Which Bond ETFs are Most Vulnerable to a Rise in Interest Rates?

Interest rates are still at historic lows but they have only been maintained at such levels due to economic conditions. When interest rates rise, the price of bonds will fall (for a straightforward explanation of why this inverse effect occurs, see Investopedia's article on the question) as investors demand a higher rate of return. Bond ETFs are collections of individual bonds with varying maturities and coupon rates. Thus, a rise interest rates rise will see the value of bond ETFs fall and inevitably the market price of bond ETFs will fall too.

How do we measure the effect? The answer is a metric called Duration, which measures the amount any one bond, or a collection of bonds, will react to interest rate changes.e.g. a duration of 5 means a 1% rise in interest rate / required investment return will cause a 5% fall in price.

Fortunately the ETF providers do the fairly complicated calculation of Duration (see the Gummy bond tutorial II from the Financial Webring to see the math) for us and we only need to look it up on their respective websites. Let's have a gander at the range of Canadian bond ETFs to find out how much interest rate exposure we investors face in buying these funds today. We'll see that there is wide range amongst bond funds.

Durations of Canadian Bond ETFs
(click on image for details)


The lessons of the comparison table follow common sense:

• Short maturity funds of five years or less have substantially shorter Durations (around 3) and sensitivity to possible interest rate increases while funds with long-dated maturities are the most susceptible (around 12-13).
• All-inclusive broad market funds have a mid-range Duration of about 6.
  
• There is a general pattern of higher yield for higher duration - other things being equal, the more interest rate risk one is prepared to take on, the higher the yield.
• While Duration may be the same, all sectors are not the same, especially with regard to credit risk (the risk of not getting paid). This risk is reflected in higher yields for corporate over government bonds. The iShares DEX HYBrid Bond Index ETF (symbol: XHB), with its holdings of higher credit risk corporate bonds yields the most of all.
• A seeming anomaly is the combination of very low yield and very high duration of the two real return bond ETFs, iShares ' XRB and BMO's ZRR, which mainly contain bonds issued and guaranteed by the Canadian government. Are investors in these funds somehow in a very bad deal? Not necessarily ... A major cause and component of higher interest rates is inflation. Real return bonds include an automatic ratcheting mechanism for CPI increases that protects against inflation. Compare ZRR and XRB with ordinary long maturity and long Duration bonds issued by the Canadian government, e.g. in BMO's ZFL fund. They do not contain any ratcheting for inflation, though they do incorporate an inflation expectation roughly equal to the difference in yield with the real return bonds, in this case about 3.3% - 1.1% or 2.1% per year. If inflation spikes up above 2.1%, XRB and ZRR investors are protected but ZFL owners lose (as do all the other bond ETFs). The protection is worth a lower yield.

A few caveats - the Duration formula of x% price change per 1% change in interest rates isn't exactly uniform and linear. At low yields, such as those prevailing nowadays, Duration changes faster than interest rates, so the formula exaggerates a bit. Duration is most accurate for small changes in interest rates, say +/ 1% - beyond, that the effect becomes less and less and pronounced in a way beneficial to the investor - a big rise in interest rates makes a lesser bond price hit and a big fall makes more of a price rise.

Interest Rate Increase Protection Options

• The obvious tactic is to buy into funds with shorter Duration, though as we observe, there is loss of yield
• Another strategy is to try to, as the finance textbooks say, immunize your bond holdings by matching Duration with your investment time horizon. See this brief explanation on eHow.com, the key sentence of which is "When the duration of a bond or a bond portfolio is equal to the investor's expected investment horizon, the investor will be immunized against interest rate risk." In other words, match the Duration of your bond holdings with the time when you will need the money. A key assumption is that the interest is reinvested (ETFs such as those of BMO and Claymore that let you choose to DRIP automatically instead of having to buy new shares on the market are very useful in that regard). If you do not reinvest, the gain on the higher interest rate from new investments will not be there to offset and compensate for the initial loss of capital/share price when interest rates rise and you the investor will be a net loser in the process.
• Buy actively managed bond mutual funds, whose managers try to figure out the direction and amount of future interest rate changes to change the bond portfolio in advance. You rely on the skill of the manager and as usual, past successful performance may not be repeated; in fact, most active mutual funds do worse than than a passive index and finding the ones who will be successful is hard. To get a list of bond mutual funds, use the fund filter of your discount broker or the free Fund Filter at GlobeInvestor. All of the ETFs in our table are passively managed funds that merely try to reproduce the performance of a representative set of bonds according to sector and market cap.

Interest rates will inevitably rise when conditions improve, the only question being how soon that will happen. Be ready!

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.

