Investment strategy: prefer defensive diversifiers
Synchronised global growth along with subdued inflationary pressures continue to provide a positive environment for equities and bonds. However, the revived inflationary threats and the possibility of higher interest rates could erode corporate profitability and lead to further bursts of volatility. In this environment, we favour investment strategies that allow investors to cautiously participate in market upside, either by selecting quality assets or managing portfolios to enhance yield and limit interest rate risk.
Benefiting from higher implied volatility
The rise of expected volatility results in a higher premium for investors selling call options on their equity holdings, namely implementing covered call, sometimes called ‘buy-write’, strategies. In our covered call strategies included in the BMO Enhanced Income Equity ETFs, we have increased the mid-term option yield target from 2 to 3% per annum across all regions – UK, US and Europe. What’s more, the current outlook of stable to slightly rising equity markets is positive for our covered call strategies as investors can benefit from positive market performance while also receiving an additional premium from selling index call options against 50%2 of the portfolio. Typically, steadily rising markets allow our ETF portfolio managers to gradually adjust the ‘moneyness’3 of the call options to minimise the risk of the options being exercised while allowing upside participation.
Overall, we expect to enhance the current net dividend yield of 4.4% for the FTSE 100 Index, 3.1% for the Euro Stoxx 50 Index and 1.6% for the S&P 500 index (as at 29 March 2018), by 3% per annum over the medium-term, to a total estimated annualised portfolio yield of 7.4% in the UK, 6.1% in Europe and 4.6% in the US. Read our February note for more.
Avoiding the ‘yield trap’
Fundamental screening of higher-yielding companies reduced the risk of falling into a yield trap, while also reducing volatility and still capturing decent yield. Investors can benefit from the combination of quality and dividend yield factors through a systematic investment style to capture the excess returns of high-quality stocks over low-quality stocks. Quality companies are less vulnerable to rising interest rates as they usually exhibit low leverage, superior profitability (a company’s ability to generate earnings as compared to its expenses) and lower earnings variability, which suggests they are aptly managed and can quickly adapt to economic changes. BMO Income Leaders ETFs track the MSCI Select Quality Yield Index, which selects the most robust companies according to these three aforementioned fundamental criteria before screening for the top 50% of them according to their dividend yield. Read our March note for more.
Duration management using bond ETFs
As the yield gap between dividend yield and bond yield collapses, we expect a gradual rotation from equity to fixed income investments. We believe global corporate bonds are likely to benefit from the improving global economic backdrop, while US corporates will also benefit from the Tax reform.
However, the rising interest rate environment is particularly challenging for fixed income investors, as bond prices move inversely to interest rates. BMO 1-3 year Global Corporate Bond ETF is one option for conservative short-duration fixed income exposure. For longer-term investors, looking for income and diversification, BMO Global Corporate Bond ETFs offer different maturity buckets (1-3yr, 3-7yr, 7-10yr) which are useful tools for implementing a range of interest rate immunisation strategies, without involving a complicated set of calculations. In addition, to be cost-effective, bond ETFs also provide an extra layer of liquidity allowing investors to quickly adapt to the changing economic environment. Read our January note for more.