Foresight - Spring 2020

We have fielded a few queries recently about our investment rationale behind owning the iShares 1-5 Year Laddered Government Bond Index ETF. We can see how there could be a misconception about the performance of this ETF, as it appears to be constantly, although incrementally, going down from a capital standpoint. What isn't as apparent is that the monthly interest payments that you receive from the ETF are a combination of the interest yield and a return of your capital.

This ETF is a portfolio of bonds maturing 1 to 5 years from now. As bonds mature, new 5-year bonds are purchased so the 5-year ladder continues to roll out. This is a very efficient way to allocate your funds which are called to fixed income. However, in today's reality of very low bond yields, there are very few bonds that have yields exactly paying the current 5-year bond rate. If an existing bond has a coupon yield above current market yield, that bond will trade at a premium to its maturity value. That premium price reflects the difference between the current market bond yield for that maturity and the coupon rate that bond is paying.

As an example, the current bond yield for a $100 5-year Province of Ontario bond is 1.7%, ie paying $1.70 per year. A $100 Province of Ontario 2.6% bond maturing June 2nd 2025, paying $2.60 per year, was recently trading at $105.11, even though it will mature at $100 five years from now. The $5.11 difference is paid back through the higher interest payments ($2.60 vs $1.70) over the five years.

It is important to note that, although our bond yields in Canada and the United States remain frustratingly low, our bond yields are still in positive territory. There is currently over US$15 trillion dollars of government bonds globally trading with negative yields, meaning that the bond buyer pays the bond issuer for the privilege of lending them money. Germany, Switzerland, Japan, the Netherlands and France lead that group of countries with negative yields.

The current bond yield environment aside, we have been very pleased with the iShares 1-5 Year Laddered Government Bond Index ETF, as it provides excellent diversification in government bonds at a very low cost (15 basis points). It also gives us an excellent vehicle by which to rebalance your portfolio effectively across the entire bond ladder immediately, and at a very low transaction cost. When a rebalancing call comes in, we don't have to wait for cash from a maturing bond, or need to sell a bond pre-maturely, which always costs a spread in the bid/ask bond market. Bond ETFs have been very effective in lowering the bid/ask spreads in the bond market as they are bringing bond pricing out into the open on the stock exchange and away from the proprietary bond desks at the bank-owned dealers.

We remain focused on short-duration in your bond portfolio, as we do not view the incremental yield of approximately .3 to .5 of 1% to be sufficient for owning a 10 or 20 year bond,  as opposed to a 5 year bond. The market value volatility of a 20 year bond over its life time will amplify in a future rising interest rate environment. For instance, a 2% increase in 20-year bond yields would see its market value temporarily decline by approx 25%. Of course, holding the bond to its maturity ultimately will return the investor’s capital, but cause unsavvy investors some angst along the way from the fluctuating values. 

Lastly, we also hedge your bond portfolio against rising bond yields and inflation by owning government floating-rate bonds and government real rate of return bonds.

A Global Approach….

At Trivest, we take a global approach to investing in equity markets as part of our diversification strategy. Volatility in these international investment returns can be exacerbated, or  mitigated, by currency fluctuations. When investors buy an investment in a country, or ‘union of countries’ (as in Europe), they also implicitly are buying the underlying currency. At the end of an investing year, the investor’s return is equal to that foreign market’s return, plus-or-minus the exchange conversion back into the investor’s home currency. As you can see below, in any given year, the cross-currency exchange movements between two countries can be significant. The yen, in particular, is very volatile. 

The following chart shows the last five years of exchange fluctuations:

					Historical Annual Change in Canadian Exchange Rates From Canadian dollar to:
	2019	2018	2017	2016	2015
US $	5.04%	-7.81%	+3.08%	+3.08%	-16.18%
Euro	7.06%	-3.25%	+6.07%	+6.07%	-6.60%
Japanese Yen	3.76%	-9.99%	+0.09%	+0.09%	-15.92%

(“+“ means a rise of the Canadian $)

We continue to augment your foreign content with a list of international ETFs that are “hedged” to eliminate the currency impact of international investing, and they span geographic regions and industrial sectors. You may see them on your NBCN statement by their ticker symbols, including XHC, XBM, XCD, XGI, XEU, XQQ, FHB, VUS, XEH, XIN, CJP, XSP, XSU and VEF.

The shaded returns across the diagonal in the chart below show the calendar 2019 domestic equity returns in the major economies. All of the other entries add the currency impact to these returns to show the effective returns for investors who are branching out internationally from their own domestic market. Global markets uniformly performed exceedingly well in 2019, part of which was  recouping the prior year’s losses. The loonie appreciated against all of these currencies in 2019, also recouping last year’s losses, giving Canadian investors who invested internationally some foreign currency losses to offset the world-wide positive market returns (far left hand column). Quarterly data that we track show that, over the past 13 years, the US/Canadian foreign exchange movements contributed approx. 11% of the overall return.    