Bond ETF Comparison: Canadian Broad Market Funds

Bonds are popular these days so let's have a look at three ETFs containing a broad range of corporate and government holdings. Bond funds are typically included in a portfolio to provide diversification for equities and other asset classes, to preserve capital by virtue of being more stable and secure than equities, or to generate income for spending from the interest they pay out on a regular basis. There are also many narrowly focused bond funds, such as high yield & risk, international bonds, short or long term maturities, corporate or government holdings, but broad ETFs provide a basic starting point and core holding for a portfolio.

The ETFs

• BMO Aggregate Bond Index (quote symbol: ZAG) - newest entrant, launched in January of 2010 and still with a tiny asset base of $17 million
  
• Claymore Advantaged Canadian Bond (CAB) - also very new, will be a year old in November 2010 but small as well, with $71 million in assets
  
• iShares DEX Universe Index Fund (XBB) - started in 2000 though it changed to its current broad holdings only in December 2004; it also dwarfs the others with its $1.6 billion in assets
  

Key Comparison Factors:
(for details click on the table image below)


Management Expense Ratio - ZAG is lowest overall by a hair at 0.28% over XBB. CAB's ratio is double that figure but its unique features may be worth it for certain investors with specific needs, as explained below.

Net Assets and Trading Costs - The winner here is XBB whose sheer size ensures a very active market for its shares. That keeps the spread between bid and ask prices very tight, which in turn minimizes investor trading costs (i.e. you can buy - the ask price - at a slightly lower price and sell - the bid - at a slightly higher price).

Diversification and Credit Risk - It's hard to conclude which is best on this dimension. On the one hand, XBB dominates on the number of holdings, which means the impact on the ETF of trouble at any single bond issuer is lessened. And it does have a higher percentage of its holdings in possibly safer government bonds than CAB. However, ZAG with the fewest number of holdings has the most in government bonds. CAB's strong suit is that, unlike ZAG and XBB, it holds none of the BBB or lower credit quality bonds that are most likely to run into trouble. Take your pick!

Interest Rate Risk aka Duration - Interest rates are as low as they have ever been right now but sooner or later they are likely to rise. Duration measures the sensitivity of the portfolio's bonds to changes in interest rates - the lower the duration, the lower the sensitivity (see Shakespeare's brief explanation here and a detailed mathematical explanation here on gummy's stuff of the Financial Webring). CAB is the least exposed with its lowest duration, but not by very much.

When interest rates do begin to rise, that will put downward pressure on the prices of bonds within the ETFs and the share price of the ETFs will fall as well. A mini preview of this effect occurred in April of this year when interest rates briefly spiked up about 0.5% only to fall back down 1% by today. The Google Finance chart below shows the price dip of our three ETFs followed by the upswing.


Yield to Maturity vs Distribution / Coupon Yield - Some investors mislead themselves by looking at the cash distributions (termed either the Distribution Yield or the Weighted Average Coupon percentage) paid out by the ETF as the investment return they will get. But that neglects the fact that the return of a bond or a collection of bonds is made up of the interest coupon (the cash part) and the difference between the price paid for the bond and the eventual payback of the principal of the bond upon its maturity (again, see the above Shakespeare link for a good explanation). The real economic return, which takes account of both factors, the one that we investors need to look at, is the Yield to Maturity. Note from our comparison table that the yield to maturity is much lower than the cash yield from the payout of interest coupons - about 2% less for ZAG and XBB and about 0.5% less for CAB. Don't be fooled - the 2.7% or so that the three ETFs give off is the real return you will be getting at today's ETF price and current interest rates. The low yield reflects the low interest rates in the economy.

There is very little difference between the three ETFs in yield to maturity, only 0.06% between the lowest ZAG and the highest CAB. That's not enough to call a winner.

After-Tax Cash Flow - For investors who buy bonds to receive cash income to spend, the cash distribution amount is a factor to examine. Here is where there is significant difference between CAB and the other two ETFs. ZAG and XBB simply hold bonds and pay out whatever coupon interest is received as they are obliged to do. ZAG and XBB have very similar payout rates of 4.6% and 4.7% respectively.

CAB has a unique structure, deliberately created by Claymore to fill a niche for a bond fund to be held in a taxable account. Most investors do not want or need that, having heeded the oft-repeated advice (e.g. at TaxTips.ca) to hold bond funds inside registered accounts where interest income does not get taxed until withdrawn. Some investors, perhaps having maxed out their RRSP, may want the stability and steady income of bonds outside a registered account. CAB uses a clever forward contract arrangement with TD Bank that allows it to distribute its income as a Return of Capital (ROC) for tax reporting. The cost of doing this - apparently TD receives a fee of 0.3 to 0.4% for its efforts - reduces the gross income but the after-tax net income is very competitive with the coupon yield of XBB and ZAG, especially for taxpayers in higher brackets e.g. the equivalent pre-tax distribution of CAB for a 40% tax rate is 5.34% versus only 4.7% for XBB.

