Foresight - Fall 2022

Financial asset price volatility remains the theme for 2022 as we move into the Fall. When one raises the topic of price volatility it often carries a negative connotation. However, volatility swings both ways; while rising prices are seen as positive, not as volatility, falling prices are seen as volatility! Thus far in 2022 we have seen healthy doses of volatility in both directions. At writing, the current direction is up for equity markets, recovering from a recent June low. After a historically long bull market of 11 years that ended in February 2020 with the global pandemic, we now have had our second bear market in equities in just over 2 years. Market observers are debating whether this US S&P 500 60-day recent rally of over 20% since the mid-June lows is the start of the next bull market. Time will tell. However, it is important to remember where we have come from over these last 2 ½ years. Although the S&P 500 dropped 24% from its December 2021 highs, resulting in the new bear market, it was still 9% above the pre-Covid bull market highs of February 2020. At writing, the S&P 500 is 23% above the highs of the previous 11 year, pre-Covid bull market… a 9% compound annual rate of return since February 2020. An impressive run, given we have experienced a global pandemic resulting in a stalled global economy, followed by inflation rates not seen in 40 years and economic concerns over rising interest rates and global supply chain problems.

The good news for bond purchasers in Canada and the US is that bond yields across all durations have finally returned to the 3% level and look to be going higher in September. We will wait to see how bond yields respond following the expected interest rate hikes by the Bank of Canada and the U. S. Federal Reserve. The bad news for bond holders is that this increase in bond yields has resulted in falling bond prices on existing holdings. For the first time in many years, we have seen bond portfolios post rolling 12 month small negative returns since last summer. 

Bond fund returns 12 months to July 31, 2022

TDB	-10.3%	SHY	-3.33%	TIPs	-3.83%
XFR	0.28%	CLF	-3.55%	XSTH	1.1%

During this period of rising interest rates, we primarily have been buying Floating Rate Bond ETF (XFR) and a short duration 0-5 Year Government TIPs (Inflation Hedged) Bond ETF (XSTH) for funds called to fixed income.

We observed in our June 30th annual reports (see back page) that we have reached a time when both stock and bond annual returns were negative, albeit small. Typically across the long term, they tend to take turns back-stopping each other from negative overall portfolio returns. We did some research and discovered that coincident negative returns have only happened (on a calendar year basis) three times in modern history: in 1931, 1937 and 1969.

Equity markets tend to swing on fairly low trading volumes throughout the summer months. With global market participants getting back to work in early September, we are likely to see a more defined trend. If the trend goes lower due to short term concerns, we will do what we did in June - buying selective equities. If the trend continues to move higher, we will rebalance asset allocation plans to sell down selective equities and buy bonds at these new, more attractive yields.

Under the Hood of Passive ETFs

At Trivest, we use exchange-traded funds as core holdings in our portfolios. An industry-term, “Core-and-Explore”, describes portfolio construction which has ETFs as the Core and individual security holdings (stocks and bonds) as the Explore. ETFs are “baskets” of securities, much like mutual funds. The key difference is that mutual funds typically are “actively” managed by the portfolio manager, who will buy and sell securities throughout the year. ETFs are “passive”, as each one thematically mirrors some “index” which is a phantom portfolio that has been created by a third party, for instance S&P Dow Jones/ASX, FTSE Russell and MSCI. The notional holdings in any particular index encompass some “theme”, thus qualifying which securities are eligible for that index. 

The range of themes is large, and increasing as ETF providers identify new ones, in hope of attracting investors (eg climate theme). Themes include, for example:

• World regions-eg Pacific Rim, Emerging markets, World ex-US

• Countries - pretty much every major country in the world

• Sectors—all of the industrial sectors

• Size of company— eg Global 100 (the largest 100 companies in the world), Small-Cap

• Growth vs value companies– eg companies that pay solid dividends vs companies that have “big” ideas that might explode into something great

• Foreign exchange management—ETFs that “hedge” currencies against the Canadian $ to remove exchange fluctuation from the return vs those that bear the extra element of currency movements

The selection of a particular ETF might simultaneously answer to portfolio construction in two fashions, eg sectoral and regional, like buying an ETF of banks in the U.S.

The typical number of holdings varies with the ETF. The Canadian Dividend ETF “XDV” has only 30, the Europe ETF “IEV” has 363, the global ex-US/Canada ETF “XIN” has 900 and the Tech-focused ETF “IXN” has 132.

ETFs are available on both Canadian and U.S. exchanges, the latter thus being purchased in US$. For instance, the largest 500 U.S. companies can be bought in a U.S. ETF called “IVV”. On the other hand, the same 500 companies can be purchased currency-hedged in Cdn $ in a Canadian ETF called “XSP”. Rather than buying those same 500 companies, that ETF simply holds units in the USD version IVV and folds in a currency hedge. 

Given the dynamic of real life, the companies that meet a particular ETF theme change over time...some fall off and others draw in. Why? For instance, some companies draw in under a new IPO, some companies fold, some are taken over by bigger companies, some grow larger etc. As the phantom index tweaks its notional holdings, the ETF provider that mirrors it is incented to execute real-life changes to its portfolio...buying and selling. Thus, strict passivity of the ETF portfolio does not occur; rather there are these periodic adjustments. While active managers may trade most days in the year, these passive indices reset less frequently….from monthly to annually, with quarterly being the most common.

Reconstitution refers to changing both the list of companies included and the weightings. Rebalancing refers to weighting changes only. Lets refer to the two of them as re-jigging!

