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Equity ETF Strategies to Consider: Canadian Bank Stocks

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When we experience a market selloff as significant as we have since the end of February, it can be a nerve-wracking experience. Even the most seasoned investors can have their emotional fortitude tested. In fact, the extreme volatility we have observed, in conjunction with the occasionally wild price swings, suggests that even professional investors are having difficulty navigating the torrent of news.

Do you sell? Do you buy? Do you do nothing?

We are not going to opine on whether you should make significant portfolio reallocations during these types of market events. Ideally, thoughtful portfolio allocation strategies are typically designed to potentially weather market corrections. No doubt, investors have already received a deluge of marketing updates and capital markets commentaries urging patience and sticking with quality assets. Historically, there’s a lot of merit to this advice.

The intent here is to provide some insight on ETF strategies that could generate potentially attractive total returns coming out of the correction.

Are the Big Six Banks Nearing a Bottom?

The selloff in Canadian bank stocks took a lot of investors by surprise, and it was largely a result of the broad selloff in financial stocks and growing concerns about the health of the Canadian economy. However, in terms of quality cash-flow and diversified sources of revenue, the banks remain well-positioned and currently have high dividend yields by historical standards.

As at March 19, 2020, the weighted average current dividend yield1 on the Solactive Equal Weight Banks Index, which is the underlying index of the Horizons Equal Weight Banks Index ETF (HEWB), was more than 6%. HEWB is the lowest-cost2 option when it comes to buying an ETF with exposure to the six large Canadian banks, all of which are equally weighted in the index. HEWB is down 31.14% on a total return basis for the one month period ending March 19, 2020, offering a rare opportunity to gain exposure to Canadian banks at their lowest price point in nearly four years.

Below are performance and dividend yields of the six banks as of the market close on March 19, 2020.

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Source: Bloomberg as at March 19, 2020.
** Since HEWB’s inception on January 22, 2019.
1The most recently announced dividend amount, annualized based on the dividend frequency, then divided by the market price as at the close of March 19, 2020 has been used. Gross or net dividend amount is used based on market convention.

The indicated rates of return are the historical annual compounded total returns, including changes in share value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The rates of return above are not indicative of future returns. The ETF is not guaranteed, its values change frequently, and past performance may not be repeated.

For Canadian retail investors, the idea of potentially getting around a 6% current yield on bank stocks (assuming no change in underlying dividend distributions) would likely have a lot of appeal, particularly as interest rates decline. The Canadian banks have been a solid bulwark of Canadian portfolios and could potentially be viewed as a safe-haven income equity asset for income-focused investors.

Best Yield Since 2008?

This chart shows the RBC dividend yield and price performance over the last 20 years. We use RBC here, but could show a similar trend with any of the other Big Six banks. What we have witnessed over the last several weeks is the yield on RBC spiking to its highest level, which has not been observed since the 2008/2009 financial crisis.

History doesn’t necessarily repeat itself, and we would never suggest it would in this case. Investors who entered into RBC when the yield on February 23, 2009, saw an approximate 323% price return and 550% total return over the next decade if they continued to hold until February 21, 2020.

chart2.png

Source: Bloomberg from 3/19/2000 to 3/19/2020.

Some key benefits of HEWB:

● Low-cost2: With a 0.30% management fee, HEWB is the lowest-cost equal-weight Canadian banks ETF in Canada
● The Total Return Index Advantage*: HEWB is part of the Horizons Total Return Index family of corporate class ETFs (“Horizons TRI ETFs”). HEWB uses a total return swap contract to replicate the performance of the Index. This structure typically reduces tracking error associated with replicating an index and increases tax efficiency
● Tax Efficiency: HEWB is not expected to make taxable distributions, making it advantageous for taxable accounts. The reinvestment of index constituent distributions are reflected in HEWB’s Net Asset Value (“NAV”) on their ex-date – which can result in more efficient compounding than ETFs that compound only quarterly or even monthly

2 HEWB has the lowest management fee among a total of 3 “equal weight Canadian banks” ETFs, as at February 21, 2020

Given current market conditions, investors may be able to sell individual shares of Big Six banks at a loss, harvest a capital loss that could be used to offset future capital gains, and diversify their exposure across the Big Six using HEWB.

*Horizons Total Return Index ETFs (“Horizons TRI ETFs”) are generally index-tracking ETFs that use an innovative investment structure known as a Total Return Swap to deliver index returns in a low-cost and tax-efficient manner. Unlike a physical replication ETF that typically purchases the securities found in the relevant index in the same proportions as the index, most Horizons TRI ETFs use a synthetic structure that never buys the securities of an index directly. Instead, the ETF receives the total return of the index through entering into a Total Return Swap agreement with one or more counterparties, typically large financial institutions, which will provide the ETF with the total return of the index in exchange for the interest earned on the cash held by the ETF. Any distributions which are paid by the index constituents are reflected automatically in the net asset value (NAV) of the ETF. As a result, the Horizons TRI ETF receives the total return of the index (before fees), which is reflected in the ETF’s share price, and investors are not expected to receive any taxable distributions. Certain Horizons TRI ETFs use physical replication instead of a total return swap. The Horizons Cash Maximizer ETF does not track an index but rather a compounding rate of interest paid on a cash deposit that can change over time.

The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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