That's because ROC is not taxed at all. Instead the ETF owner / taxpayer must reduce the Adjusted Cost Base of his/her ETF holding. The investor will eventually pay tax on the income as a capital gain instead of income at the time when he/she eventually sells the ETF holding (see our previous post on Calculating Capital Gains in ETFs and Mutual Funds). Claymore says it intends and feels it can achieve to only ever pay out ROC, and not income or capital gains from CAB. This is believable if the arrangement with TD or some other bank in its place is maintained indefinitely since then the returns (both income and price gains if any) will never get realized in tax terms. It's the same principle we outlined in our previous post Return of Capital: Separating the Good from the Bad as "good ROC" in the point about unrealized capital gains in mutual funds. At no point is CAB's income taxed at the higher marginal rate of interest - it achieves the minor miracle of turning the "water" of interest into the "wine" of deferred capital gains! The method used is totally legitimate and well established (the new TSX 60 index tracker from Horizons BetaPro which we reviewed here uses a very similar technique).

XBB and ZAG will produce interest income almost exclusively, though with a minor amount of good ROC - XBB gave off under 5% of its income as ROC in 2009 (see its Distribution History here). This is due to the growth of the ETF assets as investors buy in and more shares are created whose operation we described in our previous post on ROC under the heading Index Mimicking in ETFs.

Bottom line on this measure: XBB and ZAG are both fine and about equal for registered accounts while CAB is clearly best for a non-registered taxable account.

Automatic & Commission-Free Purchases and Withdrawals - For investors not wanting to receive and spend / withdraw the income, e.g. while in the portfolio buildup saving years, a DRIP that reinvests the income into the purchase of extra ETF shares automatically and without trading commissions is a big convenience and cost saver. ZAG and CAB both have the valuable DRIP feature while XBB does not. Two further valuable convenience features that only CAB offers are free and automatic pre-authorized chequing purchases of additional shares or systematic withdrawals by selling shares.

Which is best overall?
CAB is clearly superior for an investor who wants to hold bonds outside a registered account, especially those in higher tax brackets. Within registered accounts, ZAG and XBB are very similar whose slight differences offset each other. For someone building up a portfolio, ZAG is a hair ahead of XBB, due primarily to the DRIP.

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.

Online Education for the Canadian DIY Investor

The Internet is a wonderful cornucopia of information at our fingertips but the flood of data and the huge number of websites, blogs and forums can be overwhelming. Today, we run through a few favorite independent neutral non-vendor websites that offer the Canadian DIY investor, in a manner akin to online books, broad, structured educational content on key investment areas.

Investing 101 and Beyond

• Shakespeare's Investment Primer - a good place to start, always practical in describing the range of investments available to the ordinary person and showing how to put it all together; covers basic components like stocks, bonds, ETFs, preferred shares, REITs, options, foreign content, gold and explains how to manage risk, diversify and allocate assets in a portfolio and withdraw funds in retirement
• RetailInvestor.org - advanced material oriented to stocks, especially how to assess their value; seems to enjoy knocking down myths; meticulous and thorough with lots of detail, calculations shown and useful spreadsheets to download for one's own use;
• Independent Investor.info - (free registration required but they don't sell anything) describes the gamut of common investments equities, fixed income, alternative investments, ETFs, mutual funds; focus on how to protect yourself - advice on dealing with brokers, articles on scams, regulation, costs and industry malpractices; also discusses registered accounts (RRSPs etc) and taxes
• ByloSelhi - not so much original content itself, but has a large collection of discerning links to high-quality articles on key subjects - ETFs, retirement, real return bonds, financial/investing education
  

Taxes

• TaxTips.ca - covers taxes on investments (dividends, capital gains, foreign currency etc) within personal taxation; deals with registered vs unregistered accounts; includes calculators and many tips; best of all, it's understandable

Retirement

• RetirementAction - serves up assessments of pensions and often-complex investment products oriented to retired people like annuities, GMWBs, structured products, segregated funds; discusses ETFs, asset allocation, inflation/deflation, lifecycle investing and many other topics of import to retirees

Discussion Forums - though not really highly structured content we think one of the best ways to learn is to be able to ask questions and you can ask away in these online forums:

• Financial Webring - long-lived and active, it tends to be dominated by knowledgeable individuals who reveal many of the fine and sometimes critical points of investing in their quest to outdo each other; there is a separate area called the Finiki that aims to be an encyclopedia of the combined wisdom of the forum
• CanadianBusiness - tends to be a bit more oriented to the newer investor, lots of active threads in categories such as stocks, mutual funds, investing for beginners, taxes

The list is just a start. Many other useful sites are out there. If you have any to suggest, by all means drop a comment onto this post.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above information is not an investment recommendation. The websites may not provide correct information or advice in every case or subject. Their 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.