				Annual Equity Index Returns that include Foreign Exchange Changes– Calendar 2019
Country/     Equity Index	Canadian Investor	American Investor	European Investor	Japanese Investor
Canada /TSX 60	18.11%	23.14%	25.16%	21.87%
US/S&P 500	24.08%	28.88%	31.20%	27.98%
Europe/Euro 350	15.99%	20.31%	22.58%	19.42%
Japan/Japan 150	12.62%	17.16%	19.50%	16.25%

The following chart shows on the right the last five years of simple returns for a Canadian investing around the world. It also shows, on the far left column, the 15 year compound returns (2005-19). The difference between that and the Domestic International returns column to its immediate right, highlights the 15 year geometric currency impact on Canadians investing internationally. You can see that these 15 years of currency volatility tend to flatten out the international domestic returns.

Canadian Investor International Returns 2005-2019

	Cdn   15 yr cpd	Dom Int’l 15 yr cpd	2019	2018	2017	2016	2015
TSX 60	6.46%	6.46%	18.11%	-10.50%	9.78%	17.70%	-7.91%
S&P 500	9.63%	8.08%	24.08%	2.28%	15.49%	6.52%	18.6%
Euro 350	5.57%	5.51%	15.99%	-9.65%	17.37%	-6.12%	12.64%
Japan	4.53%	3.14%	12.62%	-5.4%	17.26%	-2.69%	17.48%

 Investors have an affinity towards high returns. It makes them feel better, and fortifies their feeling of financial comfort. Investment management isn’t just about generating returns.... it is about generating returns relative to risk. Risk-and-return operate asymmetrically...meaning that achieving higher returns probably means that one has taken on more risk, but conversely, taking on more risk does not guarantee higher returns. One of the sub-characteristics of a portfolio is its volatility: how much does it fluctuate in value– in the short run, but more importantly, in the long run. One of the markers for this is the statistical measure called standard deviation. In the following chart, we have calculated the 15 year standard deviations from the historical return data in the Annual Equity Index Returns chart. The numbers on the right represent the standard deviation for each of the geographic domestic markets. The numbers on the left represent the standard deviation for a Canadian investing in those markets, factoring in the currency aspect. 

Standard deviation	Canadian investor	Domestic Int’l
TSX 60	16.14%	16.14%
S&P 500	12.74%	16.53%
Euro 350	16.13%	18.67%
Japan 150	14.52%	23.01%

 Here, we see that the 15 year currency fluctuations acted to reduce the volatility for a Canadian international investor. This analysis can be fine-tuned by creating a mock portfolio where a Canadian investor invests across all of these geographic markets (simulating what we actually do). This mock portfolio would have a 15 year compound return of 7.31% and a standard deviation of 12.8%.

Always beware of “lies, damned-lies and statistics”! These analyses are only based upon the 15  years that we have been tracking this data. Prudent investing always needs a long term perspective.

Twelve month sectoral results for 2019

The chart below shows our annual report on how the industrial sectors performed in Canada, the U.S. and globally for 2019 (Annual historical comparatives on sector data can be found on our website). These are price returns, which means they include the price appreciation (or decline) year-over-year, but exclude the dividend income. The Canadian results are reported in our domestic currency. The U.S. S&P returns are reflected in USD rather than our currency, so that the foreign exchange movement does not contaminate a comparison. Global returns of course reflect a myriad of the world’s currencies, which here are consolidated in USD; thus, there is some foreign exchange element to that data. The top line “WHOLE INDEX” return data in the chart below result from applying sector weightings to the sector returns. These weightings are different in the three regions. In the small capital market of Canada, the breadth (number) of players in a particular sector can be quite thin. Thus, the results of the few can significantly impact that sector’s return. This is particularly true in Canada for consumers, health and tech.   

It was a “correction” year to the prior “correction” year, with large positive returns across the board in almost all sectors and across the globe. What was notable was that, in the Global 1200 and US S&P500 indices, all of the sectors experienced this recovery “correction”, with the exception of Energy. Several Canadian sectors significantly lagged the robust global results, including Health Care, Consumer Discretionary & Staples, Banks and Telecoms. Alternately, two Canadian sectors outperformed global results, Utilities and Technology. The dominant Energy sector, at a lowly 5.9%, weighed down the whole Canadian index. The lagging Canadian sectors of consumers and healthcare are ones into which we deploy very little.

Throughout the year, we were monitoring these sectoral movements and chose to realize the appreciations in those leading sectors (notably Health, Tech and Utilities) at various points in the year. 

For the year 2019 SECTOR	Annualized Price Returns for S&P Global 1200 Index Sectors (in US dollars)	Annualized Price Returns for US S&P 500 Index Sectors (in US dollars)	Annualized Price  Returns for Cdn. Composite Index Sectors (in Canadian dollars)
WHOLE INDEX	25.0%	28.9%	19.1%
Energy	7.8%	7.6%	5.9%
Materials	18.9%	21.9%	22.1%
Industrials	25.5%	26.8%	24.7%
Consumer Discretionary	24.8%	26.2%	13.6%
Consumer Staples	20.4%	24.0%	11.4%
Health Care	21.4%	18.7%	-11.2%
Financials	20.8%	29.2%	16.9%
Information Technology	46.0%	48.0%	60.2%
Telecommunications	24.5%	30.9%	8.2%
Utilities	20.0%	22.2%	31.6%