BMO ETF Portfolio Strategy Report 0.45 0.5 0.55 0.6 0.65 0.7 Oct-2007 Feb-2008 Jun-2008 Oct-2008 Feb-2009 Jun-2009 Oct-2009 Feb-2010 Jun-2010 Oct-2010 Feb-2011 Jun-2011 Oct-2011 Feb-2012 Jun-2012 Oct-2012 Feb-2013 Jun-2013 Oct-2013 Feb-2014 Jun-2014 Russell 2000 Index/ S&P 500 Composite Index Ratio Small caps beginning to break down versus larger caps GDP Annualized Q/Q Strong Rebound in GDP -8 -6 -4 -2 0 2 4 6 8 Mar -2004 Aug-2004 Jan -2005 Jun -2005 Nov-2005 Apr -2006 Sep-2006 Feb-2007 Jul -2007 Dec -2007 May-2008 Oct -2008 Mar -2009 Aug-2009 Jan -2010 Jun -2010 Nov-2010 Apr -2011 Sep-2011 Feb-2012 Jul -2012 Dec -2012 May-2013 Oct -2013 Mar -2014 In this report: Recent Developments ............... 1 Things to Keep an Eye on .......... 2 Changes to the Portfolio Strategy..................... 3 Stats and Portfolio Holdings ................................... 4 Portfolio Characteristics........... 5 The Good, the Bad, and the Ugly............................. 6 All prices or returns as of market close on October 3, 2014, unless otherwise indicated. Alfred Lee, CFA, CMT, DMS Vice President, BMO ETFs Portfolio Manager & Investment Strategist BMO Asset Management Inc. [email protected]In this report, we highlight our strategic and tactical portfolio positioning strategies for the fourth quarter using various BMO Exchange Traded Funds. Our key strategy changes are outlined throughout the report and in our quarterly outlook on page six. • Canadian equities have performed well year-to-date, with the 11.0% total return of the S&P/ TSX Composite Index outpacing the 8.1% total return of the S&P 500 Composite Index since the beginning of January (local currency terms). In spite of this, we continue to recommend an overweight to U.S. equities. We believe the U.S. will continue to lead the global economic recovery, placing upward pressure on its currency. A rising U.S. dollar would likely subject the commodity heavy Canadian equity market to a headwind. • The U.S. Federal Reserve Board (“Fed”) is expected to keep its overnight rate at its current level until 2015. We expect the Fed to begin telegraphing this move in its Federal Open Markets Committee (FOMC) meetings before the end of 2014. In anticipation, the 10-year Treasury bond yield is trading 34 bps higher than its Canadian equivalent, a spread not seen since 2009. U.S. gross domestic product (GDP) recently came in at 4.6% (Chart A) annualized quarter over quarter, notably higher than the 4.2% on its last read. • We don’t envision that U.S. Treasury yields will move up significantly, as the overall rate environment should remain low on an absolute level. However, with investors earning slightly more yield from government bonds and should credit spread levels remain relatively even, a potential de- risking in bond portfolios could occur. This could benefit higher quality issuers at the expense of non- investment grade bonds, provided inflation levels remain low, not offsetting the pick-up in yields. • With the Scottish referendum now in the past, the focus will now move to Catalonia. In addition to the Spanish community’s fight for independence, potential political risk may also stem from the ongoing Ukraine and Russia conflict as well as the U.S. lead coalition against ISIS. With the threat of political uncertainty potentially leading to stock market volatility, we are avoiding the emerging markets, which tend to have a higher beta than traditional bonds. In addition, with the smaller cap Russell 2000 Index breaking down against the S&P 500 Composite Index (Chart B), we are focusing on higher quality large- and mid-cap names. • Despite the potential threat of higher rates in the U.S., we expect rates to remain low overall. However, we expect some bond repositioning across the world, such as reducing duration and increasing emphasis on higher quality corporate bonds. As a result, the fixed income portion of a portfolio will likely contribute less yield, placing greater emphasis on dividend paying stocks to make up for the overall shortfall in portfolio yield. In Search of Quality Chart A: U.S. Economic Recovery Gaining Traction Chart B: Small Cap Stocks Breaking Down Source: BMO Asset Management Inc., Bloomberg Source: BMO Asset Management Inc., Bloomberg BMO EXCHANGE TRADED FUNDS Fourth Quarter 2014
Transcript
BMO ETF Portfolio Strategy Report
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Russell 2000 Index/S&P 500 Composite Index Ratio
Small caps beginning to break down
versus larger caps
GDP Annualized Q/Q
Strong Rebound in GDP
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In this report:
Recent Developments ...............1
Things to Keep an Eye on ..........2
Changes to the Portfolio Strategy .....................3
Stats and Portfolio Holdings ...................................4
Portfolio Characteristics ...........5
The Good, the Bad, and the Ugly .............................6
All prices or returns as of market close on October 3, 2014, unless otherwise indicated.