P/E and PEG Ratios - Remember the Effect of Interest Rates

Value investors constantly search for under-valued companies and two of the most common metrics to identify such stocks are the Price to Earnings (P/E) ratio and the ratio of P/E to expected future growth rate of earnings (PEG). P/E and PEG are also used to judge whether the stock market as a whole is under-valued.

Wrong Generalizations: One often sees these kinds of statements made about P/E and PEG:

• low P/E stocks are under-valued, or a lower P/E stock is a better value than a higher P/E stock; a corollary is that when the stock market is above its long-term historical average P/E of 15, it is over-priced.
  
• the P/E ratio of a correctly priced stock is equal to its growth rate and therefore when the PEG ratio <>1 the stock is likely over-priced and should be avoided
  

Beware! Such statements are too simplistic, misconceptions that arise under the assumption of "all other things being equal", which they rarely are. One particular key variable that can substantially affect appropriate values of P/E and PEG (and which seems to receive scant mention in popular media) is the level of interest rates. Let's see how this works.

What is the Alternative? Earnings Yield Compared to Risk-Free Bonds
Turn the P/E ratio upside down into E/P. The E(arnings) can then be seen as simply the profit divided by the P(rice) to pay per share - it gives a percentage return, called the earnings yield, for the stock e.g. a P/E of 20 (which happens to be approximately the current figure for the TSX Composite Index, i.e. the average of all the stocks in the index) is saying that the earnings yield is 1/20 = 5%. If the earnings never change that's what an investment in that stock will provide the investor. A P/E of 15 is thus an earnings yield of 1/15 or 6.7%.

Now, let's bring in interest rates. An investor contemplating buying a stock or a market index ETF (e.g. the TSX index-tracker iShares S&P/TSX Capped Composite Index Fund, symbol: XIC) looks at alternatives. What else is available and what is the yield? The usual reference benchmark alternative is a risk-free long term government bond like a Government of Canada bond maturing in 20 years. If interest rates are low, the investor is satisfied with a lower return on stocks, which means that a higher P/E is acceptable.

Interest rates today are lower than they have been since the 1950s (see this table of Government of Canada long-term bond yields from the Presitigious Properties website). A 20-year Canada bond currently yields about 3.3% per Canadian Fixed Income.ca. Back only ten years ago when such bond rates ranged between 5 and 6%, an investor would have required a higher return from stocks at that time. Since interest rates are currently very low, higher P/E ratios should be expected and acceptable.

Adjusting for Risk
The current bond rate of 3.3% is less than the stock earnings return of about 5%. The question is whether there is enough difference to compensate for the extra risk, of stocks in general, or of a particular stock. For stocks in general, the usual method to get a return is to add a so-called Equity Risk Premium to the risk-less rate. How much should we add? We could take the long term actual historical average of 3.7% for Canada (per the Credit Suisse Global Investment Returns Yearbook 2010). For other countries or the world equity market, historically riskier than Canada, we might take the 4.5 - 5% estimated by Dimson, Marsh and Staunton in The Worldwide Equity Premium: a Smaller Puzzle from the SSRN website). For riskier emerging market countries, it should be higher still. For individual stocks, their relative riskiness would require an upward or downward adjustment.

Inflation is inter-twined with interest rates and risk, having the effect of increasing both. Thus, higher inflation creates lower P/E values. Since inflation is currently low - indeed some feel the bigger concern at the moment is deflation (see our August 24th post on the inflation vs deflation debate) - and the low expectations for inflation implied by the 2.1% difference per Bank of Canada rates between nominal and real return bonds (see Bank of Canada's Inflation Expectations and Real Return Bonds), we can say that the inflation picture reinforces the idea that current P/E values can be acceptably higher.

Growth Adds to Price and Pushes Up P/E
The final factor to consider is the growth rate G. Using the current earnings yield assumes a steady state with no growth in earnings. It is normal that companies grow, that's what creates economic growth. Intuitively, higher future earnings are worth something to the investor so it is worth paying a higher price today. The more growth, the more future earnings will be generated, so P(rice) is justifiably higher. P is higher compared to today's earnings and so P/E is higher too.

