26 July 2019

Reimagining RBC: How Canada’s Biggest Bank Is Tackling the Never-ending Threat of Disruption

The Globe and Mail, James Bradshaw & Tim Kiladze, 26 July 2019

Top executives at Royal Bank of Canada were feeling pretty confident in 2016 that a new retail strategy they were crafting would be groundbreaking.

Their plan, dubbed Vision 2025, would reshape the way they approached retail banking. A decade out, RBC imagined acquiring customers in bold new ways, including starting businesses that had very little to do with banking but would attract entrepreneurs and new immigrants. The bank also planned to rely more on digital apps to handle simple transactions – and to glean insights about client behaviour.

Then they landed in China.

On a reconnaissance trip, the executives were confronted with a cluster of digital behemoths such as WeChat already touching every corner of a consumer’s life. The popular messaging app lets users make payments and money transfers, book flights, hail a ride-sharing car or order food delivery, all from a mobile phone. From each of these services, WeChat learns more about its consumers’ lives in an era when customer data – once a domain in which big banks held a significant advantage – are increasingly valuable.

“As we met with Alibaba and the large digital firms there, [we realized] they’re already three years down this path,” recalls Neil McLaughlin, RBC’s head of personal and commercial banking. The harsh truth about RBC’s strategy to embed itself more deeply in all aspects of a customer’s digital life was laid bare: “This isn’t us innovating, this is us coming to the same conclusion that another market already got to."

Even more terrifying, he adds, was the pace of change. Chinese digital giants seemed to be moving five times faster than RBC.

For Canada’s largest bank, this raised the prospect of an existential threat. Retail banking is a profit machine for RBC, delivering nearly half of last year’s profit.

In Canada, it can seem as though the banks are too big to disrupt – they appear to have neutralized the initial threats from financial-technology companies, or fintechs, and weathered the first forays into financial services by Silicon Valley giants. Apple Pay, for instance, has been slow to catch on.

But RBC is still focused on addressing the threat, because it isn’t going away. As the bank celebrated its 150th anniversary in June, chief executive Dave McKay and Mr. McLaughlin spoke to The Globe and Mail about the challenges ahead, as well as their vision for what the bank, and the industry, might look like in 2035.

“We’re reimagining the role we play in a client’s life,” Mr. McKay said. “Because that role has been kind of fixed for 150 years, it was pretty straightforward. But now … barriers are breaking down between industries.”

RBC executives are consumed with imagining how clients’ habits might change as new technologies and tech companies transform how – and where – they spend their money. Why borrow from a bank to buy a car if, 10 years from now, Lyft offers a subscription service that meets most driving needs?

Then there is the “open banking” movement. The Canadian government is currently weighing new rules that make it easier for clients to move all their account info and data to startup financial institutions.

“Executives are rightly nervous,” said Paul Battista, the head of Ernst & Young’s Canadian financial-services consulting practice. “There is a lot of fundamental change going on right now … and it will be profound when it hits.”

Rising threats

One of the first things RBC tackled when revamping its retail-banking strategy was customer acquisition. For much of its history, banks pursued clients using traditional sales tactics, such as mailing millions of credit-card offers directly to Canadian homes or relying on branches to serve as large nets. Once clients walked in, staff could offer a variety of financial products.

In a digital world, signals of what’s going on in customers’ lives and where they’ll spend their money are increasingly showing elsewhere – on social media, through search engines and from online purchases. Although banks still gather a fair amount of information through transaction data, it is often not as detailed as data collected by tech companies. A credit-card statement might show a purchase from Amazon.com, but not what was purchased. In that instance, Amazon can gather far more intimate portraits of a customer’s intentions.

So the bank launched RBC Ventures in 2018, a startup accelerator of sorts whose businesses are designed to reach clients long before they consider a banking product. For instance, instead of advertising small-business loans, the bank built a new digital business in-house called Ownr that walks the user through all the steps necessary to set up a company – hoping that, eventually, the customer will borrow from RBC. Another app, called Arrive, provides step-by-step guides to help new immigrants get set up in Canada, giving the bank a way to reach prospective customers as soon as they touch down in the country.

That was just Step 1. RBC’s leaders are now working on a new strategy, dubbed Vision 2035, and no question is off limits.

“What does the consumer balance sheet look like [in 15 years]?" Mr. McKay wonders. Could the traditional approach that led RBC to accumulate $1.38-trillion in assets become less relevant – or even a liability?

"I don’t know. I don’t have an answer for you,” Mr. McKay said.

RBC’s leaders are also trying to anticipate the next wave of disruption. For one, as technology breaks down barriers between industries, Mr. McKay expects more customers may ask home voice assistants built by Apple, Amazon or Google, “What’s the best mortgage rate?” The machine might spit out a single search result and access to that customer could be sold by the voice-assistant maker to the highest bidder.

“How terrifying is that?” Mr. McKay said.

Meanwhile, Canada’s federal government is currently weighing the merits of so-called open banking. The movement, already established in Britain, is essentially a set of rules that will allow consumers to share and move their banking data from one provider to another, often with a swipe of a finger.

If it unfolds as expected, it could increase customer switching rates between financial institutions, loosening the grip incumbent banks hold on their customers – and that’s the last thing RBC, the largest of the Canadian banks, would want.

How RBC is responding

Risk-averse banks may seem ripe for disruption, but RBC contends banking is not simply about transactions and that its track record is hugely valuable.

“An awful lot of retail customer decision-making is emotional, not logical," Mr. McLaughlin said. Customers will subconsciously think, “I have an affinity for this brand, and I trust them.”

To better understand the way clients think, RBC began hiring ethnographers a couple of years ago. Ethnographers are trained to observe people in everyday situations and RBC sends them to visit customers’ homes and employees’ workplaces to explore the different relationships people have with money. At a basic level, Mr. McLaughlin explained, ethnographers “help what is a very logical industry think through, ‘Here’s how we need to speak and interact with customers.'"

