Don’t play Monopoly with your portfolio

Posted on: November 7, 2011 in: Canadian Equities, Dividends with 0 comments

BMO Equal Weight Utilities ETF ( Ticker: ZUT )

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Globally equity markets staged an incredible recovery from their October lows. However, Europe’s ongoing troubles ensure that heightened anxiety will remain. Even more reason to keep a careful eye on risk inside your portfolio.

Major equity indices for the United States, Europe and Emerging Markets rallied by 14% to 20% over the last five weeks. The S&P TSX 60 rose 12.5%. Commodities rallied too, with crude oil and copper up about 19%.

Euro-zone relief drove the rally, just as Euro-zone despair drove the drop. Until the Euro-zone begins to resolve its debt issues, every move it makes will agitate markets. When the Greeks decided to put their debt plan before a referendum last Tuesday, European equity markets fell 5%.

In this volatile environment, investors must be more vigilant in managing portfolio risk. One risk often overlooked is counterparty risk. As the exchange-traded market has developed, more, er…esoteric, ETFs have arisen, some of them with counterparty risk.

First, I should stress that most ETFs invest directly in stocks or bonds. These plain vanilla ETFs pose no counterparty risk. Other ETFs use futures contracts: no counterparty risk here either, but they do have other issues such as leverage that I have discussed before.

Then, there are ETFs that use “over-the-counter” (OTC) derivatives contracts. These are the ones that come with counterparty risk. These ETFs do not invest directly. Instead, they pay a fee to a counterparty, say a bank, and in exchange, the bank pays the ETF the return on some index like the S&P 500. All goes well until the day the bank is unable to pay the return.

How can you tell whether your ETFs have counterparty risk? You must read the prospectus. In a past role as a manager of OTC derivatives for a Bay Street fund manager, I was responsible for controlling counterparty risk. Are most investors ready or willing to do that? Unlikely.

In Europe, institutional investors are selling their OTC ETFs in droves and shifting to plain vanilla ones. France’s second largest bank, Société Générale, has seen outflows of Euro 4.4 billion this year from the OTC ETFs managed by its Lyxor division. There is nothing inherently wrong with the ETFs but investors are worried about SocGen’s exposure to Greek debt. SocGen’s stock price has fallen nearly 60% this year.

In recent notes, I discussed sector diversification and lower-risk, higher-dividend sectors like REITs. Another is the utilities sector.

When we play Monopoly, my sons tend to pass on Water Works and Electric Company in favor of Pacific Ave or Boardwalk. Like them, most Canadians pass on utilities for their portfolios.

That’s largely because the S&P TSX Composite passes on utilities. Three sectors dominate the Composite – financials, energy and materials – with nearly 80% of the weight. Utilities account for just 2%, even though their benefits would seem to mesh well with what most investors want.

Utilities are less volatile than energy, materials and even the Index as a whole. They pay better dividends than the Index and every other sector barring telecoms. Best of all, they are not so closely tied to the events in Europe.

There are a couple of Canadian utilities ETFs available: the iShares S&P TSX Capped Utilities (XUT/TSX) and the BMO Equal Weight Utilities (ZUT/TSX). Of the two, BMO ZUT is larger with about $95 million in assets.

iShares XUT is market cap weighted and holds 11 companies, with Fortis, TransAlta, Emera, Canadian Utilities and Atco making up about 70%. XUT pays a dividend of about 2.9%.

BMO ZUT is rebalanced twice a year to equal weights across 15 companies. It pays a dividend of about 5.3%. ZUT also holds one oil pipeline company, Pembina: not strictly a utility but the same idea.

The high yield will attract longer-term investors. In the near term, keep in mind that valuations are rich. The average price-to-earnings ratio for the companies inside ZUT is 23.4 times, with a price-to-book of about 1.93 times. For the Composite, the values are 15.2 times and 1.84 times.

Some of the premium is justified by the benefits. But a price fall in the near term is possible and that would be a good time to enter.

 

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ZUT is less volatile than XIU, the TSX 60 ETF.

archerETF Metrix ZUT
Category Canadian Equities
Benchmark S&P TSX 60
Total Holdings 15
52 Week High $16.13
Recent Price $15.72
52 Week Low $14.38
Avg Daily Volume 0.02 Million Shrs
Avg Daily Volume ($) $0.37 Million
Total Market Cap $95.10 Million
ETF Annual Fee 0.55%
ETF Trading Currency CAD
ETF FX Exposure CAD
Annual Volatility Not Available
Correlation to S&P 500 69.8%
Return to Risk Ratio Not Available
Use of Leverage No
Use of Futures No
6 month Return 1.48%
1 Year Return 3.56%
2 Year Return Not Available
3 Year Return Not Available
Dividend Yield (TTM) 5.27%

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archerETF offers Global Tactical Portfolio Management.

Our outlook is Global: we invest across countries, sectors, commodities and other asset classes to improve returns. Our management is Tactical: we strive to select the right opportunities at the right times in response to changing market conditions to manage and minimize portfolio risk.

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© 2011 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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