Daniel Straus, Head of ETF Research & Strategy, National Bank Financial

FOCUS: ETFs

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Market Outlook

2016 can almost be demarcated into two periods of market dynamics. For the first 10 months of the year, stock indices were punished by widespread fears of slowing growth in emerging market economies. With the outcome of the U.S. election in November, and to a lesser extent the U.K.’s Brexit vote in June, markets reacted first with shock then with surprising bullishness, finishing the year ahead in many regions. Against this backdrop, National Bank’s Economics team continues to recommend an asset mix tilted towards equities and away from bonds, with varying views on different regions.

• Canadian Equity: Canadian equities were among the best performing in the developed world in 2016, ending the year strongly with a total return of 21.1 per cent. This represents the best performance in seven years. Such a feat is unlikely to be repeated in 2017.
• U.S. Equity: The market appears to be pricing in an expectation of fiscal stimulus which could indeed lift U.S. growth, but the extent of the boost will depend on the specifics, and if they’re implemented at all.
• International Equities: These represent a mixed story, coming from a multiple ingredients of uncertainty. The path towards Brexit implementation is still cloudy, but a surging U.S. economy could do well for European exports. Borrowing costs are on the rise in Japan, but indicators such as growing output are pointing to expansion.
• Fixed Income: Bond markets could face many headwinds in the coming months: upside surprises in the Chinese economy; Fed tightening; new agreements for oil production cuts; or potential fiscal stimulus in the U.S. While we see bonds as a core asset class meant to provide ballast to a portfolio during down markets, cash can sometimes play a similar role.

ETF Industry Growth Trends:

ETFs in Canada finished 2016 with $114 billion in assets, an increase of nearly $25 billion prompted by recovering markets in Canada combined with record inflows of $16.8 billion. These historic inflows, which narrowly edged out the previous year’s record of $16.5 billion, accumulated over a year in which multiple geopolitical surprises forced many investors to revisit their portfolios and position them for a shifting global reality. Some prominent milestones and flow patterns from 2016:

• Records and Milestones: ETFs in Canada reached $100 billion in May of 2016, and the pace of growth hasn’t slowed down since then. March of 2016 was the month with the highest inflow ($3.6 billion) on record.
• New Providers: Six new providers entered the ETF marketplace in Canada, bringing the total number to 18. Asset managers large and small are moving to the ETF structure to deliver their ideas and solutions to investors in a cost-effective, efficient, and liquid manner.
• Investor adoption of “strategic beta” products: While the index-tracking products still attract the lion’s share of flows as a result of their scale and low costs of ownership, “strategic beta” products are starting to show signs of adoption in their flow patterns.

Top Picks

iShares Edge MSCI Multifactor USA Index ETF CAD-Hedged (XFA.TO) – Last time I focused on low-cost, purely passive index-tracking ETFs, and these are perfectly good vehicles for long-term core exposure. This time I’m highlighting a so-called “factor-based” or “strategic beta” fund for U.S. equities that build its portfolio with the aim of outperforming the broad benchmarks (such as the MSCI USA Index, or the S&P 500) over the long term. XFA uses a quantitative index methodology to build a portfolio that combines four factors into one ticket: momentum, value, low size (small cap), and “quality” (low financial leverage, high ROE, stable earnings etc.). XFA charges a fee of 45 bps, which is certainly higher than the 10 bps you can get for U.S. exposure in Canadian ETFs, but it’s still competitively priced compared with some other strategic ETFs, and certainly cheaper than many other forms of active management.

BMO MSCI EAFE Index ETF Cad-Hedged (ZDM.TO) – As I mentioned above, despite Euro-related concerns, our economists believe that international equities remain an opportunity for patient long-term investors. There are dozens of ETFs to pick from in this category, but we’re highlighting ZDM because of its extremely low management expense ratio (0.23 per cent), currency hedging, and large-cap focus, which should help concentrate its portfolio in the more stable blue chip multi-national companies that could benefit from rising export conditions.

Purpose High Interest Savings ETF (PSA.TO) – Our asset allocation team considers cash an asset class, and right now they are recommending 5-to-8.5 per cent of a portfolio be kept in cash depending on whether the investor profile tilts towards conservative or maximum growth. Investors can take one of several interesting directions for this line in their portfolios: there are ETFs for money market instruments, floating rate notes, or investment grade floating rate debt. PSA invests in high interest deposit accounts, which currently reside with National Bank and Manulife bank.

Past Picks:  MAY 26 2016

iShares S&P TSX Capped Composite Index Fund (XIC.TO)

• Then: $22.32
• Now: $24.52
• Return: +9.85%
• TR: +12.24%

Horizons Active Global Dividend ETF (HAZ.TO)

• Then: $18.53
• Now: $19.17
• Return: +3.45%
• TR: +5.22%

Vanguard Canadian Aggregate Bond Index ETF (VAB.TO)

• Then: $26.04
• Now: $25.38
• Return: -2.53%
• TR: -0.81%

Total Return Average: +5.55%

Website: www.nbc.ca