlying preferred shares according to Scotia McLeod's annual Guide to Preferred Shares 2014 edition. Unlike bond index funds whose future possibilities under rising interest rates we examined last year, we would hesitate to forecast the probable evolution of any of these ETFs in detail. Certainly, if interest rates rise, the capital value / market price of the ETFs will fall in response, but by how much and for how long is too hard to tell.

Bottom line - Though it is not possible to predict exactly what will happen, the ETFs would slot into a fixed income portion of a portfolio as follows:

  • Horizons' HFP fits as a reasonably stable short-term holding that generates better after-tax income than a short-term bond fund
  • The others are best considered for longer term or indefinite time holdings to generate fairly steady income superior in varying degrees over the years to bond funds but with volatility in capital value.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 16 June 2014

Centenarian Companies in Canada - Surviving and Thriving, Mostly

We'd all like to live to be 100 years old. But more than that, we'd like to be healthy and vigorous. It's not easy to achieve for people and just as difficult for companies. We decided to have a look at Canadian publicly traded companies that have existed for at least a century to see how they are doing, whether they are merely surviving or doing well.

No casualties amongst 2010 centenarians - The first pleasing thing to note is that all twelve of the companies in our 2010 post Twelve Ultimate Buy and Hold Canadian Stocks are still around and doing quite well, thank you.

Dominant players on the TSX - Three of the centenarians, led by the Royal Bank (TSX: RY), followed by TD Bank (TSX: TD) and Scotiabank (TSX: BNS), are the three largest companies, measured by total market value of stock, in Canada.

Beyond the original twelve, we did more digging (in University of Western Ontario's Canadian Centennial Companies and the Globe's Report on Business Top 1000) and uncovered another dozen companies that have a continuous 100-year history, though at times quite eventful (we are thinking especially of the oldest one of all, the Hudson Bay Company, which went private for several years recently and has undergone plenty of restructuring).
(click on table to enlarge image)

The two dozen companies together are massive - they constitute only 10% of the number of companies but they make up 33% of the total value of the TSX Composite Index. As our comparison table shows, the centenarians' market cap almost all far exceed the average of $1.6 billion (based on the stats from the iShares ETF (TSX: XIC) that invests in the TSX Composite).

Banks and insurance companies in the majority - Almost half (11) of the companies are financial companies, including all of Canada's largest banks. There is only one or two representatives from other sectors - mining (Teck), forestry (Domtar, though it evolved from an industrial company), industrials (CPR and Russel Metals), energy (Imperial Oil and Enbridge, which was originally Consumers Gas), booze (Corby and Molson), telecommunications (BCE), consumer (HBC, North West Company and George Weston) and publishing (McGraw-Hill Ryerson).

Stock price stability - The majority of the centenarians' stock prices are quite stable, as the Beta (a measure of a stock's price volatility compared to the market average) figures below the market average of 1.0  in our table demonstrate. Of course, when the stock market experiences extreme stress, as during the 2008 financial crisis, then the stock price stability can change dramatically. The nature of the crisis will influence individual stock reactions too - during the financial crisis, bank stocks in Canada, despite the strength of Canada's banks unlike those of the USA, Europe and the UK, suffered a sharper drop than the overall TSX. The bank stocks' price recovery was faster than the TSX too, pushing up the Beta, as the chart from TMX Money below shows. Upward high volatility / Beta can be good - current CPR shareholders will attest to that.

Prosperous and healthy at the moment - The centenarian companies are still as blue chip as they come (cf  Earnings, Dividends and Return on Equity in our comparison table above) with solid consistent profits, healthy and rising dividends. Only HBC is losing money and only Manulife has a negative stock return over the past five years and only three companies have 5-year compound returns less than the TSX Composite/XIC.

All the companies pay dividends but the growth of dividends is one relatively weaker spot of the centenarians. One company - MFC - has had to cut dividends. Several others have not increased theirs at all over the past five years while others have not increased their distributions by as much as XIC's 6.4% annual rate.

One other apparent anomaly on dividends, North West Company's (TSX symbol: NWC) 2% drop in dividends is a result of its conversion from income trust to corporation in 2012, which forced it to change from distributing pre-tax income to after-tax dividends (and which would leave an investment in a taxable account no worse off due to the dividend tax credit). The corporate NWC has increased its dividend in 2013 and again in 2014, up a total of 17% over 2012.

Swings and roundabouts of company and shareholder returns - Extending the view of these companies' histories shows that some have done considerably better than others.

The chart below using BMO InvestorLine's graphing tools shows the price-only (i.e. excluding dividends) performance since 1984 of four of the centenarians - Royal Bank, BMO, Russel and Imperial Oil - against the TSX. The dark blue line of RY is way above the others, though at one point in 2007, IMO briefly topped it. Meanwhile Russel has doddered along, more or less returning nothing but dividends to shareholders who may have bought 30 years ago.

That doesn't look at all good for Russel ... but then consider the last ten years alone. Suddenly, Russel is the best performer of all, exceeding even Royal Bank. Stay in the game long enough and good things may happen. We might adapt the Star Trek motto, "Live long and prosper" to "Live long enough and you will prosper".

The mix of positive and negative analyst recommendations in our table suggests however that success is not assured. Indeed our list of centenarians is biased in that it includes only survivors and excludes those many companies that have fallen by the wayside.

Yogi Berra's delightful quote, "it ain't over till it's over", sums it up. Unlike people, whose bodies and minds eventually deteriorate but cannot be repaired or replaced, companies have the potential to bring in new people, hopefully to absorb and continue the best elements of the past while adapting to inevitable changes. A report in the Economist magazine suggests that longevity and prosperity are not accidentally associated. The centenarians provide an interesting starting list of companies to consider for a long term portfolio.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.