The exercise has reinforced how vital brand loyalty is to RBC. So the bank is trying to expand the appeal of the banking bundle, adding on discounts, rebates, loyalty points and special offers to create as many reasons as possible to dissuade customers from taking any part of their business elsewhere.

RBC recently partnered with Petro-Canada to share some customer data, persuading clients to link their cards from the two companies by offering discounts at the gas pump. The bank also launched Ampli, a proprietary loyalty program in tandem with WestJet Airlines Ltd. and major Canadian retailers, that will offer perks and travel rewards designed to tie customers ever more closely to the bank, and aggregate their data.

The goal is to make customers question whether the grass really is greener at rival institutions, especially at fintech startups. "Are they going to offer cents off at the [gas] pump? Do they give me a discount on my mortgage?” Mr. McKay said.

At the same time, RBC is trying to expand the scope of what a customer does through their bank. Traditionally, a bank served a prospective homeowner with products, such as mortgages and lines of credit. RBC’s mission is to solve as many “pain points” associated with housing as possible, and “not just financing,” Mr. McKay said.

For instance, if RBC can refer a borrower taking out a mortgage to a real estate listings site, a moving company and a contractor to do renovations in the span of a few clicks, RBC will seem more indispensable to that client. “That’s where opportunity lies for banks and non-banks,” said Geoff Rush, a partner at KPMG Canada.

However, it requires rethinking the way these relationships are structured. “The interesting challenge is, in that end-to-end experience, who owns the customer?” Mr. Rush added.

Amid all this change, RBC’s leaders also plan to make full use of the bank’s size. Banks are already spending billions of dollars annually on new technology systems – RBC spends well in excess of $3-billion each year. But because it has annual revenues in excess of $42-billion, which leads all Canadian banks, it can spread those costs more widely across its business.

Last year, CIBC World Markets analyst Robert Sedran summed up RBC’s approach in two words: “Weaponizing scale.” In a note to clients, he wrote: “Not only does this bank have an advantage on the sector, that gap is growing.”

The major question is what all of RBC’s investments will add up to. Two startups tied to RBC Ventures – the financial-advice app Finfit and wellness app Carrot Rewards – have already shut down, proving how hard it can be to build a digital following and to run digital businesses. And some of that cash spent on digital experiments could have been returned to shareholders or poured back into improving existing businesses.

But RBC’s executives say they can’t risk giving digital challengers even the smallest chance to pluck away products and services that make banks valuable to their clients.

"We never want to give a customer a reason to go shop across the street," Mr. McLaughlin said.

24 April 2019

RBC Capital Markets Is Playing In A Different League Than Its Canadian Rivals

The Globe and Mail, Marina Okhromenko, 24 April 2019

It’s time to acknowledge that when it comes to investment banking, RBC Capital Markets is playing in a different league than its Canadian rivals. The deal-making arm of Royal Bank of Canada churned out $8.4 billion in revenue last year, almost as much as its second- and third-ranked domestic competitors put together. In the same way it seems preordained that football’s New England Patriots will be Super Bowl favourites every year, it now appears certain that RBC Capital Markets will make far more money than any other Bay Street dealer.

What's the secret to this run? Like the most successful coaches in sports, Royal Bank CEO Dave McKay says staying on top in increasingly complex markets starts with keeping things simple. “The beauty of the capital markets strategy is consistency and what I call the simplicity,” he said at a conference in March. “It is [built] around great people, using your balance sheet, creating value, advising and cross-selling, and it takes time to build up those relationships.” To use another gridiron adage, it's also about the team, rather than individual superstars. When that teamwork kicks in, it can turbocharge revenues and earnings.

Like many perennial winners, McKay pushes his team to do better each year, too. RBC Capital Markets earned a $2.8-billion profit in 2018, which translated into a healthy 13% return on equity—a performance any other Canadian bank would envy. But McKay isn't measuring his team mainly against Bay Street rivals such as Bank of Nova Scotia, which posted capital markets revenue of $4.5 billion in 2018. Royal Bank is competing against global players such as JP Morgan Chase, which generated $35.4 billion (U.S.) in revenue from corporate and investment banking.

RBC Capital Markets began to pull away from the rest of the Canadian bank-owned dealers in the late 1990s, when it found itself advising many of its Canadian corporate clients on international expansion plans. The division's leaders in that era, including long-time CEO Anthony (Tony) Fell, decided that to stay relevant to those clients, it needed to grow with them abroad, with an initial focus on the U.S. market.

In 2000, Royal Bank spent $1.5 billion (U.S.) to acquire a technology-focused investment bank, Minneapolis-based Dain Rauscher Corp. When the tech bubble burst in 2001, Dain Rauscher started losing money. Royal Bank also targeted relatively small growth companies, which was out of step with its focus on large-cap clients in established industries. Veteran real estate banker Doug McGregor was dispatched from the head office in Toronto to Minneapolis to turn things around.

McGregor and his colleagues stuck with a U.S. expansion strategy, but eschewed another acquisition, opting to take a slow-and-steady approach by hiring individuals and some entire teams from U.S. banks. They did the same with British, French and German rivals in Europe.

If Dave McKay is Royal Bank’s head coach, the role of quarterback falls to the 61-year-old McGregor, who’s chair and CEO of RBC Capital Markets and head of the bank’s investor and treasury services. A champion wrestler in his university days, McGregor looks like he could still pin an opponent, and he is disarmingly blunt and direct. He says the big-ego Masters of the Universe financiers made famous by author Tom Wolfe were never welcome at RBC Capital Markets. McGregor has hired 31 senior bankers in recent months, and says his goal in every interview has been ensuring the new partners are a “safe” cultural fit, which means “understated and team-oriented.”

As the bank has expanded internationally—RBC Capital Markets now has 3,300 employees in the U.S., 2,700 in Canada and 1,300 in Europe—McGregor and his colleagues say the concept of teamwork became more essential. No one player can do everything for large and complex corporations.

Take health care. Derek Neldner, RBC Capital Markets head of global investment banking, says that a generation back, one banker could be the sole contact with a pharmaceutical company. Now, he says, “if you are going to offer serious coverage to a health care client, you need an analyst who can talk authoritatively on medical devices, an expert on pharmaceuticals, one on biotech and so on.”

