Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed-income and asset-mix strategy. He is a former lead manager of Royal Bank’s main bond fund.
The world as we know it has changed profoundly since the lockdowns. Government efforts in recent years to micromanage the economy, as well as mounting debt issues, have created an uncertain outlook for markets. Choosing your investments carefully has become increasingly important.
Over the past 30 years, the S&P 500 index total return averaged 9.89 per cent a year. But individual calendar years have seen returns ranging from 37.5 per cent in 1995 to a loss of 37 per cent in 2008. And let’s not forget that stock markets have seen periods of zero real returns for decades. Japan has yet to return to its 1989 highs and even the S&P 500 had a rough time in the decade before the bull market that began in 1982.
Did the bull market end in 2022? Probably. Long-term stock valuation models like the Buffett Indicator and the Shiller P/E ratios showed stocks reached overbought levels at the end of 2021. In the past, this has been a harbinger of the beginning of a period of poor equity returns for a decade or more. The fact that we have a massive debt problem and a rapidly aging population is adding to a bearish future and spending and production patterns will be significantly different going forward.
Given the uncertainty and headwinds facing equities, investors will need to rely less on the seemingly endless double-digit annual price returns and more on interest and dividend payments. Exchange-traded funds provide a low-cost and efficient means for investors to gain exposure to a large variety of specialized income asset classes.
Here are a few ETF picks that are a bit “outside the box” but are attractive on a potential return-to-risk basis. Importantly, these ETFs do not correlate strongly with equity markets, thereby lowering risk, and hopefully mitigating overall downside risk of one’s nest egg.
Go provincial
Provincial bonds provide both a shorter-term and longer-term opportunity. Interest rates have increased dramatically, providing investors with higher annual cash flow than they have had in years. Furthermore, provincial bonds provide a generous yield, usually 50 to 100 basis points above similar term issues by the federal government. Although short-term rates are currently higher than rates for longer terms, these so-called yield curve inversions have always been temporary. Investors are compensated, historically, for the extra interest rate risk associated with longer-term bonds. BMO offers the Long Provincial Bond Index ETF. The fund distributes interest monthly and has a management expense ratio of 0.28 per cent. Potential returns over the next year may be generous as we expect long rates to decline and provincial spreads – the difference between interest rates offered by provincial versus federal bonds – to remain stable or even narrow.
Really go the distance
Canadian investors should consider the U.S.-dollar-denominated debt of emerging markets. There are many ETFs in this space to choose from. An example is the iShares J.P. Morgan USD Emerging Markets Bond Index ETF. The ETF has almost 600 issues and is very well diversified with respect to country and region. Its two biggest exposures are Mexico and Saudi Arabia at about 6 per cent and 5.6 per cent, respectively. Although some countries in the fund, such as Turkey and South Africa, are having difficulties, their yields reflect this reality. Also, many of these nations have bright futures, such as Eastern European countries which have narrowed the income gap between them and their more developed neighbours. The longer-term outlook for Asia outside China looks good as those economies industrialize and transition to cheap Russian energy while the West’s preoccupation with climate change and ESG will be a drag on economic growth.
Canadians should realize that the world and Canada have changed in the past generation. Canada once ranked in the top three of nations in terms of gross domestic product per capita and had relatively low government debt. Many of the emerging nations have seen major improvements and reduced poverty. Canada now fails to rank in the top 20 in those two metrics. Canada has weakened relative to emerging markets as other nations have gone from lower income to middle income levels.
Consequently, relative value and spreads warrant the investor having a serious and prudent look at this sector. The fund is yielding approximately 300 basis points above similar term U.S. Treasuries and more than 350 basis points above Government of Canada bonds. (A basis point is 1/100th of a percentage point.) A rally in the bond market, high spreads and potential narrowing of spreads will benefit investors.
Go for real estate
Another income vehicle investors should consider for the long term is real estate. Real estate investment trusts, or REITS, are an optimal way of gaining exposure to this enormous asset class. REITs provide regular income to the investor. In essence, the fund manager engages in property management on the investor’s behalf and passes on the rent paid to tenants after expenses.
REITs are a hybrid investment. They are not stocks. They are income investments, but unlike bonds their payments are not fixed. Consequently, they are an excellent inflation hedge as property owners can pass on inflation to tenants. Also rents and property values have a tendency to go up as nominal GDP rises. The investor also benefits from the capital appreciation of real assets. Of course, asset value can decline in hard times but our focus is long term. Furthermore, REIT prices fell in 2022, which might be a buying opportunity. Besides capital losses, the other major risk to a REIT is an overlevered capital structure and a reliance on floating rate debt if interest rates rise. Most managers of larger REITs realize this so they tend to be cautious. Furthermore, REIT ETFs are diversified in a way as to avoid undue risk from being too specific to companies, geographical regions or industries.
The largest REIT ETF in North America is the Vanguard Real Estate ETF, with about US$36-billion in assets. It has a low management expense ratio of 0.12 per cent. It is also well diversified across the United States and is in different sectors. Although we are concerned about the office and retail segments over the near term, the fund only has an exposure of 18.5 per cent to those two sectors and they may be relatively cheap already. About one-third of the fund is exposed to industrial, residential and health care REITs, which are relatively stable.
Investors should be open-minded to income-related products. The easy money in the equity markets has ended as expected turns will be lower and downside risk rises.
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