Two Types of ETFs to Consider for Diversification When Your Bond ETF Isn't Working
Here are some additional ways Canadian investors can diversify their portfolios via ETFs.
For Canadian investors seeking stability and diversification, the recent performance of bond ETFs has been disheartening. Historically, bonds have been the bedrock of a diversified portfolio, offering a counterweight to the inherent volatility of equities.
However, the financial landscape of 2022 and 2023 has upended this conventional wisdom. In the face of rising interest rates, bond ETFs, once considered bastions of stability, have found themselves on shaky ground.
Take for instance the BMO Aggregate Bond Index ETF (ZAG), a popular choice among Canadian investors. As of October 18, its price returns are down by a significant -4.80% year to date. The situation becomes even grimmer when considering long-duration variants like the BMO Long Federal Bond Index ETF (ZFL), which has plunged by -10.50% over the same period.
This challenging scenario has put a strain on the traditionally "balanced" 60/40 portfolio strategy, composed of 60% equities and 40% bonds. This approach has long been favored by many for its blend of growth potential and risk mitigation. Unfortunately, Canadians who've adopted this strategy are now likely grappling with steeper losses than they had anticipated.
That being said, there are alternative ETF options that Canadians might consider to improve their portfolio. Here's a look at two from Purpose Investments and Picton Mahoney Asset Management.
Real Asset ETFs
Real assets are tangible or physical investments with intrinsic value. These include precious metals like gold, silver, and platinum, which have long been viewed as stores of value.
Then there are commodity futures, contracts that derive their value from underlying commodities like oil, wheat, soybeans, or even livestock.
Additionally, real assets from an ETF perspective can encompass the stocks of companies directly involved in sectors such as infrastructure, real estate, agriculture, mining, and energy.
The allure of real assets becomes evident when considering inflationary pressures. Bonds, in particular, can see their real returns (i.e., after accounting for inflation) diminish. Most stocks, while often considered a hedge against inflation, can still be affected if the companies behind them face rising input costs that they can't pass on to consumers.
On the other hand, real assets tend to be more resilient in inflationary times. Precious metals, for instance, often sees demand as investors look for tangible stores of value when the purchasing power of currencies decline.
Similarly, commodities can benefit when their prices rise faster than the overall consumer price index. Companies involved in infrastructure or real estate may see the intrinsic value of their tangible assets rise with inflation. Additionally, sectors like energy or agriculture can potentially benefit if the prices of oil or crops increase.
A great example of an ETF that offers diversified exposure to all of the above is the Purpose Diversified Real Asset Fund (PRA). This actively managed ETF weights five different real asset categories based on their risk: energy, agriculture, base metals, real estate, and precious metals.
What's unique about PRA is its breadth across different asset classes. In all sectors but real estate, the ETF holds both stocks and real assets directly.
For example, in energy, PRA holds companies like Exxon Mobil, but also oil futures. In precious metals, the ETF holds both physical bullions, but also miners like Franco-Nevada Corp.
Alternative ETFs
In Canada, the term 'Alternative ETF' is more than just a label; it's an indicator of the regulatory framework in which these funds operate.
The Canadian investment regulatory environment mandates that Alternative ETFs adhere to specific investment strategies and holdings not typically permitted in conventional ETFs.
While regular ETFs might be restricted in terms of the leverage they can employ or the derivatives they can hold, Alternative ETFs have a wider latitude.
Diverse hedge fund-like strategies can be found under the umbrella of Alternative ETFs. These range from merger arbitrage, where funds attempt to profit from price discrepancies in merging companies, to long/short strategies, wherein the fund goes long on stocks they anticipate will appreciate and short on those they predict will decline.
Among the myriad strategies employed, the market neutral approach merits special attention. A market neutral fund seeks to exploit price discrepancies between related securities while aiming to maintain a zero-net exposure to market movements. This is achieved by taking equal and offsetting long and short positions.
The beauty of market neutral funds lies in their ability to offer potential returns that are uncorrelated with broader market movements. In other words, they can provide diversification by not being tied to the fate of the general market, whether bullish or bearish.
Such funds are designed to deliver consistent, absolute returns irrespective of the market's direction. This can be particularly beneficial during periods of heightened volatility or uncertainty, where traditional asset classes might be moving in tandem and offering little in the way of diversification.
A great example is the Picton Mahoney Fortified Market Neutral Alternative Fund (PFMN), which has achieved an annualized net return of 7.79% since its inception against a low annualized standard deviation of 5.02%.
From a risk-adjusted return perspective, the ETF's Sharpe ratio of 1.19% is extremely impressive. This is even after accounting for the ETF's much higher 0.95% management fee and 20% performance fee.
Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.