Earnings growth is driven by the combination of the profitability of a company and the proportion of earnings reinvested (instead of being given out as dividends). The higher the profitability and the more that is reinvested, the faster the growth.

NYU professor of Finance Aswath Damodaran has produced a graph that shows how dramatically high the P/E of fast-growth companies can justifiably be. A high P/E stock may reflect a higher potential growth rate and not be a poor value compared to a lower P/E stock with lower growth. Conversely, a low P/E stock may reflect no growth or even expectations of earnings decline and may not be worth buying at all.


Low Interest Rates = Higher P/E and Higher PEG
The net effect of all factors combined shows up in the following table, calculated with standard finance formulas:

• P/E values are highest for lowest interest rates, no matter what absolute return the investor seeks
• PEG ratios are also highest for lowest interest rates, where they greatly exceed 1
• PEG ratios for correctly valued stocks are above 1 in most interest rate scenarios
  
• PEG ratios of 1 or less for under-valued stocks only occurs: primarily, when interest rates are quite high (Government bonds at 10% or more) and secondarily, when investors require higher rates of return (5% or more over the Government bond rate)

TSX Over-Valued at P/E 20?
Since the above table shows no P/E above 18 at the lowest possible interest rate and the lowest required return, does that mean the current TSX P/E of 20 indicates an over-valued Canadian stock market?

Not necessarily. If the required Equity Risk Premium lies at 2.0%, below the historical 3.7% TSX rate, the justifiable P/E rises to around 20. Or, if the future profitability (ROE) of companies in the TSX rises fast and is higher than the required investor return by 3%, a P/E of 20 makes sense at current interest rates (see table below).


Bottom Line - Making the judgement of over- vs under-valued is quite difficult because it requires estimating what the future will bring. But we should not trip ourselves up by ignoring current low interest rates that have the effect of raising justifiable levels of both P/E and PEG.

Further reading: Burton Malkiel, author of the investment classic book A Random Walk Down Wall Street, said about the US market in September 2001, Don't Sell Out

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.

Canadian Large Cap Equity ETFs: BetaPro's HXT Joins the Fray

A significant new player - Horizons BetaPro S&P/TSX 60 Index ETF (TSX symbol: HXT)- has come onto to the scene of Canadian Large Cap Equity ETFs since our review of last December. How does the new entrant, which started trading on September 15th, stack up against the others - BMO Dow Jones Canada Titans 60 Index ETF (ZCN), iShares S&P/TSX 60 Index Fund (XIU) and Claymore Canadian Fundamental Index ETF (CRQ) - and how have the others changed since December?

HXT's Unique Product Design
Instead of buying and holding the companies in its index like the other ETF providers, the Horizons manager of HXT has set up a contract, called a Total Return Swap, with the National Bank under which the the bank agrees to provide HXT with the exact return on daily basis of the S&P/TSX 60 Index, including the value of any distributions the constituent companies pay out. This has a number of implications and consequences when HXT is compared to the other ETFs:

1) Counter-party Risk - What Happens if National Bank Cannot Pay?
This has generated a lot of controversy (e.g. this Financial Webring forum thread) and misunderstanding about whether HXT is inherently much more risky due to its structure. Blogger WhereDoesAllMyMoneyGo provides an excellent summary and explanation of exactly how HXT works, the bottom line of which is that HXT does not have appreciably more counter-party credit risk due to the Swap form of construction. See also Horizon's clarification posted on the Canadian Capitalist blog.

2) Dividends/Distributions get automatically reflected in the asset value of HXT as if they were being reinvested completely and instantaneously. This can be good or bad for the investor, depending on his/her needs and circumstances. Whereas ZCN and CRQ offer an optional Dividend Reinvestment Program (DRIP), there is no choice but to reinvest with HXT. The Total Return index tracking makes this happen in effect as part of the design. That's good if the investor is building a portfolio and wishes to reinvest but not so if you wish to receive the cash. XIU is inferior on this factor since iShares offers no DRIP.

3) Deferred Capital Gains vs Immediate Dividends - HXT does not, as noted above, actually receive dividends. Instead their value is incorporated within the share price and is only realized when the investor sells the shares, which means capital gains are deferred. Nor does HXT pay out any dividends. There will be no annual tax slips issued. In a registered account, it doesn't matter since there is no annual tax liability, only income tax to pay when a withdrawal is made from the account. Within a taxable account the absence of annual taxable distributions can make a very large positive difference in the end total after taxes since the dividends can grow and compound on a tax-deferred basis. But there is a caveat - it does not help low income investors (up to about $40,000 taxable income in Ontario - see this table in TaxTips.ca) since they do not pay any income tax on eligible dividends (and that's what constitutes 90% or more of distributions from the S&P/TSX60) - see our previous post Three Reasons to Love Dividends for more on how this works.

