Colin Cieszynski, Chief Market Strategist, SIA Wealth Management makes the case for what the future of equity ETFs will look like.
One of the drawbacks of passive Index investing is having to participate in the performance of all companies in the index, the perennial winners and the perennial laggards. Focused ETF portfolios utilizing relative strength analysis try to increase performance and manage risks for investors by focusing on the top performers within a , attempting to avoid the biggest losers and having a plan to make changes as relative performance evolves over time.
Passive investing and the developing equity market
Over the last several decades, passive investing through holding Equity Index ETFs has become increasingly popular with investors looking to capture the performance of the overall market, while reducing trading costs and fees relative to traditional mutual funds.
Passively tracking an index portfolio, however, leaves investors with two major risks. Firstly, a broad index portfolio exposes investors to the performance of all of the individual stocks in the index, the good, the bad, and the ugly. Second, index ETFs by definition need to be 100% invested in their underlying index portfolio all of the time.
While investors can benefit from close index tracking in bull markets, investors also need to recognize the risk that index ETFs also closely track their underlying indices downward in bear markets with no brakes.
Although North American stock markets quickly recovered from their late 2018 selloffs, previous bear markets in this century took much longer to recover; 5-6 years from the 2000 and 2008 bears for the Dow Jones Industrial Average and the S&P/TSX Composite Index, and over 16 years for the NASDAQ to recover from the 2000 Technology Bubble Collapse.
Equity ETF investors and their advisors do have the ability to try and enhance returns, manage risk or mitigate losses by moving positions between Sector, Style or Factor ETFs. Investors also can attempt to bypass bear markets by selling Equity ETFs and moving to cash in times of market stress.
The responsibility for correctly timing the market with an ETF rotation strategy falls to the investor or advisor along with the increased transaction costs that can be incurred by changing positions.
In order to optimize returns, manage risks and keep costs low, it makes sense for investors to have access to investment vehicles with the ability to run concentrated rules-based equity portfolios that can tactically rotate between equity sectors, move to cash if necessary and focus on perennial outperformers while dodging perennial losers.
SIA Wealth Management and BMO Global Asset Management recently launched two new focused Equity ETFs which combine relative strength analysis, concentrated stock portfolio and unconstrained mandates with the ability to vary holdings between zero (100% cash) and 15 (100% equity) stock holdings.
In context: the Canadian stock market
The Canadian stock market is essentially divided into four pillars; Financials, Energy, Materials and everything else, such that the “Big Three” sectors represent nearly 60% of the market cap in the S&P/TSX Composite, while the other eight sectors represent about 40%. (In comparison, the three largest sectors in the S&P 500 are about 48% of the total market cap).
Because of this concentration, Canadian broad index ETF holders carry a significant exposure to banks and commodity stocks. Sometimes that can help an investor but so far in 2019, that has worked against Canadian investors.
While the S&P/TSX Composite Index returned nearly 12.0% in the first five months of 2019, the combined return of the “Big 3” sectors was only 6.1% while the remaining eight sectors have returned 18.0% combined.
"Over the last several decades, passive investing through holding Equity Index ETFs has become increasingly popular with investors looking to capture the performance of the overall market, while reducing trading costs and fees relative to traditional mutual funds."
The tactical, bottom-up, relative strength approach of the BMO SIA Focused Canadian Equity Fund (ZFC.TO), has enabled the ETF to focus its holdings on individual positions in the strongest performing, rather than the largest market cap areas so far in 2019.
At the end of December, ZFC.TO had a zero weighting to Banks/Energy/Materials, 59.2% of its holdings in the other eight sectors and 40.8% in cash.
As market conditions improved, the cash was deployed back into stocks in early February, but even then, the focus has remained on relative strength. At the end of May, ZFC.TO had only a 9.8% weighting in the under-performing Banks/Energy/Materials groups and an 89.1% weighting in the other eight groups which outperformed as a whole.
The Active Share of ZFC.TO relative to the S&P/TSX Composite (an indicator of active versus passive management where 0 is the same as a benchmark index and 100 is completely different), ended May at 93%.
As the risk profile of equities in general or the relative performance of stocks/sectors changes over time, ZFC.TO is able to move capital into the highest performing stocks within its universe and avoid areas that are relatively weakening and move to cash as needed.
The unconstrained mandate of these next generation ETFs, relative to current Index and Sector ETFs, provides investors with the ability for technologically driven tactical rotation that capitalizes on opportunities and manages risk minimizing opportunity and transaction costs.
Ted Bader, President, SIA Wealth Management will discuss how to use technology to grow your business at Inside ETFs Canada in Montreal, June 18-19, 2019.
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