In this report, we highlight our strategic and tactical portfolio positioning strategies for the fourth quarter using various BMO Exchange Traded Funds. Our key strategy changes are outlined throughout the report and in our quarterly outlook on page six.
• Canadian equities have performed well year-to-date, with the 11.0% total return of the S&P/TSX Composite Index outpacing the 8.1% total return of the S&P 500 Composite Index since the beginning of January (local currency terms). Inspiteofthis,wecontinuetorecommendanoverweighttoU.S.equities.WebelievetheU.S.willcontinuetoleadtheglobaleconomicrecovery,placingupwardpressureonitscurrency.ArisingU.S.dollarwouldlikelysubjectthecommodityheavyCanadianequitymarkettoaheadwind.
• The U.S. Federal Reserve Board (“Fed”) is expected to keep its overnight rate at its current level until 2015. WeexpecttheFedtobegintelegraphingthismoveinitsFederalOpenMarketsCommittee(FOMC)meetingsbeforetheendof2014.Inanticipation,the10-yearTreasurybondyieldistrading34bpshigherthanitsCanadianequivalent,aspreadnotseensince2009.U.S.grossdomesticproduct(GDP)recentlycameinat4.6%(ChartA)annualizedquarteroverquarter,notablyhigherthanthe4.2%onitslastread.
• We don’t envision that U.S. Treasury yields will move up significantly, as the overall rate environment should remain low on an absolute level. However,withinvestorsearningslightlymoreyieldfromgovernmentbondsandshouldcreditspreadlevelsremainrelativelyeven,apotentialde-riskinginbondportfolioscouldoccur.Thiscouldbenefithigherqualityissuersattheexpenseofnon-investmentgradebonds,providedinflationlevelsremainlow,notoffsettingthepick-upinyields.
• With the Scottish referendum now in the past, the focus will now move to Catalonia. InadditiontotheSpanishcommunity’sfightforindependence,potentialpoliticalriskmayalsostemfromtheongoingUkraineandRussiaconflictaswellastheU.S.leadcoalitionagainstISIS.Withthethreatofpoliticaluncertaintypotentiallyleadingtostockmarketvolatility,weareavoidingtheemergingmarkets,whichtendtohaveahigherbetathantraditionalbonds.Inaddition,withthesmallercapRussell 2000 IndexbreakingdownagainsttheS&P 500 Composite Index (ChartB),wearefocusingonhigherqualitylarge-andmid-capnames.
• Despite the potential threat of higher rates in the U.S., we expect rates to remain low overall. However,weexpectsomebondrepositioningacrosstheworld,suchasreducingdurationandincreasingemphasisonhigherqualitycorporatebonds.Asaresult,thefixedincomeportionofaportfoliowilllikelycontributelessyield,placinggreateremphasisondividendpayingstockstomakeupfortheoverallshortfallinportfolioyield.
In Search of Quality
Chart A: U.S. Economic Recovery Gaining Traction Chart B: Small Cap Stocks Breaking Down
• Onthecreditsideofourstrategy,wewanttoincreaseourexposuretoinvestmentgradeU.S.corporatebonds(movingupinquality).ShouldU.S.Treasuryratesrisenextyear,someinvestorsmayreduceriskastheycanpickupsomeextrayieldgivenasteepertreasurycurve.Thiswouldlikelyhaveanimpactonnon-investmentgradebonds,asinvestorsmaynothavetooverweightriskinordertogeneratehigheryields.U.S.investmentgradebondsmaythereforebethesweetspot,providingahigheryieldthangovernmentbondsbutlessriskthanhighyielddebt.HighgradecorporatebondsintheU.S.maybenefitfrombothhigherinflowsandcreditspreadtighteningfromthetreasuryside.WeareincreasingourweightingintheBMO Mid-Term U.S. IG Corporate Bond Index ETF (ZIC)by3.0%asresult.
