TDAM TALKS ETF Podcast: TBNK - Banking on the Fundamentals

ANNOUNCER:

TD Asset Management welcomes you to this week's podcast. As a reminder, this podcast cannot be distributed without the prior written consent of TD Asset Management. 

BRITTANY PUGLIA:

Hello and welcome back to TDAM Talks ETFs. A podcast about the exchange traded fund market in Canada and TD ETFs. My name is BRITTANY PUGLIA. I am the manager of ETF Business Development here at TD Asset Management. In this episode, we'll be discussing the Canadian banking sector and the TD Canadian Bank Dividend Index ETF, Ticker: TBNK. 

Canadian bank stocks have a ten year annualized total return of approximately 10% and a return on equity of 14%. We compare this to the 7% average annual total return and 10% return on equity of the broader Canadian stock market. Historically, of the big six Canadian banks, the ones that increased their dividends the most were the ones that performed the best. 

Today I am joined by JAMES HUNTER, Vice President on our fundamental equity team, and CHAD WOOD, Vice President on our product development team. Thank you both for being here today. 

JAMES HUNTER:

Thanks for having us.

CHAD WOOD:

Yeah, thanks!

BRITTANY PUGLIA:

Chad, we hear about the banks in headlines so often. Can you please share with the audience a little bit about what you do at TDAM and why did we create a bank ETF?

CHAD WOOD:

Yeah, and again, thanks for having us. And first off, I think we have a pretty cool solution to talk about today in terms of, ETFs on the marketplace. So we're very excited and we think our clients are really excited to invest and we think they're going to see value in a product like this. And I’ll get into it , who am I?

So I work on the ETF Product Strategy team here at TDAM and I'm going to say TDAM probably a couple times - that means TD Asset Management just in case. You know, there's a lot of acronyms out there. So I work on the Product Strategies team. So really our job is two-fold. First, we make sure the products that we do have are doing what they're supposed to do. 

So we design them to, for example, give you technology exposure that we need to make sure that those ETFs are giving you technology exposure. Or if it's to give you income, we make sure it's giving you income. So that's like one aspect of our job is to really manage the products that we have from a product design point of view.

The other side of the mandate would be on the development side, so developing new strategies and - what are the clients demanding? And that's where we can really talk about why did we create a bank ETF? And what the clients were asking us when we were at conferences and meetings was, Hey, how do I invest in the banks?

Do you have a product for us so we can do that? And at the time, the answer is no. But, you know, we listen to our clients, we find out what they're demanding, and then we look at the numbers as well. So we do our own research. And in the last year alone, there was over $2 billion that went into Canadian bank ETFs.

So, yeah, exactly. So lots of demand. So people aren't only, you know, they're putting their money where their mouth is, like they're asking for it. But they're also investing in it. And why wouldn't they, at the end of the day, Canadian Banks over the long term, like you said, to provide over 10% annualized returns for, I think over 20 years?

They provide great income. They've been increasing that income and giving you those solid, total returns. So that's why we're launching this and we're adding this to our lineup. An ETF vehicle is perfect to do it because it gives easy access to these banks. So instead of buying six banks, you can buy one product. It gives you access to all of them.

So that would be the main reason why we're launching.

BRITTANY PUGLIA:

Fair and as an American and don't hold that against me, I am familiar with many U.S. large cap blue chip stocks. Here in Canada, the banks really are the large cap blue chip stocks. So using an ETF makes sense because that investor would own a basket of them, still receive the dividend that they pay out and have an easy way to continue to add to their investment over time, all without having to manage what to buy and listening to the earnings calls.

Chad can you tell us more about the evolution of bank ETFs here in Canada?

CHAD WOOD:

The evolution of bank ETFs in Canada - well, first off, they've been in Canada for a long time now, over a decade, I think almost 15 years. We've had bank ETFs in Canada. So which is great because it gives, like we said, the it's a diversification for investors looking for that income, looking for that growth all in one product.

What we really saw first was the equal weight approach. So what that means is you get exposure to all the banks, but you put the same amount of money in each of the banks. And just to be clear, too, and we talked about the banks, which banks we're talking about, so we're talking with TD, Royal (RBC), National (Bank), CIBC, BMO and Scotiabank.

So those are the big six banks in Canada. So any ETF we talk about today, our ETF follows those big banks. So like I said, started it with equal weight approach. So what that's basically doing is giving an average return of all the banks very easy and very simple to get access to them. And then from there, we started to see companies innovate and change that approach a little bit.

So then we saw a few years ago a dividend yield approach. So you put more weight in companies that are in the banks that are yielding more of a dividend. What's a dividend yield, you ask? It's dividend that the bank is paying divided by the current price and that will be a yield. So how does that change? Well a dividend can go up or down.

Usually we're hoping it goes up so the yield will go up, but dividends only change maybe once or twice a year. So not very often in the banking world, but the price changes every day. So if the price goes down 20%, your yield is going to go up by a lot too. So that strategy can be successful if there's mean reversion that happens.

