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Jan 30, 2017

Looking Back...What’s Next?

by Canadian MoneySaver

We are quite pleased with the performance of the Canadian MoneySaver Model (CMS) portfolio. Over 2016, the CMS portfolio is up 13.3% including cash distributions. On a price basis alone, the portfolio showed a 10.6% return versus our benchmark return of 9.2% over the same period. This resulted in our portfolio adding 1.4% of alpha over the benchmark.

There will be plenty of opportunities in both equity and bond markets during 2017. It may surprise our readers that we will be making limited changes to our positions. In our opinion, the CMS portfolio is well diversified by region and sector, and is properly positioned to both take advantage and avoid some of the trends we are seeing play out in markets ‘today’. The one trade we have made as of December 31, 2016 is shown below. Both are of course dividend growth strategies but doing so will tilt the portfolio to positive tailwinds out of the U.S. and will better balance equity sector exposures.

  • Buy: 3.0% position in Vanguard Dividend Appreciation ETF (VIG)
  • Sell: 3.0% positions in iShares S&P/TSX Canadian Dividend Aristocrats Index ETF (CDZ)

Investment Objectives

The CMS portfolio allocation reflects a growth strategy and is appropriate for the higher risk equity investor. Our target allocations are as follows: equity (75.0%), fixed income (22.0%) and cash (3.0%). Our current allocations are all within 1.0% of the targets. Within the equity category, our regional targets are Canada (50.0%), U.S (40.0%) and international (10.0%).

From an asset class perspective, we remain comfortable with the higher equity allocation. While many investors are quick to point out valuation risk, investors are increasingly focused on the end of the 35-year bond bull market and the ‘great rotation’ out of fixed income and into stocks. The catalyst for this discussion has been the jump in the U.S. Treasury yields on the back of the most recent U.S. Fereal Reserve (FED) 25 basis point (bps) rate hike. Although the bond market has sold off with iShares Canadian Universe Bond Index ETF (XBB) down -4.1% over the last three months, our positions in iShares S&P/TSX Canadian Preferred Share Index ETF (CPD) and iShares U.S. High Yield Bond Index ETF (CAD-Hedged) (XHY) are up 4.0% and 0.5%, respectively. We like this higher risk fixed income balance against the more conservative XBB and iShares 1-5 Year Laddered Corporate Bond Index ETF (CBO) holdings, as both CPD/XHY can benefit from a rising rate environment in conjunction with improving economic growth. The yields are also very attractive. However, with a rough split between XBB/CBO and CPD/XHY, this is a higher risk fixed income portfolio already so we would not load up on these names beyond current levels.

Regional Exposure

Against the U.S. target allocation of 40.0%, we are slightly overweight (at the expense of Canada). While the U.S. market is likely the most expensive on a valuation basis, it also remains one of the most diverse and resilient economies. One risk we see facing global markets in 2017 is the OPEC deal. A non-cooperation issue or a meaningfully different agreement once the current deal expires in six months could be a source for higher volatility in commodity economies. In such an environment, we would expect to see capital rotate to safe-haven assets or economies, such as the U.S.

From a risk management perspective, we see the lower international equity allocation as a prudent move, especially when considering the combined effects of the higher risk international economies with the small-cap allocation via iShares Russell 2000 Growth ETF (IWO). Admittedly, we are seeing some positive momentum in international (developed) economies and valuations remain attractive across the group. However, there are simply too many prospective headwinds or unknowns to make us comfortable with a larger allocation. Growth remains elusive in Europe and the ‘Brexit’ deal continues to evolve with little insight into long-term impacts. With rising U.S. rates, we could see capital flow out of emerging economies in search of improved risk-adjusted returns. Our current regional allocations are as follows:

Sector Exposure

Going forward into 2017, we see opportunities tilting the portfolio to growth sectors and going underweight on defensive sectors. The latter traditionally include consumer staples, utilities and telecommunications. These sectors have done very well over 2016, particular utility stocks. However, we are seeing prices pull back over the last few months and valuations in all three are very high. For example, the consumer staples sector is trading at a forward Price/Earnings (P/E) fundamental of 20.1x and only yields 2.0%. With higher U.S. interest rates and expectations for a more aggressive FED approach in 2017, investors have started rotating capital out of dividend equities for better risk-adjusted yields elsewhere. These defensive sectors form the bottom three allocations for the CMS portfolio at an average weight of 6.1%. At this lower weight, we still see the portfolio as being fully diversified, as we often view 5.0% as a lower bound for lesser conviction sectors. Given that this is predominantly a growth portfolio, a lower allocation to defensive sectors continues to makes sense.

Of course, defensive sectors are not the only place where investors can find yield. Indeed, financial, industrial, energy and consumer discretionary sector equities can all offer attractive payouts. However, these sectors also benefit from increasing economic growth and investment. Such growth sectors represent the top allocations of the CMS portfolio with financials being the largest at 21.9%. We prefer to see no one sector account for more than 20.0% of the equity portfolio; however, the financial sector is traditionally driven higher by rising interest rates and economic growth. We have of course witnessed a run-up in financial sector ETFs over the last month and think this trend should continue into 2017. Most of the financial sector allocation is in Canada but the valuations are better domestically versus the U.S. The sector is trading at a forward P/E of 11.5x (only healthcare is cheaper) and yields 4.1%. With an improving price of oil and general oil landscape, we are ‘ok’ with the higher energy allocation. We are seeing some positive revisions to the sector with increasing production targets and Capital expenditure (CAPEX) budgets. Again, at least one risk is the OPEC deal falls through.