• Overall,U.S.highyieldbondsremainattractiveformanyreasons.Thedefaultratesremainnearall-timelowsandfromaportfolioconstructionstandpoint,theassetclassprovidesdiversificationpropertiestobothtraditionalequitiesandbonds.However,withthehighyieldoptionadjustedspread(OAS)nearpost-recessionlowsandbecomingmorevolatile,webelievethereisthethreatthatspreadsmaywidenout.Thus,wearereducingourpositionintheBMO High Yield U.S. Corporate Bond Hedged to CAD Index ETF (ZHY)by3.0%.
Sell/Trim Ticker (%) Buy/Add Ticker (%)
BMO High Yield US Corporate Bond Hedged to CAD Index ETF ZHY 3.0% BMO Mid-Term US IG Corporate Bond Index ETF ZIC 3.0%
Total 3.0% Total 3.0%
Portfolio Strategy Report – Fourth Quarter 2014 4
Ticker ETF Name Position Price MER Weight (%)
90-Day Vol
Volatility Contribution
Yield (%)*
Yield/Vol
Fixed Income
ZDB BMO DISCOUNT BOND INDEX ETF Debt Core $15.40 0.20% 14.0% 3.0 5.8% 2.5% 0.85
ZIC BMO MID-TERM U.S. IG CORPORATE BOND INDEX ETF Debt Tactical $15.97 0.25% 10.0% 5.5 7.7% 3.4% 0.61
ZCS BMO SHORT CORPORATE BOND INDEX ETF Debt Tactical $14.76 0.12% 9.0% 2.2 2.8% 2.0% 0.90
ZST BMO ULTRA SHORT-TERM BOND INDEX ETF Debt Tactical $56.64 0.15% 3.0% 2.0 0.8% 2.0% 1.01
ZIC BMO MID-TERM U.S. IG CORPORATE BOND INDEX ETF 10.0%
ZCS BMO SHORT CORPORATE BOND INDEX ETF 9.0%
ZDV BMO CANADIAN DIVIDEND ETF 9.0%
ZLB BMO LOW VOLATILITY CANADIAN EQUITY ETF 8.5%
ZEQ BMO MSCI EUROPE HIGH QUALITY HEDGED TO CAD ETF 7.0%
ZSP BMO S&P 500 INDEX ETF 5.0%
ZIN BMO S&P/TSX EQUAL WEIGHT INDUSTRIALS INDEX ETF 5.0%
ZPR BMO S&P/TSX LADDERED PREFERRED INDEX ETF 5.0%
ZUB BMO EQUAL WEIGHT U.S. BANKS HEDGED TO C$ ETF 4.0%
ZHY BMO HIGH YIELD U.S. CORP BOND HEDGED TO C$ INDEX ETF 3.5%
ZST BMO ULTRA SHORT-TERM BOND INDEX ETF 3.0%
ZWB BMO COVERED CALL BANKS ETF 3.0%
ZWA BMO COVERED CALL DOW JONES INDUSTRIAL AVERAGE HEDGED TO C$ ETF 3.0%
Core 47.5%
Tactical 52.5%
Cash
Alternatives
Equities
Fixed Income
Stats and Portfolio Holdings
Investment Objective and Strategy: The strategy involves tactically allocating to multiple asset-classes and geographical areas to achieve long-term capital appreciation and total return by investing primarily in exchange traded funds (ETFs).
• U.S.GDPremainsstrongandunemploymenthasmoved lower. Strengthening U.S. economic data will increase the Fed’s likelihood in raising rates.
• U.S.EmpireStateManufacturingcontinuestotickup. This implies improving sentiment in business conditions.