And then what's mean reversion? Well, “mean” means average reversion means to come back to you. So coming back to the average, so if that you went up, that could be because of stock down. And so I don't get too technical but those strategies can do well if the, losing companies do better and the winning companies come back to the mean.

And from there, we also see strategies that put an emphasis on that mean reversion. So we actually have strategies out there where if you believe in mean reversion is happening in the banks, then you can buy, strategies that - there's going to be companies that did poorly last quarter. They would overweight those. There are going to be companies that did well last quarter you're going to underweight those hoping that it's all going to merge to the mean and in that way, I would say outperform equal weight.

So those are those couple of strategies on the on the marketplace today and they're all great because they give you that instant diversification we're talking about and giving you access to the big banks. But the main thing that we took away, the underlying theme is they're either trying to play to that mean reversion or just give you the average return of the banks.

So that's what we're seeing today.

BRITTANY PUGLIA:

Got it. Okay. Well, then tell us what makes TBNK or “T Bank” different from what already exists.

CHAD WOOD:

And that's kind of what our main goal was. And don't worry, listeners, we're going to make sure James is going to talk way more than me because he has way more insights into the banking world and it's a treat to hear him cover this stuff. So he's definitely going to be answering questions. And in terms of how we made a difference, I'm going to start with what we did and then I want to explain kind of why we did it.

Like you said, “T Bank,” ticker TBNK, the TD Canadian Bank Dividend Index ETF. And basically what we did is we took the price equation. So we don't want to have price be a reason why we put more weight into a bank or put less went into a bank. And so what we did is we actually follow a fundamental driver of growth, which is dividend growth. 

So - what is dividend growth, first of all? So what we do is we take a look at the dividends paid the last 12 months of each bank, compare that to the previous 12 months and look at the growth. We then rank it from 1 to 6 and then from there, if you're ranked first, you're going to get around 28% of our ETF.

If you're second ranked and dividend growth gets a 23/24%, and then if you're sixth ranked all the way down, you'll get around 5%. So we're really overweighting the banks that are that are growing their dividend. And we believe that's going to be an approach that investors can understand and simple and sets them up for success in investing in this category.

And I guess to finish off, why did we do that? And that's where we really ask ourselves two questions: Is there demands for the sector? We’ve already answered that. Yes, people are asking there's billions of dollars going into it. And the second question is: is there room for more innovation? We already saw a couple of innovations out there.

Is there room for us to do the same thing? And we thought that answer was yes. And like I said, there was a common theme among the current strategies that there. So we wanted to improve on that. And the way we really did that is we looked at the 20 year history of all the banks and it's the same story for 20 years.

But we really look at the six banks. How did they do over 20 years? And then we rank them, but we really saw was there was a top three group and a bottom three group. They both did really well, but that top three group of performers gave you 13.1% over the last 20 years, which is, you know, like “Sign me up!”

BRITTANY PUGLIA:

Definitely.

CHAD WOOD:

That's awesome. But then the bottom three group was 9.8%, which again is amazing. But I still would rather that top group. So we started to wonder like 20 years ago if we had to invest in the Big Six banks, how could we have done it in a way that still give you exposure to all them, but maybe gave you more exposure to those top three?

So when we looked into dividend growth and this is a conversation with James and you know, what metrics can we look at for banks? We saw that the top three dividend growers were also those top three performers that you said in your intro. And the bottom three different girls are also the bottom three relative to each other, of course.

So that was, you know, confirmation. And we built a model and we really think that this approach is a differentiated story out there and gives a unique product to clients and the product that they're asking for. So we're pretty excited about it. So that's, that's how we're different and I'll definitely pass it over to you and James to maybe talk a little bit more.

BRITTANY PUGLIA:

Well I think it's great that product and James, for example, you cover financials and you research these companies all day, every day. So to have that conversation of knowing what our clients are asking for, going straight to the source to figure out what's the best way of doing that, and then bringing that to market is pretty cool.

So James can you tell our audience more about what you do at TDAM and what do you feel are the fundamental drivers that are most important?

JAMES HUNTER:

Sure thing. Yeah, my career. It started just after the financial crisis, so that was a tricky time to start. But I found my way to TD Asset Management in 2014. So this is my ninth year and I've been very lucky to cover many different parts of the market: energy, utilities, real estate and now the banks and insurance companies.

Although I joke with some of my colleagues, I only seem to cover sectors when they're going through really tough times. So my fear has a lot more gray hairs now, definitely passionate about research. I love covering the financial sector and in doing that, I guess I've learned your question, Brittany, there are two fundamental drivers for the bank stocks.

So the first thing I'd point to is the economy. When the economy's growing, the banks, they benefit from faster loan growth. So you can think of mortgages, business loans, credit cards, you name it. And a strong economy will also go hand in hand with a healthy job market and that will result in fewer bad loans that helps profitability.