To cover the cost of employing all those specialists, a bank needs global scale, Neldner says. He adds that one of RBC Capital Markets' most significant internal accomplishments in recent years was devising a compensation system that ensures bankers and traders get paid for helping on a transaction even if they don't have direct ties to that client.

RBC Capital Markets' reach now vastly exceeds that of any domestic rival. The firm played a role in $1.5 trillion (U.S.) worth of syndicated loans last year, $74 billion (U.S.) in stock sales and $764 billion (U.S.) in bond offerings for Canadian and international clients.

Teamwork often boosts revenues, which is why McKay fixates on cross-selling. Jonathan Hunter, RBC global head of fixed income currencies and commodities, remembers working on an acquisition in British Columbia for a German client. Along with helping negotiate the deal, RBC arranged debt financing and used derivatives to hedge currency risk. “If our fee was a dollar on a conventional advisory assignment, we were able to earn a buck-sixty here by providing extra services while also doing a better job for the client,” Hunter says.

Size and outsized profits in capital markets also bolster the premium valuation for Royal Bank stock, analysts say. “When the waves pick up, we prefer to be on a bigger boat,” said CIBC World Markets analyst Rob Sedran in a recent report on Royal Bank. Like the Patriots, in good markets and bad, McKay’s team just keeps winning.

10 April 2019

Why Shorting the Canadian Banks on Housing Makes No Sense

The Globe and Mail, Tim Kiladze, 10 April 2019

When Steve Eisman warns about a downturn, investors listen – so his recent bet against Canadian banks is getting a lot of attention. Famous for his prescient call against the United States housing market before the 2008 global financial crisis, one of the fantastically profitable wagers profiled in The Big Short, Mr. Eisman, a fund manager, is now predicting trouble for Canada’s largest lenders.

He is very clear that he does not expect a U.S.-style housing collapse, yet he worries that Canada’s housing market is cooling quickly. Mr. Eisman also fears the fallout from a sluggish economy. Because the Big Six banks dominate domestic lending, he expects they will suffer.

It is a compelling story, one that other hedge funds have been making as well. The problem with the thesis, however, is that there are a number of holes in it.

From afar, the statistics about Canadian debt are jarring. Household debt has risen to 179 per cent of disposable income. The bulk of that debt is from mortgages, and the vast majority of these loans are financed by the Big Six lenders. So the banks look particularly vulnerable in any downturn.

But the specifics about the market structure matter, and Canadian fund manager Rob Wessel, who runs Toronto-based Hamilton Capital Partners Inc., has zeroed in on these in a new research note to push back against the short trade. The same is true for Australia, he argued, a country whose banking system closely resembles ours.

“While the housing story has not yet been fully written, we believe the ongoing corrections will remain orderly and that a ‘big short’ position in the Canadian and Australian banks will continue to be challenging,” he wrote.

Mr. Wessel has an interesting vantage point. His firm specializes in investing in financial institutions around the world, and he personally knows the Canadian market intimately after spending years as an equity research analyst who covered the domestic banks.

Crucially, he noted, healthy levels of collateral and mortgage insurance “provide huge buffers to direct losses for the banks." He isn’t completely dismissive of the short story, but he believes "it would take a truly significant decline in home prices for Canadian and Australian banks to incur a large increase in direct mortgage credit losses.”

Major Canadian banks have an average loan-to-value ratio of 54 per cent on their mortgage portfolios. That means if a buyer were to default, the bank should be able to repossess the home and sell it for far more than the remaining loan value.

Mortgage insurance provided by Canadian Mortgage and Housing Corp. is also a crucial element of the Canadian market, protecting the lenders when they’re issuing mortgages with smaller down payments. On average, 44 per cent of Big Six bank mortgages are insured, so the lenders are protected if borrowers on these insured loans default.

As for the argument that a sluggish economy will cause problems, Mr. Wessel notes that the national employment rate of 5.8 per cent hasn’t been this low in decades. The broad labour market strength should do wonders because loan losses are positively correlated with unemployment rates. Plus, for all the doom and gloom, Canada’s gross domestic product is still predicted to grow over the next two years.

Lately, bearish investors have cautioned that the expected economic expansion is smaller than recently predicted. Yet, Mr. Wessel writes, that means interest rate hikes will likely remain on hold, and that has started to push borrowing costs down.

Despite the vocal arguments made by fund managers such as Mr. Eisman, recent statistics show broad swaths of investors aren’t growing intensely bearish – at least not yet. Since the start of the year, total short interest in the Big Six banks has remained flat around US$10-billion, according to S3 Partners, a financial analytics company. Of these lenders, Canadian Imperial Bank of Commerce has the highest percentage of its float shorted, at 5.6 per cent.

But bank CEOs have still had to defend their institutions. On Tuesday, Bank of Nova Scotia CEO Brian Porter spoke at the lender’s annual meeting, and he provided a detailed riposte to the short narrative.

“We stress-test our portfolio on a regular basis, a daily basis. And we stress-test it against what we would view as very harsh metrics," he said, offering examples such as a 600-basis-point increase in interest rates and a huge jump in unemployment. Even in those scenarios, "our business is still profitable, the bank still pays a dividend, and we carry on.”

09 April 2019

Scotiabank Spending $300-million a Year in Anti Money Laundering Efforts

The Globe and Mail, James Bradshaw, 9 April 2019

Bank of Nova Scotia is spending about $300-million annually to combat money laundering even as it pulls out of some riskier markets, at a time when Canada’s government is promising new resources to fight financial crime.

The bank’s chief executive officer, Brian Porter, voiced support for an array of new measures unveiled by the federal government in last month’s budget, speaking to reporters after Scotiabank’s annual meeting of shareholders on Tuesday. The new initiatives are the government’s response to continuing criticism over significant gaps in Canada’s anti-money-laundering regime.

