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  • BMO ETF Portfolio Strategy Report

    BMO EXCHANGE TRADED FUNDSTh i rd Quar ter 2013

    7/5/2013

    5/1/2013

    1.0%

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    In this report:

    Recent Developments ................1

    Things to Keep an Eye on ...........2

    Changes to the Portfolio Strategy ......................3

    Stats and Portfolio Holdings ....................................4

    Portfolio Characteristics.............5

    The Good, the Bad, and the Ugly ..............................6

    All prices or returns as of market close on July 5, 2013, unless otherwise indicated.

    Alfred Lee, CFA, CMT, DMS Vice President, BMO ETFs Portfolio Manager & Investment Strategist BMO Asset Management Inc. alfred.lee@bmo.com

    In this report, we highlight our strategic and tactical portfolio positioning strategies for the third quarter using various BMO Exchange Traded Funds. Our key strategy changes are outlined throughout the report and in our quarterly outlook on page six.

    • The major storyline that drove markets this quarter was the expectation that the U.S. Federal Reserve (“Fed”) would look to moderate or “taper” its current US$85 billion per month bond buying program. Given that U.S. monetary policy either directly or indirectly drives the interest rate policy of other countries, yields, as a result of the expectation, rose globally. The U.S. ten-year treasury bond yield rose 111 bps to 2.74% from May 1 (the May Federal Open Market Committee “FOMC” meeting) to July 5. The Canadian ten year bond saw a similar jump rising 87 bps over the same time horizon to 2.55% (Chart A).

    • It should be noted, however, that the tapering by the Fed of its bond buying does not mean the end of the program altogether. Additionally, interest rates are expected to remain low, with the expectation that the U.S. will maintain its current overnight rate level until 2015. It is important to remember that it is a positive to the overall economy that the Fed is hinting at tapering, as it suggests the economy is no longer as reliant on the central bank’s stimulus measures.

    • Over the quarter, U.S. equities continued to outperform with the S&P 500 Composite’s 2.9% total return in the second quarter outpacing the 0.8% and -4.1% total return of the S&P/TSX Composite Index and MSCI World Index respectively. Volatility in equities returned momentarily with the concern over the Fed’s tapering and continued to rise after the Fed confirmed the possibility that the tapering could come as early as late-2013. Volatility however abated to end the quarter as market conditions later normalized.

    • In light of the concerns for higher interest rates, the U.S. Treasuries curve took on a parallel shift, with points along the term structure rising in yield. The Canadian federal yield curve also made a similar shift (Chart B), putting significant pressure on income-oriented assets, as those assets tend to be more sensitive to interest rate changes. All of equities, bonds and commodities were negatively impacted, although certain sectors within those asset classes were less affected.

    • Despite the skittishness in the markets to end the quarter, equity market volatility remained reasonably low. The CBOE/S&P Implied Volatility Index (VIX)1 rose from 12.7 on March 31, to 16.9 to end the second quarter and the Canadian based S&P/TSX 60 VIX Index (VIXC) rose 11.7 to 15.0. The steepening of the term structure for VIX futures also appeared to be moderate with September 2013 VIX futures rising only 30bps to 18.75. We reiterate that rising rates signal an improving economy and extreme volatility would not be justified.

    • Since early May of 2011, the U.S. dollar has been strong relative to most major currencies, with the U.S. dollar index gaining 15.8% since that time. This gain has been due to two reasons, improving economic data, particularly with U.S. real estate and unemployment and other major currencies such as the Japanese yen and our own Canadian dollar have been weaker. Should tapering concerns lead to higher long-term rates in the U.S., relative interest rates between the U.S. and other countries may narrow, leading to a further tailwind for the greenback. Therefore, U.S. assets, which we have recommended investors to overweight, could potentially provide an additional currency return.

    The Taper Tantrum

    Chart A: A Rise in Sovereign Yields Chart B: The Canadian Yield Curve Has Shifted Upwards

    Source: BMO Asset Management Inc., Bloomberg Source: BMO Asset Management Inc., Bloomberg

  • Portfolio Strategy Report – Third Quarter 2013 2

    1-May-13

    5-Jul-13

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    Yield on emerging market debt becoming attractive again

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    Things to Keep an Eye on...

    Three quarters ago, we recommended that investors consider U.S. banks to gain exposure to the recovering U.S. housing market. Since then, economic data has suggested that the housing industry south of the border continues to gather momentum. The S&P/Case Shiller 20 City Home Price Seasonally Adjusted Index2 is up 12.0% year- over-year and mortgage defaults are also on the decline. Several weeks ago however, we saw the spread between the average 30-year mortgage rate in the U.S. and 30-year U.S. treasury yield (“Spread”) temporarily widen. While this may cause a short-term boost in mortgage refinancing, it is important for both the Spread and the absolute mortgage rate to remain low to ensure the ongoing U.S. housing recovery.

    Recommendation: The BMO Equal Weight U.S. Banks ETF (ZUB) is a way to gain exposure to the recovering housing industry in the U.S. Our recommended weight for this ETF in our strategy remains at 3.0%. We believe the industry will continue to strengthen and rising dividends and shares buy-backs will be an ongoing theme in the industry.

    As aforementioned, the yield curve has undergone a significant shift over the last eight weeks, making interest rate-risk a tactical theme. Interest rate expectations have taken a new direction as inferred by the overnight indexed swap (OIS) market, whereas it indicated a miniscule 0.20% probability of the overnight lending rate rising from 1.0% to 1.25% by the December 4 Federal Open Market Committee (FOMC) back on May 1, the OIS market is now indicating a 17.5% chance that we will see a quarter-rate hike by that same meeting.

    Recommendation: Whether rates move higher by year’s end will be determined by the strength of the economic recovery over the next several months. We do believe that the long-term secular trend of overall low interest rates and aging demographics will put yield-oriented assets in high demand. There has, however, been a key inflection point in the market. Cyclical-oriented areas, which have lagged the market since the market bottom in 2009, tend to be less interest rate sensitive and benefit from a stronger economy. As a result, we continue to recommend key tactical positions in areas such as technology and industrials to complement yield-oriented areas.

    Source: BMO Asset Management Inc., Bloomberg

    Source: BMO Asset Management Inc., Bloomberg

    Last quarter, we eliminated our positions in emerging market bonds and precious metals given both the macro-economic concerns and technical weakness in these areas. At that time, we believed emerging markets to be overbought, putting a compression on overall yields. Our concern for gold was that outside of seasonal trends, there were few, if any, reasons to own gold over the coming quarters. These decisions proved to be timely, given the 10.7% and 23.5% sell off in the Barclay’s Capital Emerging Markets Tradable USD Sovereign Bond Index and gold bullion respectiv