• Onapricetocashflowbasis,NorthAmericanstocks appear inexpensive. The 10.7x P/CF ratio oftheMSCI North America Index is well below the 19.3x pre-recession high.
• Relativestrengthoflowerbetastockshasgainedagainst the broad market. We recommend reducing beta, as we expect a market correction in near term.
• TherecentbreakoutintheU.S.dollarmakesitoverbought, but we expect it to remain strong over the long-term as the Fed looks to raise rates innearfuture.
Bad
• With,lowinflation,astrongU.S.dollar,goldprices look to head lower, unless political risk breaks out.
• UnemploymentinCanadaisflatat7.0%.Momentum in improvement has stalled in last twoyears.
• TheS&P/TSX Composite Index has seen its earningsmultipleexpand13.7%year/year.Webelievecommodityheadwindswillnowcauseitsmultiple to contract.
• Manybroadmarketequityindicesareaboveitsrespective10-yearaveragesnow.Furtherpricegains should be met with earnings expansion to be justified.
• RecentspikeintheU.S. Dollar Index was a major headwindforCanadianstocks.WecontinuetobeoverweightU.S.equitiesasweexpectthegreenback to remain strong.
• UpwardmomentumintheS&P 500 Composite Index looks to be weakening. A consolidation wouldbehealthy.
Ugly
• Politicalriskcontinuestomountinanumberofgeographic regions. Russia/Ukraine, the Middle East, North Korea are ongoing issues. Protests in Hong Kong are now another concern.
• TheMSCI Europe IndexcurrentlyhasaP/Eratioof19.6x.Thisisa14.1%premiumtoits10-yearaverage.GiventheunevenrecoveryinEurope,investinginqualitywillbethekey.
• LongertermindicatorsshowabreakdownintheRussell2000Index. While small cap U.S. stocks look short-term oversold, gains should be used as selling opportunities to move into larger cap higherqualitystocks.
”S&P®” and “S&P 500®” are trademarks of Standard & Poor’s Financial Services LLC (“S&P”) and “TSX” is a trademark of TSX Inc. These trademarks have been licensed for use by S&P Dow Jones Indices LLC and sublicensed to BMO Asset Management Inc. in connection with ZSP, ZIN and ZPR. ZSP, ZIN and ZPR are not sponsored, endorsed, sold or promoted by S&P Dow Jones LLC, S&P, TSX, or their respective affiliates and S&P Dow Jones Indices LLC, S&P, TSX and their affiliates make no representation regarding the advisability of trading or investing in such ETFs.
The Dow Jones Industrial Average Index is a product of S&P Dow Jones Indices LLC and has been licensed for use by the BMO Asset Management Inc. Dow Jones®, Dow Jones Industrial Average®, and DJIA® are registered trademarks of Dow Jones Trademark Holdings LLC (“Dow Jones”), and have been licensed to S&P Dow Jones Indices LLC and and sublicensed for use by BMO Asset Management Inc. in connection with ZWA. ZWA is not sponsored, endorsed, sold or promoted by S&P Dow Jones Indices LLC, Dow Jones, or their respective affiliates, and S&P Dow Jones Indices LLC, Dow Jones and their respective affiliates make no representation regarding the advisability of trading or investing in such ETF.
The exchange traded funds referred to herein are not sponsored, endorsed or promoted by MSCI, and MSCI bears no liability with respect to any such exchange traded funds or any index on which such exchange traded funds are based. The prospectus contains more detailed description of the limited relationship MSCI has with BMO Asset Management Inc. and any related exchanged traded fund.
This communication is intended for informational purposes only and is not, and should not be construed as, investment and/or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.
BMO ETFs are managed and administered by BMO Asset Management Inc., an investment fund manager and portfolio manager, and separate legal entity from Bank of Montreal.
Commissions, management fees and expenses all may be associated with investments in exchange traded funds. The indicated rates of return are the historical annual compound total returns including changes in prices and reinvestment of all distributions and do not take into account commission charges or income taxes payable by any unitholder that would have reduced returns. Please read the prospectus before investing. Exchange traded funds are not guaranteed, their value change frequently and past performance may not be repeated.
® “BMO (M-bar roundel symbol)” is registered trade-mark of Bank of Montreal, used under licence.
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