Scotiabank spent nearly $300-million enhancing anti-money-laundering capabilities last year, and expects to invest “pretty close to that in 2019," he said. And he acknowledged that Scotiabank is keenly aware of growing scandals over money-laundering lapses at two Nordic lenders, Danske Bank and Swedbank, that have claimed executives’ jobs, damaged those banks’ reputations and drawn heightened attention to global flows of illicit funds.

“This is a big issue and it’s one I think about a lot," Mr. Porter said. “We’ve all read in the papers about Danske Bank and Swedbank and what went on there."

Scotiabank spends more heavily on anti-money-laundering controls than some of its peers, partly as a function of its geographic footprint. Not long ago, the bank operated in more than 50 countries, from Russia and Turkey to the Caribbean and Latin America, many of which have been targets for those looking to wash illegal funds. Since Mr. Porter took over as CEO five years ago, the bank has sold businesses in some 20 countries, focusing the bank’s international footprint but also reducing its exposure to money-laundering risks.

Money laundering is only one risk factor the bank has looked to mitigate by “divesting some smaller markets. It’s a function of managing operational risk,” he said.

Scotiabank has made key hires in recent months to bolster its anti-money-laundering efforts, including naming Stuart Davis as its global head of financial crimes risk management. Mr. Davis was formerly the global chief anti-money-laundering officer at Bank of Montreal.

The bank had previously scaled back its metals business, ScotiaMocatta, having failed to sell the unit in 2017 after it was linked to a money-laundering scandal. In 2015, Scotiabank reached a written agreement with U.S. regulators to fix its oversight and monitoring of suspicious activity, correcting gaps in its compliance program.

Some estimates suggest that the total sums of money laundered each year add up to between 2 per cent and 5 per cent of global gross domestic product (GDP), or trillions of dollars, though it is hard to be precise about funds that exist in the shadows by their nature. “And this isn’t just drugs, it’s human trafficking, it’s all sorts of terrible things going on," Mr. Porter said, noting that banks have "an important role” to play in stemming the flow of such funds.

In recent years, Canada has received lukewarm ratings for its effectiveness at combatting financial crimes such as money laundering and terrorist financing. In response, the latest federal budget promised a series of investments and measures to try and “modernize” Canada’s regime to enforce anti-money-laundering laws.

The government promised to invest $16.9-million over five years in the Financial Transactions and Reports Analysis Centre of Canada (FinTRAC), and to boost the RCMP’s investigative capacity with tens of millions of dollars in annual funding. There are also plans to create an Anti-Money Laundering Action, Coordination and Enforcement (ACE) Team, drawing together experts from intelligence and law-enforcement agencies to boost co-operation.

“I think that’s good for the system, good for the country, and we’re supportive of that," Mr. Porter said.

08 March 2019

Big 5 Banks Led the 2009-2019 TSX Bull Market Run

The Globe and Mail, Tim Shufelt, 8 March 2019

On Day 1 of the recovery from the worst bear market since the Great Depression, the big Canadian banks led the charge on the Toronto Stock Exchange.

Royal Bank of Canada’s shares rose 14 per cent on March 10, 2009, as investors stormed back into the much-maligned financials sector. RBC’s fellow Big Five incumbents all posted double-digit gains of their own.

That day would prove to be the inflection point that separated the global financial crisis and devastating recession from one of the best bull markets in history.

It would also usher in a decade of bank dominance in the Canadian stock market, displacing resources as the main driver of domestic equities.

In the 10 years since the market bottomed out, the Big Five together have contributed nearly half of the total returns generated by the S&P/TSX Composite Index. Just five stocks contributed 47 per cent of a decade’s worth of gains in an index that contains around 240 of the country’s largest companies.

“The banking sector hasn’t really had a bump in the road in 10 years,” said Tom Bradley, president of Steadyhand Investments. “They’ve just had these howling tailwinds.”

But it’s hard to imagine those tailwinds being quite as intense in the years ahead. The burdens from indebted households, a moderating economy and a slowing real estate boom mean the next decade in banking, and bank investing, is unlikely to have the same sheen as the gilded decade past.

In the aftermath of the global financial crisis, Canada’s banking sector became the envy of the developed world. With relatively little exposure to the toxic securities that felled 25 U.S. banks in 2008 and destabilized the global financial system, Canada’s banks remained quite profitable. They didn’t even cut their dividends.

The World Economic Forum ranked the Canadian banking system as the world’s soundest, while U.S. President Barack Obama recognized Canada as “a pretty good manager of the financial system.”

While the banks themselves were spared from the worst of the carnage, their stocks fully participated in the crisis. Amid fears of contagion infecting the Canadian financial system, the diversified bank group declined in share price by 58 per cent from their 2007 peak to the market’s 2009 nadir.

“In a downturn, investors don’t look at earnings any more,” said Bill Dye, a banking analyst and portfolio manager at Leith Wheeler.

The combination of operational strength and cut-rate valuations set the Canadian bank stocks up for a monumental rebound. Citigroup Inc. provided the spark. After the company survived only by virtue of a bailout in the form of US$476.2-billion in cash and guarantees, Vikram Pandit, Citi’s beleaguered chief executive, told his employees on March 9, 2009 – the very day of the market bottom – that the bank turned a profit in the first two months of the year.

By the end of 2009, Canada’s group of big bank stocks had more than doubled. There was much more to come. Over 10 years, the banks have generated an average total return of more than 18 per cent a year. Not only did that performance trounce the broader Canadian stock market, it beat the S&P 500 index through the longest bull run in history. It even beat Warren Buffett – Berkshire Hathaway Inc. shares have returned 15.7 per cent a year over the same period.

Operating within a comfortable oligopoly, banks have undergone a decade of growth and become wildly profitable in the process. In fiscal 2018, the six largest banks generated $45.3-billion in earnings, amounting to more than $1,200 for each Canadian. They have thrived off of a generational housing boom, have come to dominate the wealth-management business in Canada and have used their domestic proceeds to expand well beyond Canada’s borders.

