Office towers loom over Toronto's financial district on Sept. 28, 2020.Mark Blinch/The Globe and Mail
The best Canadian banking ETF might be the one investors build for themselves.
Lacklustre returns from the dozens of available exchange-traded funds composed of Canadian financial stocks make it difficult to justify the management fees, experts say.
Combined with the rise of low and even zero-commission trading, ETF providers have been forced to get creative in their attempts to add value.
“To be honest, while we like the idea of owning the Big Six Canadian banks, we actually believe the homemade or do-it-yourself [DIY] solution is the optimal way to go,” says Jeff Kaminker, chief executive officer of Frontwater Capital.
“Investors can easily replicate a Canadian bank ETF with minimal effort and save themselves the 60 basis points since we are only talking about six stocks, so just buy all of them, weight them equally, rebalance once every year, and you’re good to go.”
Some Canadian banking ETFs, such as CI Financial’s CI First Asset CanBanc Income Class ETF (CIC-T) or Bank of Montreal’s Covered Call Canadian Banks ETF (ZWB-T), use covered-call options to provide more leverage or to boost dividend yields for income-focused investors.
Hamilton ETFs even launched a new product with 25-per-cent leverage built in, the Hamilton Canadian Bank 1.25X Leverage ETF (HCAL-T), in mid-October, built around the thesis that Canadian bank stocks are still trading below their prepandemic levels and are therefore undervalued.
The product debuted barely three months after Purpose Investments launched Big Banc Split Corp. (BNK.PR.A-T), an arguably even more bullish fund that includes a mix of preferred and common shares from Canada’s six major banks with as much as 30-per-cent leverage through an active covered-call-writing strategy.
“What we do as asset managers is rebalance [BNK] quarterly, but we also actively sell calls to juice the income and sell puts to try and add some downside protection into it,” says Greg Taylor, chief investment officer at Purpose.
Mr. Kaminker agrees: “You have to be opportunistic in doing it. You need someone who is looking for opportunities at the right time to sell those covered calls.”
Yet history suggests “selling covered calls on Canadian bank stocks has been an underperforming feat,” Mr. Kaminker says. “There are now too many institutions, too many investors that are doing it, which lowers the call-option premium.”
Canadians “are already gorged on banks, relatively speaking,” says Yves Rebetez, senior executive consultant at Credo Consulting and former managing director of ETF Insight. “They generally already comprise a much greater percentage of people’s portfolios in Canada.”
That would explain why, according to Morningstar data, there are a total of 29 financial ETFs available in Canada – more than the 26 comparable products that exist in the United States.
“That was all before the advent of commission-free trading,” says Ian Tam, Morningstar’s director of Canadian investment research. “When Wealthsimple came on the scene with their zero-dollars-per-trade, that, in my opinion, changed things for us in Canada.”
Now, Mr. Tam says, “it is very cost-effective and very easy for the average DIY person” to build their own Canadian banking ETF.
Chris Heakes, portfolio manager with BMO Asset Management, acknowledges that “truth be told, there is not a giant difference” between the various Canadian banking ETF products since “the Canadian banks tend to trade in relative sympathy with each other.”
Active management, “particularly with Canadian banks, is a tricky game to play,” Mr. Heakes says, since many of the actively managed products in the space, even if they do outperform their automated peers, also have those higher fees.
“If you’re going to be doing an active strategy, you want to get paid for it, hopefully,” he adds.
Comparing the five-year trading history of the ZWB to BMO’s pure-play Equal Weight Banks Index ETF (ZEB-T), Mr. Kaminker says, is quite telling, as “the ZWB has actually underperformed its pure-play cousin [ZEB]” by multiple percentage points most years.
Choosing between the DIY and active management approach comes down to how much uncertainty investors believe still lies ahead for Canada’s top banks.
Concerns over widespread pandemic-related mortgage deferrals have kept valuations down even as some analysts such as BMO’s Mr. Heakes believe the worst could already be over for the Big Six.
“In 2008, the Canadian banks didn’t cut their dividends and were seen as a beacon of safety globally in terms of financial institutions, [and] we are still up there today,” Mr. Heakes says. “I think it’s an interesting proposition for investors to make sure their weight is there or perhaps even be overweight the Canadian banks.”
Without a clear path to recovery from the current global crisis, Credo’s Mr. Redetez warns, “in order to go into banks in the current environment, you’ve got to be able to acknowledge that the challenges they are facing aren’t necessarily disappearing tomorrow.”
“Some people might look at it and say they want leverage because it is already risky enough to go into banks that might still have to seek provisions,” Mr. Redetez says.
Still, because of their “relative underperformance and relatively attractive valuation and yield levels,” he says Canadian banks could “actually be a defensive place to go.”
“Normally, if you were worried about the economy going down, that is not necessarily where you would intuitively think to go and hide,” Mr. Redetez says.
That means whether or not the worst is truly over for Canada’s Big Six banks, a case can still be made for investors to buy them.
“There is a joke about running pension money in Canada, which I did for a while, where you sell the best-performing bank and you overweight the worst-performing bank and you rebalance every year,” says Mr. Taylor at Purpose, “and then you don’t waste any more time managing the Canadian banks.”
For Frontwater’s Mr. Kaminker, the process is even more simple: “Just go to sleep and make sure you wake up once per year.”