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Three investment ideas for uncertain times

Three investment ideas for uncertain times

With stocks failing to break out of the doldrums following a steep decline in February, BMO’s ETF investment strategist Morgane Delledonne spoke last week on how to plan for further jitters.

Giving an overview of macro developments, Delledonne said, ‘Fundamentally the global economy looks better, is still supported by very accomodatory monetary policies, and fiscal policies are probably taking the stage to help economies to continue to recover.'

When it comes to ETF flows, this translates into continued appetite for risk – with lower rated investment grade bonds doing well, steady emerging market demand, and duration management through short term bonds.

‘On the flip side of the coin you have building vulnerabilities that probably need more [discretion] when you need to allocate money.’

From questing for quality to covered calls, here are three ways BMO is planning to stay ahead of the curve.

Not yielding to the yield trap

In light of increased volatility and the move into late cycle, a defensive strategy is to invest in high quality stock offering high dividends.

‘For our ETFs we are tracking the MSCI select quality yield for different regions, the USA, the UK, European ex-UK, and emerging markets,’ Delledonne said.

While bluechip US equity yields are below that of the benchmark two year Treasury bonds, she explained, ‘when you screen for quality and dividend yield you still have a positive gap. So you still make more yield using equities.’

Source: BMO Global Asset Management, MSCI, Bloomberg, March 199-February 2018

The benefit of the strategy is that ‘It improves the Sharpe ratio… so you improve your return and reduce the volatility.’

Delledonne stressed the need to ‘avoid the yield trap’ – inadvertently investing in unsuccessful businesses in pursuit of superficially attractive dividends – and gave three ways to assess quality: return on equity, low leverage, and stability in earnings growth.

Companies with low leverage are seen as less vulnerable to rate rises, while stability of earnings growth suggests a company’s management has the nous to react promptly to changes in the economy.

Value from volatility

In order to actually benefit from anticipated volatility, Delledonne also recommended a covered call strategy – gaining income from selling call options while tracking the market:

Source: BMO Global Asset Managment. For illustrative purposes.

‘The higher the implied volatility, the higher the premium.

‘Implied volatility has increased by a very important extent. And there is a change in the volatility regime since the beginning of the year.

‘This is a way to diversify away from traditional asset classes. It’s really taking advantage of a price inconsistency on the call options.’

Fixed income finale

BMO is pursuing an immunisation strategy based around both short and long-term bonds in order to protect investments from rising interest rates.

Delledonne advocates keeping some long-term bonds in order to offset capital risk, saying the short term risk to capital values is largely neutralised for investors able to hold to maturity. 

‘And these coupons will be reinvested at a rising interest rates, that will just compensate – more than offset – the risk you have on the capital invested.’

Conducting an analysis of three hypothetical portfolios with varying proportions of short and long-dated bonds, BMO found the portfolio with the most long dated bonds (16% vs 84% short dated) gave the best returns when interest rates were the only variable.

Source: BMO Global Asset Management as at 29.12.2017

Source: BMO Global Asset Management as at 29.12.2017. For illustrative purposes only.

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