“They got through the crisis okay. They’ve grown their dividends. They put up these unbelievable numbers. What’s not to love?” Mr. Bradley said. In return, Canadian investors have developed a cult-like loyalty to the banks, which form the cornerstone of countless Canadian investment portfolios. “I get people that ask me, ‘Why wouldn’t I just own the five banks?’” Mr. Bradley said. That kind of radical concentration is one sign that sentiment toward the banks is overwhelmingly favourable, he added.

And yet, bank valuations never seem to get too out of hand. Despite their vaunted status among the investing masses, the big banks trade at an average forward price-to-earnings multiple of about 10.5. That’s considerably less than the valuation on the S&P/TSX Composite Index of about 15.

“Their valuations just don’t seem to get higher over time,” said Christine Poole, CEO of Toronto-based GlobeInvest Capital Management. “Some bank CEOs argue that they are fairly defensive and stable businesses, and ask why they’re not getting a higher multiple.”

But there is a good reason such highly leveraged businesses trade at a significant discount to the market. As a result of high leverage ratios, “when things turn down, the banks tend to get hit very hard,” Leith Wheeler’s Mr. Dye said. “Retail investors sometimes forget that.”

The financial crisis served up a good reminder of that, not that anyone’s anticipating Canadian bank stocks to face such a severe test any time soon. But the forces that have elevated the mighty banks since the financial crisis are undoubtedly weakening. With household debt near record levels, the average Canadian has little room left to borrow.

“Over the next few years, loan losses are likely to be higher than they are today, even if there isn’t a recession,” Mr. Dye said. “And earnings growth is almost assuredly going to be lower.”

22 February 2019

Comparison of the All-in-One Diversified ETF Portfolios

The Globe and Mail, Dan Bortolotti, 22 February 2019

In many aspects of our lives, we embrace convenience. We buy prepared meals instead of assembling and cooking the ingredients ourselves. We shop in malls rather than driving to four or five individual stores. We recognize our time is valuable and our mental bandwidth is limited, so we look for very good solutions, not perfect ones.

Except when it comes to investing. It’s the one area where simple, excellent options are available, yet too many people resist them because they’re too, well, simple. Here’s hoping a recent trend in the ETF marketplace will help investors overcome that tendency.

In the past year or so, all three of Canada’s largest exchange-traded-fund providers have launched products that allow investors to own a complete portfolio with just one trade. Each includes a mix of global stocks and bonds, so anyone with a brokerage account can get extremely broad diversification with minimal maintenance and rock-bottom costs.

Vanguard Canada was the first ETF provider to launch one-ticket solutions just over a year ago, and iShares followed in December. Earlier this month, BMO joined the party with its own family of all-in-one portfolios.

Let’s look at a typical example: the Vanguard Balanced ETF Portfolio (VBAL). Like its counterparts, it’s a “fund of funds” built using seven underlying ETFs. There are three for fixed income: one each for Canadian, the United States, and global bonds. Then there are four equity components: Canadian, U.S., international developed and emerging markets. Vanguard has estimated that the portfolio offers exposure to about 94 per cent of the world’s public markets.

VBAL has a long-term target of 40-per-cent bonds and 60-per-cent stocks, which is the traditional split for a balanced portfolio. But there are other options for people with different risk profiles, ranging from just 20-per-cent stocks in the Vanguard Conservative Income ETF Portfolio (VCIP) to 80-per-cent stocks in the aggressive Vanguard Growth ETF Portfolio (VGRO). All the funds have the same components, just in different proportions.

The iShares and BMO families are very similar. They vary in their specific holdings, but they all include a target allocation of Canadian and non-Canadian bonds, plus an equity mix with one-quarter to one-third domestic stocks, with the remainder split between the U.S. and overseas markets. In all, we’re talking about thousands of stocks and bonds from around the world, which is all the diversification anyone needs.

Moreover, as markets move in different directions and at different rates, the ETFs will be rebalanced so they maintain those long-term targets. This feature makes them virtually maintenance-free, and it puts some competitive heat on robo-advisers, the online services that charge about 0.50 per cent and advertise automatic rebalancing as one of their key benefits.

And the price tag for this elegant portfolio? The management fees range from 0.18 per cent to 0.22 per cent, which is about 90-per-cent cheaper than traditional balanced mutual funds. On a $100,000 portfolio, the monthly cost is a little more than you’re paying for Netflix.

The good news is that these all-in-one ETF portfolios have been embraced by many do-it-yourself investors: VGRO, for example, has attracted more than $570-million in assets in barely a year. But there has been resistance, too. I’ve heard from many investors who are concerned the funds are not optimized for tax-efficiency, or that you could reduce your fees even further by buying the underlying holdings individually. But how many honestly believe they can build and maintain a better portfolio? In the real world – where people are busy with work and family, and would rather watch the hockey game than fiddle with a spreadsheet – no one manages their portfolio optimally.

Others dismiss these funds as cookie-cutter solutions, or argue that they’re only appropriate for very small accounts or unsophisticated investors. What nonsense. I’ve reviewed a lot of portfolios over the years, with six- and seven-figure balances, many of which were designed by people who manage money for a living. Almost none of them were more thoughtfully structured than what Vanguard, iShares and BMO have packed into a single ETF.

Are these products right for everyone? Certainly not. Are they perfect? No, but neither is any other option. And here’s the thing: You don’t need an optimal portfolio, you just need an excellent one. No one has ever failed to meet their financial goals because they had exposure to only 94 per cent of the world’s stock and bond markets, or because they failed to keep their investing costs lower than 0.18 per cent. Countless millions have failed by trying to do better.

Eating well and staying in shape takes a lot of effort: It’s much easier to flop on the couch and order pizza. Learning to speak Gaelic, playing the trombone, nurturing a romantic relationship – these take a lot of work. But successful investing is the opposite: You usually thrive by doing less, not more. With the appearance of these all-in-one ETFs, building an extremely well-diversified portfolio has never been easier or cheaper. The only problem that lingers is the one in the mirror.

Dan Bortolotti, CFP, CIM, is a portfolio manager at PWL Capital in Toronto. He is the creator of Canadian Couch Potato, an award-winning blog about index investing.