Rejigging criteria vary….for instance:

• S&P 500-market value at least $13B (this changes over time), highly liquid, public float > 10% of shares outstanding, and profitability measures over last 5 quarters

• TSX60-volume-weighted average price in last quarter > $1, minimum weighting .025% of the index, liquidity tests

• XDV-only 30 holdings, based upon dividend growth, yield and payout ratio

• IOO–100 largest market cap companies in the world, in USD

 While this reset system sounds fairly simple and clinical, in fact it is not. For instance, the phantom index owner will announce its list of rejigging securities in advance of the effective date. The specific securities that have been tagged for phantom adding and deleting in the index will, accordingly, have significant trading volumes in the real world, which can impact the prices at which buyers and sellers meet. All of the real trades trigger market commission costs, too, which are borne by the ETF investors. The ETF provider aspires to be competitive for investor dollars and therefore tries to mitigate the harm of trading costs and pricing/other issues. The result is a “portfolio engineering” team for each ETF, which accordingly functions somewhat like, but different than, the mutual fund manager.

Turnover ratio is a statistical term to interpret the scale of re-jigging. Ironically, a search on the internet will uncover different mathematical definitions of this ratio, notably re the numerator:

• Lesser amount of year’s buys or sells, or

• Average of the year’s buys and sells, or

• The sum of the year’s buys and sells

As this statistic is always viewed as annualized, the numerator above totals for a year’s activity while the denominator is the average assets under management, usually approximated by 12 monthly data points.

Mutual funds report their turnover ratios and they often can be as high as 100%... meaning, for instance, a $100M portfolio (denominator) would have trades (numerator) of also $100M. ETFs do not report turnover ratios. However, in a published research paper, Sida Li (University of Illinois) cited 2020 data on the median turnover ratio for U.S. equity ETFs at 16%.

If the dispositions caused by the periodic rejigging result in aggregate “net gains”, then that is allocated out to the investors owning the ETF during the particular rejigging period. If the aggregate result of the period’s rejigging is a net loss, that cannot be passed on to the investor, and instead is carried forward within the fund to the following period(s) in which there are net gains.

Thus, high turnover ratios trigger large trading costs, for sure, and may trigger large gains, which would be taxable in Trading accounts. Both of these drain the investors’ pockets.

This ETF engineering industry goes about its business clinically engaged with the Market. Meanwhile, back at Trivest, we are managing portfolios one-at-a-time, bearing in mind both the market and each client. Our data base to manage all of this come from various sources, including NBIN, the Exchanges and the ETF providers. As noted above, the ETF rejogging occur on various periodicities, so we update our database accordingly. It is our job to be as up-to-date as possible with what is transpiring in your world that affects your finances. We update every portfolio and review it monthly. Over the years, we have built a collection of portfolio metrics that are aggregated in a dashboard. These give us a quick and comprehensive monthly snapshot of action-based analytics.

Some of these analytics add another layer to what the ETF providers are doing, except they are entirely specific to you! Our set of Call-to-Action indices flag potential rebalancing in response to  your particular circumstances. A lot of our equity strategy is linked to industry sector movements and, secondarily, to global market movements. To successively execute mini-strategies, we need the right investment vehicles to do the job. In our jargon ,we refer to these as “rifles”, as they allow us to achieve something very specific, for instance an ETF exclusively thematic in the global tech sector. Alternately, we have ETFs that are “shotguns”, as they invest broadly across some, most or all of the industrial sectors.

Our proprietary portfolio management system, including our Janus Diagnostic and new Dashboard, helps us keep your portfolio responsive to both big picture events and more subtle nuances in the market.   

 Perspective

The last article in the Summer Foresight issue looked at five portfolios that all had a March 31, 2022 anniversary date for their annual reports. We indicated that the precise 36 months prior to that, starting April 1, 2019, had very diverse story lines: 2019-2020 was the tail end of a long bull market, March 2020 was the market collapse in response to an unfamiliar pandemic, the rest of 2020-2021 saw an amazing 60% recovery from that collapse starting in August, and, finally 2021-22 saw a pullback. With all the good and bad that transpired in those 36 months, the cited five portfolios had three-year, annual compound returns ranging from 6.77% to 7.56% and an annual return ranging from 3.98% to 6.77%.  

Since the Summer issue, we have rolled forward another three months with annual reports ending in April, May and June. For each year-ending month, you will see the one year return in 2022, followed by the three-year compound annual return from 2019-2022. Lastly, on the far right, you will see each portfolio risk profile between fixed income and equities.

	April	3 year	May	3 year	June	3 year	Fixed/
Client	2022	compound	2022	compound	2022	compound	equity

A	2.37%	6.76%					40/60%
B*	0.54%	4.08%					60/40%
C	1.65%	7.36%					40/60%
D			1.19%	6.7%			40/60%
E			1.05%	7.32%			40/60%
F**			1.12%	7.80%			40/60%
G			1.43%	6.62%			40/60%
H					-3.95%	6.31%	40/60%
I***					-3.72%	3.74%	40/60%
J					-3.82%	6.10%	30/70%
K					-3.78%	5.19%	40/60%

We note that the one year-2022 returns have been dropping since March, and hit small, negative territory in June. However, in most cases, the three-year compound annual returns have held up quite well and, in the 6% range, are a satisfactory long term return for portfolios with this range of fixed/equity allocations. In the Summer issue we also reported the drill-down component returns to March 2022 on fixed income and equity in specific designated portfolios. We rolled this process forward for the following months of April, May and June. Like before, the designated portfolios for those months happen to be in the data table above.

	2022 return (above)	Fixed  return	Equity return	Allocation FI/E
April*	0.54%	-2.30%	5.20%	62/38
May**	1.12%	-2.51%	3.75%	42/58
June***	-3.72%	-3.92%	-3.56%	45/55

 Fixed income returns have been running slightly negative since August 2021 and, until recently, were being supported by positive equity returns. However, as of June 2022 both components have slipped into negative territory...see Editorial.