4) Income Tax Liability Risk - Though HXT is designed and expected by Horizons to continue indefinitely, in which case the only tax liability of the investor is upon selling the HXT shares for a capital gain, the termination of the Swap would cause the gains, both the price rise and the dividends, accumulated within HXT to be distributed for tax purposes as ordinary income to HXT shareholders at the time. After many years that could be a very large amount. A shareholder who had bought in much later would become liable for tax on TSX60 capital gains and dividends generated in all the years before he or she bought in. In contrast, the other ETFs distribute cash received on a quarterly basis, so any tax liability is dealt with each year and there is no overhanging risk of potential future liability beyond a quarter.

5) Management Expense Ratio - HXT is the new low cost leader with an outstanding 0.07% MER, less than half its closest rivals ZCN and XIU. Horizons claims that there are no other expenses other than 13% HST tax on the MER, which will add another 0.01% to the total.

6) Assets, Liquidity, Tracking Error and Premium/Discount to NAV - The bigger and more actively traded an ETF, the better for the investor to get efficient pricing versus the Net Asset Value (NAV) of the underlying holdings and tight bid-ask spreads that lower the difference between buying and selling prices. ZCN has made the greatest progress into a very competitive second place in terms of asset size (increasing its asset size more than ten times its size from our first review, to a hefty $526 million in total assets). ZCN is still far behind the market leader XIU, which gained more than $1.9 billion in asset size and which has maintained the smallest bid-ask spread. CRQ more than doubled in asset size. New entrant HXT has started with a small initial stake of $50 million but its trading volumes have been amazingly high at several million shares per day, indicating the heavy presence of day traders and institutional investors. Such large increases across the board reflect the growing popularity of index ETFs. Asset size growth from the gain in value of the TSX 60 would only account for about 8.7%. ZCN and CRQ are very similar with bid-ask spreads higher than XIU's, but they are still quite low. HXT's trading volume would suggest its bid-ask spread will be similar too.

Interestingly, HXT breaks the mold on tracking error and it almost surely will be the best on that dimension. Since its value is mathematically calculated to follow the S&P/TSX 60 Index, it should have only the under-performance caused by its MER fee cost, which is the lowest. XIU has its higher 0.17% MER plus reduction to due to transaction costs, re-balancing costs and portfolio optimization costs, together which amounted to 0.02% annually over the past decade, or a total under-performance of 0.19% per year. It may not seem like much difference but it all adds up as XIU returned 81.02% in the last ten years while the Index gained 84.52%.

7) Fund Diversification - ZCN, XIU and HXT share a very similar allocation amongst economic sectors. CRQ's looks very lopsided with a much higher concentration in Financial Services (45% of total assets) and much less in Materials and Energy. Offsetting this is the fact that it has a lower concentration in individual companies - the top ten holdings are only 42% in CRQ vs 45-46% for the others and in the top twenty-five, there is also a much lower concentration. Whether CRQ's portfolio is considered better or worse boils down to a judgement of its fundamental indexing approach compared to the cap-weighted approach, as we discussed in Different and Better (?) Ways to Invest in the Broad US Equity Market.

CRQ has slightly out-performed the other ETFs over the past year as the chart below from Google Finance shows. CRQ's approximate 0.8% higher price gain on the chart does not include the fact that XIU and ZCN had about a 0.4-0.7% higher dividend yield, so the net difference is only 0.1 to 0.3%.


Summary Comparison Table (click on it for larger image)


Bottom Line - a Best Fund?
It's a tough call. All these ETFs are solid choices, none is clearly bad, nor is any a winner across all factors.

• XIU offers the cheapest trading and best liquidity, but there is no DRIP and its fees are beaten by both ZCN and HXT.
  
• ZCN offers second lowest fees and an optional DRIP but unknown tracking error.
• HXT offers offers outstandingly low fees, automatic reinvestment for those who want it and tax-deferral in taxable accounts but there is the niggling worry about the Swap and potential future bad consequences.
  
• CRQ has given better returns and claims it can continue to do so, along with offering the best account features like the DRIP, Systematic Withdrawal Plan and Pre-authorized chequing contributions, but it has a much higher MER and a portfolio very concentrated in Financials.

You choose!

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.

Food Companies to Satisfy Investment Hunger

BMO Capital Markets recently put out the report It's Not Just About Flavour, It's Good Business Too (download pdf here) in which it says the Canadian food and beverage manufacturing industry "has lots going for it" in economic and business terms. Since everyone has to eat and drink, perhaps in these uncertain times there are steady performers in that industry. How does the food and beverage industry (which excludes beer, wine and hard alcohol companies) translate into investment opportunity? Let's take a look.