18 February 2019

Preview of Q1 2019 Earnings

The Globe and Mail, David Berman, 18 February 2019

Canada’s biggest banks are set to report their fiscal first-quarter results starting this week, and once again the focus is on deteriorating economic conditions and slower loan growth – a theme that ran through the latter half of 2018.

Royal Bank of Canada will kick things off on Friday, when it reports results for the three-month period ended Jan. 31. Next week, Bank of Montreal and Bank of Nova Scotia will report their respective financial results on Tuesday, followed by National Bank of Canada on Wednesday.

Canadian Imperial Bank of Commerce and Toronto-Dominion Bank will conclude the reporting season with their results on Feb. 28.

On average, analysts are expecting profit to increase just 3 per cent for the Big Six banks, year-over-year, and a mere 1 per cent from the previous quarter.

The subdued forecast reflects dimming optimism for the Canadian economy.

Many economists believe that the Bank of Canada has put interest-rate increases on hold, at least for the first half of this year. While employment gains were strong in January, there are continuing concerns about the Canadian housing market – where sales in Vancouver and Toronto have declined – and the energy sector, along with global uncertainty regarding trade and even the waning strength of the U.S. economy.

Bond yields, which surged last year in anticipation of rate hikes, fattening bank margins on loans, have fallen substantially. While lower yields will reduce borrowing costs for consumers, they suggest that demand for loans could be tempered if the economy stumbles.

RBC Dominion Securities recently reduced its price targets on a number of Canadian bank stocks, arguing that the various headwinds will leave shares trading at subdued valuations (or relatively low price-to-earnings ratios).

“Our forecast for relatively slower EPS [earnings per share] growth for the banks in 2019 and 2020 largely reflects our view that continued deceleration in domestic loan growth will slow revenue growth,” Darko Mihelic, an analyst at RBC Dominion Securities, said in a note.

He expects that personal loan growth will slow to just 2.9 per cent in 2019, down from 4.1 per cent in 2018, as today’s higher interest rates and sluggish economy weigh on mortgage underwriting activity. As a result, he estimates that revenue expansion for the Big Six banks will slow to 4.3 per cent in 2019, down from 5.7 per cent last year (when adjusted for acquisitions).

But the first-quarter results, in particular, have something else pressing on them: Volatile markets. The S&P/TSX Composite Index, among other major indexes, fell sharply from the end of August through most of December, overlapping with the banks’ fiscal quarter.

Analysts expect that the declines will weigh on banking activities such as trading and asset management.

“Everything from mutual fund fees to underwriting revenues will likely have been down. Trading, as ever, is a wildcard, but we do expect a sequential decline on that line as well,” Robert Sedran, an analyst at CIBC World Markets, said in a note.

The good news? Dividends are set to rise. Analysts expect that RBC, Scotiabank and TD will boost their quarterly pay outs in keeping with their recent pace of increases.

As well, bank stocks, which were hit hard last year, are now recovering nicely. The Big Six are up more than 9 per cent in 2019.

The rebound suggests that share prices may have been reflecting concerns over the economy back in December, when bank stock valuations fell to their lowest levels since the financial crisis a decade ago, and are now anticipating an improvement over the remainder of the year.

Indeed, some analysts believe that the low profit growth for the big banks in the fiscal first quarter will mark a starting point from which the banks will add earnings power as the year progresses, as loan losses remain low, profit margins expand slightly and bank revenue grows at a faster pace than expenses.

Mr. Sedran expects that the Big Six will report earnings growth of 6.5 per cent for fiscal 2019. While that marks a notable slowdown from 12 per cent in 2018, it implies that earnings will improve after a weak first quarter.

“While we share at least directionally the market’s concerns about the age of the economic cycle, we are unconvinced that it will show its age in fiscal 2019,” Mr. Sedran said.

01 February 2019

RBC Lowers Outlook on Banks

The Globe and Mail, David Berman, 1 February 2019

Canadian bank stocks have rebounded over the past six weeks after touching their lowest valuations since the financial crisis. But an enduring recovery rests on profit and revenue growth over the year ahead, and the outlook here is murky at best.

For sure, the stocks are enjoying some momentum right now. The Big Six have risen 11.4 per cent since Dec. 24, when the stocks traded at just 9.2-times estimated earnings, the lowest price-to-earnings ratio in nearly a decade.

But in the run-up to the start of the banks’ fiscal first-quarter reporting season on Feb. 26, some observers see potential hurdles, given a slowing Canadian economy and weak lending growth.

“We anticipate the economy will pick up again in 2020 – but during the slower economic period in 2019, risks will be elevated,” Darko Mihelic, an analyst at RBC Dominion Securities, said in a note to clients.

He cut his target prices (where he sees Canadian bank stocks trading within 12 months) by an average of 7.7 per cent on Friday, suggesting dimming enthusiasm. His target on Bank of Montreal fell to $112 from $126 previously, marking the biggest revision. His target on Toronto-Dominion Bank fell to $83 from $92.

Okay, the new targets imply average gains of about 17 per cent over the year ahead, which sounds good. But the revisions also suggest that bank stocks may be cheap for a good reason, which other analysts have also pointed out.

Gabriel Dechaine, an analyst at National Bank Financial, noted last month that low valuations imply serious concerns about the Canadian housing market. Of particular note: Residential mortgage growth – just 3 per cent in November, year-over-year – has descended to its lowest level in more than 20 years.

“Low valuations alone won’t attract investors to the sector. Indeed, we believe early 2019 housing issues could weigh on re-rating potential at least until we see stabilization in housing prices/mortgage volumes etc.,” Mr. Dechaine said in his mid-January note.

Mr. Mihelic put some numbers to his concerns. He reduced his 2019 and 2020 profit outlook for five of the Big Six banks (since he works for Royal Bank of Canada, RBC falls outside his coverage), by an average of 1.6 per cent.

He also cut his valuation targets for four banks (excluding National Bank of Canada, which is being buoyed by a strong Quebec economy, where it generates 58 per cent of its revenue), each by 0.5-times earnings. For example, he now expects TD will trade at 11.5-times earnings, down from a prior valuation target of 12-times earnings. His target for BMO falls to 11-times earnings, down from 11.5.

“We are lowering our target multiples for a number of reasons including a softer economic outlook and rising recessionary risks/late cycle concerns which could potentially lead to higher provisions for credit losses (PCLs) under IFRS 9,” Mr. Mihelic said, referring to new financial reporting standards.

Some of his numbers are sobering. He expects that personal and commercial loan growth will subside to just 2.9 per cent in 2019, down from 4.1 per cent in 2018 and 5 per cent in 2017.

Although business loan growth this year should be much stronger, at 6.9 per cent, that would mark a substantial slowdown from 11.3-per-cent growth last year.

Investors can always hope that the big banks will be able to squeeze more profit out of their revenues by cutting costs and introducing new technology. But even here, Mr. Mihelic is anticipating far more modest gains ahead. He expects that the banks’ efficiency ratios, which compare expenses with profit (lower is better), will dip only slightly in 2019, to 54.6 per cent from 54.8 per cent in 2018.

The takeaway here? Low valuations aren’t a compelling reason to bet big on banks right now, unless you can handle some bumps. “While the medium-term outlook is shrouded by uncertainty, we still like bank stocks over the longer-term,” Mr. Mihelic said.

24 January 2019

TD Bank’s Bharat Masrani on Managing Through Chaos and His Bank’s Bright Future

The Globe and Mail, Trevor Cole, 24 January 2019

Since Bharat Masrani took over TD, the bank's adjusted income has soared 50%. Bankers like predictability, and a few things have stayed unchanged since late in 2014, when Bharat Masrani became the first person of colour to run a major Canadian bank. At the time, TD was the second-largest bank in Canada, and it remains so. Masrani’s unassuming middle-management wardrobe eschewed flashy cufflinks then, and his shirts continue to be buttoned at the wrists. And more than four years after his newsmaking ascendance, Masrani is still the only example of diversity at the top of Canadian banking. Aside from all of that, things look very different.

Banking has gone highly mobile. The economy appears tilted toward recession. Interest rates are climbing as oil has plunged. And there’s a destabilizing narcissist in residence at the White House who seems intent on cooking up trouble. None of that has unsettled Masrani. Since he took over, TD’s adjusted income has soared 50%, and Masrani’s calm demeanour suggests everything is fine. For the man who helped TD weather the storms of 2008, maybe there’s nothing more predictable or manageable than chaos.

Why did the stock prices of all the banks struggle so much in 2018?

Banks are a reflection of what happens in general economies, and there are a lot of macro headwinds in the world, such as trade, what’s happening to global growth, Brexit. In Canada, we’ve seen some numbers that would suggest that perhaps there are real issues. There are views emerging that we are in for a volatile period here. I think that is reflected in the valuations you see.

In a recent interview, you said, “We enter the new year with good tailwinds in our business. The economic prospects in Canada and the U.S. are positive.” Have you changed your view?

I have not changed my view. You are asking me why the markets are behaving the way they are. From a tailwinds perspective, look at what has happened in the past year. Economic growth has been strong in the U.S. and Canada, which is where most of our businesses are. Interest rates have started to normalize, and for banks, that is positive. If you look at unemployment, there are very strong numbers in both the U.S. and Canada. So there’s a lot of momentum on our side. But that doesn’t mean there are no headwinds.

Do you see specific challenges ahead?

Trade is the worrisome one. There are real issues with respect to China, for example, on technology transfer, intellectual property. But a prolonged trade war is never positive. I think that is a big headwind going forward, and my hope is that sensible minds prevail.

“Sensible minds"—that’s asking a lot of the Trump administration.

Listen, there are stylistic issues. Economies work in different ways. The U.S. is a major economic engine for the world. I’m so glad we have a trade agreement that is refreshed now. There are chapters in the USMCA that make sense that did not exist before.

What do you expect regarding interest rates in the coming year?

Normalization is good. What is the new normal—the ideal interest rate that allows for very good employment, and deployment of an economic system versus inflation? I think that is what the world is searching for. If we go too high and too quick, it's going to be negative. For any bank, very high interest rates are not good because they cause our customers and the companies that bank with us to suffer. So I worry about it. And I think there is still more to come by way of normalization.

You spoke recently of there being “a benign credit environment.” But consumer debt levels are very high. Do you have any concerns?

Consumer debt as a headline number is high. But a lot of the Canadian consumer debt is in mortgages. The mortgage regime in Canada is a lot different than in the rest of the world—what kind of down payments are necessary, the interest rate risk financial institutions assume.

You said it’s different. How would you characterize it?

It’s better. It’s more sustainable. You know, at TD, mortgages are the biggest asset class on our balance sheet. I think that’s a positive for the Canadian system and economy. More than indebtedness, I think if the unemployment number starts to inch up, that would be a big indicator of potential problems in the economy and, frankly, potential losses.

That’s inevitable, isn’t it?

Regarding mortgages, you and Ed Clark smartly got out of mortgage-backed securities prior to 2008.

TD used to be a major player in the business of “structured products,” and thankfully we decided to exit. I don’t think we could have predicted the whole world was going to fly itself into a mountain through those products, but that’s what happened. And we were out of it. That allowed us to build out our U.S. business more quickly, because other banks were otherwise occupied.

Do you think that decision is one of the reasons you’re in the seat you’re in now?

I’m sure there are lots of decisions that go into the seat I am in. You should ask my board.

GM recently announced the closure of its Oshawa plant. What do you think about the future of manufacturing in this province?

Of course there is concern. It is a terrible thing for any community to go through. But our system has a way of transforming itself, and some new jobs will appear down the road. Many years ago, folks would not have thought of Toronto as a hub for artificial intelligence engineering talent, and today it is a major, major centre. Our system, with democracy and openness, produces terrific ideas that turn themselves into big industries. I’m confident that will happen.