1) Finding the Candidate Stocks
Our first stop is a stock screening tool such as GlobeInvestor's, which includes the option to select an industry sector, in this case Food Processing. Your discount broker website will have a stock screening tool too; in BMO InvestorLine's case, it is the enhanced version of the Globe tool. The search pulls up 21 securities, of which five are preferred shares (symbols with .PR) or debentures (symbols with .DB) and one, Menu Foods (MEW.UN), produces pet food, so we eliminate them, leaving us with 15 common stocks.

2) Companies with Consistent Profitability
Our next step is to find the companies that are consistently profitable. To do that, we go to the Toronto Stock Exchange's investor website TMX Money and:

• type in the stock symbol for each of the 15 candidates, then
  
• click on the Financials tab and
  
• pick the Income Statement and Annual View from the drop down menus

TMX shows the most recent five years of results. We select only those companies where there has been a profit i.e. whose Net Income has been positive, for at least the last four years. That leaves us with six companies. One of them - High Liner Foods - has two classes of shares, the HLF.A being non-voting equity shares, so we will consider them together:

• Rogers Sugar Income Fund (RSI.UN) - refines, processes and distributes sugar in Canada
• High Liner Foods (HLF and HLF.A) - processes and markets prepared frozen seafood
• Lassonde Industries (LAS.A) - processes and markets fruit juices, drinks, wine, sauces, soups and beans, and specialty food products such as canned corn-on-the-cob, fondue broths, bruschetta toppings and tapenades
• Premium Brands Holdings Corp (PBH) - manufactures, markets and distributes branded consumer food products across Canada and the Western United States
• Canada Bread Company Limited (CBY) - manufactures and markets flour-based products in various markets, including fresh bread in Canada, frozen par-baked bread in the U.S. and Canada, specialty bakery products including pasta and sauces in Canada and bagels in the U.K.
• Saputo Inc (SAP) - produces and distributes dairy and grocery products, including cheddars, specialty and fine cheeses, as well as mozzarella, dairy products, such as fluid milk, flavoured milk, cream, yogurt, butter and sour cream

3) Profitability, Growth and Value
A quick initial indicator of potential value is a stock's Price to Earnings (P/E) ratio. All of our profitable companies exhibit a much lower P/E than the 20.4 average of the TSX Composite (as of Sept.17th close of business). That is encouraging for our candidates.

There are other promising indicators as well, such as the rapid profit, revenue and Earnings Per Share (EPS) growth of all but Rogers Sugar. The 1-year Return on Equity (ROE) and Return on Assets all look reasonable, though Lassonde and Saputo shine brightest.

4) Safety
There is a bit more differentiation between the companies on these measures as Rogers Sugar and Premium Brands look much weaker on the amount of debt they carry, as expressed in the higher debt/equity ratio, and the consequent much lower coverage for their interest costs.

Similarly, the very high dividend payout percentage (as a % of Earnings) of these two companies is much less reassuring than the situation of the other companies. Perhaps this is a factor in the Financial Post report on a BMO Capital Markets prediction that Rogers Sugar Income Trust will reduce distributions upon conversion to a corporation.

5) Returns and Market Sentiment
It appears that it is not only BMO Capital Markets and this blog paying attention to the best of the Food Producers. The market loves these stocks. 1-year price returns on five of our six stocks (CBY being the odd one out) have outstripped the TSX Composite by a huge margin as the graph from Google Finance (link to live chart) shows.

For all except CBY, that 1-year return is far above that of their peers in the industry (see the 1 Yr O/U Median Industry Rtn column). A couple of them (RSI.UN and HLF) even provide a higher dividend yield than the TSX's 2.7%.

Analysts love most of these stocks too - three have the best five-star rating (HLF, LAS.A and SAP) - and two garner four stars (RSI.UN and PBH).

6) Past vs Future Returns
Past performance is impressive but what really matters is whether the good performance will continue. Have these stocks played out their rise?

The low P/E ratios suggest more catch-up to the market average is possible. And the professional analysts seem to feel there is still upward potential for several of our candidates, as seen in the Strong Buy rating for HLF and PBH and the Buy rating for CBY and SAP, and in the higher projected 12 month stock prices. (Note however, that analysts can be wrong, as we wrote about in Stock Market Analysts: add Salt and Pepper.)