Let’s talk about oil and gas. How much has TD reduced its exposure to the energy sector since 2016?

Our exposure is less than 1% of our total gross loans. So that is not a big issue. I think it’s the second-order effects we should look at—what happens to individuals when jobs are lost, GDP and all that. All those issues, from a TD perspective, are manageable. But that doesn’t mean this is pain-free.

So you are focused on the current state of the oil patch and what they’re going through?

Of course I am. At TD, we are all for the low-carbon economy. We multiply our lending to that area. We are one of the largest green-bond issuers. I think we are the only Canadian bank on the Dow Jones Sustainability World Index. But we also acknowledge that trying to get there instantly is not feasible.

You’ve talked in the past about TD’s “unique” culture. What’s unique about it?

It’s a unique and inclusive and performance-driven culture. Diversity plays a big role. As a bank, we don’t make anything. We don’t make cars; we don’t make computers. Our business is based on people. So, for us it’s a very serious matter. We think driving a very positive culture is not only the right thing to do but also the only way to be successful.

How does the notion of diversity manifest itself at TD?

We start with the premise that, of course, it’s the right, moral thing to do. From a business perspective, unless we reflect the communities we serve, we will not be as successful. Unless we have the best talent out there, we will not be successful. It goes right through our training programs, our leadership development programs, what targets we set. Look at how many women, for example, we have on our board. I am very happy with the progress we’ve been making.

On the retail side, more than 80% of TD transactions take place via mobile apps or online, but one of your key initiatives has been to invest in physical branches. Why?

Listen, every new channel that gets introduced, people love it. And it multiplies the number of transactions. I’m happy to report we are the largest digital bank in Canada. And we are rated No. 1 by App Annie, which is the industry standard. But 70% of our customers in Canada visited a branch in the last little while. And what we do in our branches, how those branches look, the type of service we provide, the level of advice we provide, is a lot different than it used to be.

Does that mean more branches? More people in the branches? Different functionality?

The physical nature of the branch is changing. You go to some TD locations and say, “Really? This is TD Bank?” There are branches in Canada, for example, where there is no cash! There are stores in Manhattan where there are no humans. This is what customers want, so we will adapt. And there’s a science to it.

How are the needs of customers changing?

They want to touch the bank in the way they prefer to touch it. So they want the best digital experience. And when desired, they want a branch interaction. And there, people want more than a transactional relationship. They want more information, more advice. The issue of confidence is playing an increasingly important role. Am I confident of what my needs are going to be down the road?

Let’s talk about succession. When Ed Clark was CEO, he saw you as somebody to groom for an eventual rise up. Did you talk to him? According to research I’ve done, he targeted you. Because you know a lot about Ed Clark’s mind. Well my question is, are you doing that for someone else?

You know, succession planning in a bank of TD’s size is always an important issue—at every level in the organization, not just my role. It’s a big board responsibility. It’s an ongoing exercise, and I think our bank does a pretty good job at it.

You don’t want to tell me whether or not you’ve got your eye on someone?

That's for you to find out.

09 January 2019

Banks Brush Off New Capital Rules, Saying They Have ‘No Impact’

The Globe and Mail, James Bradshaw, 9 January 2019

The chief executives of Canada’s largest banks are shrugging off tougher capital requirements introduced by the banking regulator, saying the change will have no impact on plans for acquisitions, dividend hikes or share buybacks.

Last June, the Office of the Superintendent of Financial Institutions (OSFI) revealed for the first time that the country’s six largest banks must hold extra capital, called the “Domestic Stability Buffer,” as an added cushion to help them cope in the event of an economic downturn. The regulator promised public updates on the buffer at least twice a year, and at its first opportunity in December, chose to boost it to 1.75 per cent from 1.5 per cent of a bank’s risk-weighted assets, starting April 30.

The move caught investors and analysts by surprise, as OSFI highlighted “systemic vulnerabilities” in Canada’s economy, suggesting that it is watching closely for signs of strain. Analysts speculated that OSFI’s swift move could fuel expectations that the buffer would continue to be nudged higher, adding to constraints imposed on banks since the last financial crisis.

But at a conference in Toronto on Tuesday, the CEOs of Canada’s big banks responded with a collective yawn.

“It doesn’t change anything,” said Toronto-Dominion Bank CEO Bharat Masrani.

Bank of Montreal CEO Darryl White said he sees “no impact” on the way he manages the bank, even if OSFI were to reduce the required buffer again, “because we wouldn’t chase them down.”

Royal Bank of Canada CEO Dave McKay said RBC will continue to “manage our surplus capital with the same margins," and Canadian Imperial Bank of Commerce CEO Victor Dodig said the move “hasn’t changed our view on what is the right level of capital for CIBC.”

An OSFI spokesperson declined to speculate on “future actions by the banks should stress conditions materialize,” but said that banks “are responsible for their own capital management strategy.”

In recent public comments, OSFI officials have voiced concerns over high household debt relative to incomes and uncertainty about housing markets, even as bank executives insist that Canada’s economic fundamentals are still sound. In raising the required buffer, OSFI assistant superintendent Jamey Hubbs said that “in light of positive credit performance and generally stable economic conditions, now is a prudent time for banks to build resilience against future risks to the Canadian financial system."

Currently, Canada’s Big Six banks must keep their common equity Tier 1 (CET1) capital ratios – a key measure of a bank’s resilience – at or above 9.5 per cent. That consists of a base level requirement of 4.5 per cent, a 2.5-per-cent “capital conservation buffer,” an extra 1-per-cent surcharge because of their size, plus the newly disclosed Domestic Stability Buffer. After April 30, the minimum will be 9.75 per cent.

Yet Canada’s six biggest banks had CET1 ratios ranging from 11.1 per cent at Bank of Nova Scotia, which recently completed a string of acquisitions, to 12 per cent at TD, as of Oct. 31, and appear to believe they’ve built adequate reserves.

“We’re so massively ahead of the buffer anyways, it doesn’t change anything,” said National Bank of Canada CEO Louis Vachon.