The Food sector appears to hold potential. But the investigation process isn't complete. To get a view of the future and make a decision as to whether to invest would require delving into the companies' financial and management reports on their websites, reading the news about them, examining insider trading (see Insider Trading: Using It to Get and Edge, Legally of Course) and getting a sense of what could propel further growth in revenues and earnings, since that is what will eventually determine stock price and the ability to pay increasing dividends.

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.

CleanTech & Profitable Investment - Yes, the Two Can Go Together

Clean, green technology may be the way of the future but is it possible for an investor to find solid profitable companies in the burgeoning sector? For many, the debacle of the dot com era, where start-up companies galore without profits (or sometimes even revenues) achieved stratospheric stock prices, only to have it all crash and burn into cinders, is an all-too-painful reminder that an emerging sector can pose great danger.

Let's take a look at the 19 members of the S&P/TSX Clean Technology Index (see link on this page)"... whose activities provide value-added solutions to environmental problems". The Index members are not tiny start-ups - S&P selects only companies with C$100 million or more in market cap with enough stock trading volume and shares outstanding available for trading to be reasonably liquid.

Eliminating The Unprofitable Companies
By clicking on the stock symbols in the Constituent Companies list and then the Financials tab for each company on the TMX Money website, we are able to quickly see that these companies have chronic and/or repeated big losses:

These companies may eventually be highly profitable and for many hope springs eternal (which some of the stock price charts for these companies suggest!), but for now, we say, no thanks and move on to the proven performers.

Nine Profitable Clean Tech Companies
More than half the profitable (i.e. positive Net Income) group consists of renewable hydro and wind power generation firms:

• Algonquin Power & Utilities Corp (TSX symbol AQN)
• Macquarie Power & Infrastructure (MPT.UN)
• Boralex Inc (BLX)
• Northland Power Income Fund (NPI.UN)
• Brookfield Renewable Power Fund (BRC.UN)

These companies are characterized in most cases by long-term electricity sale agreements. Barring major weather or equipment problems, they should continue to generate as much profit as power. The healthy dividends most already pay confirms that capability.

Two of the power companies - Macquarie and Brookfield - have yet to convert from the income trust structure to corporations, as they are being in effect forced to do by the federal tax change (see previous posts on this topic here and here) to take effect January 1st, 2011, but both Brookfield and Macquarie have announced the intention to convert. When that happens they will likely reduce cash distributions by about a third.

One power company - Boralex - is an interesting case. Boralex Inc has been in the throes of a takeover attempt (apparently likely to be successful under revised terms) on the similarly-named but separate income trust Boralex Power Income Fund, which has its own listing under BPT.UN and has not not been profitable.

The other four present a range of CleanTech sectors:

• ATS Automation Tooling Systems Inc (ATA) - Designs, manufactures and installs factory automation solutions for various industries including telecommunications, semiconductor, fibre optics, automotive, computers, healthcare, electronics, solar energy and consumer products. It has not had a long track record of profits. It was not profitable until 2008 but has maintained it through the recession in 2009. No dividends yet.
• Newalta Corporation (NAL) - Delivers industrial waste management and environmental services to customers across Canada. After a big dip in Net Income in 2009, it increased its dividend in August.
• RuggedCom Inc (RCM) - Designs and manufactures ruggedized communications equipment for harsh electrical and climatic environments. Its high P/E ratio of 39.6 says the market price anticipates strong rises in profits but it is not yet paying a dividend.
• WaterFurnace Renewable Energy Inc (WFI) - Designs, manufactures and distributes geothermal and water-source HVAC systems for residential, commercial and institutional applications. Profits have dipped in 2009, not much of a surprise for a company heavily dependent on the US housing sector but it did increase its dividend in the first quarter of 2010.
  

Summary of Key Financial Ratios (source TMX.com)


Market Action
None of the profitable CleanTech stocks has exactly been a market darling powering to lofty heights over the past five years as all but one stock - WaterFurnace - has done no better and in most cases much worse than the TSX Composite. However, over the past year the chart below shows that four of the power companies have done considerably better than the TSX Composite. WaterFurnace itself made all its gains in 2006; in 2009 -2010 it has seriously under-performed, falling while the TSX has risen. It seems that there is no GreenTech bubble so far.

Several of these stocks, notably Macquarie, Algonquin, Waterfurnace and perhaps Newalta, exhibit reasonably attractive combinations of low P/E, low P/B and growing dividends, enough perhaps to make them candidates for a potential buy. The final judgment as to whether any of these stocks is worth an investment needs to rely on much more than simple past profitability or ratios and a thorough examination of financial reports and each company's prospects would be the next step for the investor.

However, it is encouraging to know that clean technology companies can be considered more than a politically correct fad. Some do indeed appear to have credible investment potential.

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.