So that's the first driver, the economy. And the second driver would be interest rates. So rising interest rates are good for banks; net interest margins. But if you also think about when rates go from what we see in the last few years, like 1% to 4% in a short period of time, investors don't rush to sell financial stocks at ten times earnings, but they will scrutinize valuations in other sectors 20 times, 30 times earnings.

So the bank stocks in that environment will be more resilient. And the opposite effect sort of plays out. When interest rates decline, the economy will slow, margins go down, provisions set aside for bad loans, they rise. And so the earning power erodes a little bit and investors look to other parts of the market.

BRITTANY PUGLIA:

So in your experience, have you seen banks change in recent years?

JAMES HUNTER:

Yeah, that's a good question. And I would say that there aren’t huge differences in banking from year to year, but you can see the changes unfold over longer periods of time. And one of them that is interesting in Canada is that we have far more exposure to the U.S. than we used to. So if you roll back the clock ten years ago or so, President Obama's in the White House,

we're coming out of the global financial crisis. Well, at that time, under 10% of the earnings from the big six banks were from the US. That number has roughly doubled compared to today. High teens, 18, 19%. And that's great because it means we have more revenue diversification, but we retain all the prudent regulation and oversight that we have here in Canada. 

Another change that I would point to is customer behavior. We've gone digital. So the Canadian banks, they operate with fewer branches than they used to an interesting metric that we used to talk a lot about was automated teller machines. Do you remember those? Well, now more than ever, people are paying for things on their phones.

They're making credit card applications online. And so we count the number of active digital users. So that's a meaningful change. And the banks have benefited by being able to control their costs and become more efficient. And I should also mention integration. So the banks are becoming more integrated. People don't just have a mortgage, they might have a wealth management solution, home or auto and insurance, tax and estate planning.

The list goes on from there. So the banks, they're more digital and they're more diversified than ever before.

BRITTANY PUGLIA:

Looking back, we have seen them evolve. Are there any trends that you see coming on the horizon for banks?

JAMES HUNTER:

There are lots. There's lots we could talk about. I think the one that is probably worth mentioning is the exciting world of regulation. Authorities - fasten your seatbelts here - because the banks, they want to keep them safe. So we're talking a lot more spending a lot more time talking about capital adequacy, funding, liquidity - like real bank fundamentals.

JAMES HUNTER:

And that scrutiny, I think it's going to rise as the banks get bigger and it can also be amplified in periods of financial instability or opaque areas of the economy. If you think about cryptocurrencies, another thing we're spending more time thinking about, of course, is environmental, social governance, ESG issues and all of that. It could be good or it could be bad for the banks. Bad if we have a little bit lower return on equity, but good if it entrenches the competitive advantages that the banks already have and for now, it's too soon to tell.

BRITTANY PUGLIA:

Well, you mentioned our revenue sources coming from the US. How are Canadian banks similar or different to U.S. banks?

JAMES HUNTER:

Yeah, I'm glad you asked that because there are some big differences and they're worth knowing about. So the first one I'd point to is industry structure. In the U.S. there are over 4000 banks, biggest ones like JP Morgan, Bank of America - they're very well diversified, but the smaller ones, not as much. They offer traditional retail lending, local communities.

That's very different than how we do it. Here in Canada, we have 80 regulated banks, 35 of those are domestic. But the big six, the ones that will be in the ETF, they have a huge market share, about 75% in mortgages. It would be even higher in customer deposits. So Canada is a consolidated industry and that gives us more price discipline, which is a good thing.

Another difference is regulatory. The US banks there scrutinized by four oversight bodies. You've got the Fed, the SEC, the FDIC, the Comptroller of the Currency. In Canada, it's mostly just OSFI- and it's a shorter list. What it means is that you have fewer banks - you've got fewer regulators. So they're stronger, but also very faster levels of coordination within the banking system.

And that helps protect customers. Of course, safe and satisfied customers. That's essential. And we do that pretty well here in Canada. And there is one other thing to consider, which is deposits - the US banks, they have to compete very hard for their deposits because of the fragmentation that I mentioned. Higher funding costs can hurt your profitability, but if you have deposit flight that can result in more serious issues, and we've seen that recently, not only in the US but in other parts of the world.

So the good news is that Canada has twice the population growth of the US, 1.2% versus 0.6%. And that may not sound like a massive difference, but it means a lot and it means that there's more depositors and customers coming into the system regularly and that helps, keeps things stable.

BRITTANY PUGLIA:

Well, this is also helpful for investors who want to invest in the large Canadian banks. Do you have any final thoughts for our listeners?

JAMES HUNTER:

Yeah, I think that having a profitable growth runway is very important for any long term investment and the Canadian banks do have this in spades. Immigration policies bring in a large number of very educated people to our country, so that's a huge source of customer growth. Banks are becoming more efficient, as I mentioned. They can also allocate their capital through acquisitions and so that profitable growth marries up nicely with an ask that we hear from our clients, which is I need investments to generate income and steady growth.

And I think this is the exciting part of Canadian banks and specifically “T Bank.” You get a yield over 4% and then that grows in the high single digits. So it's really the best of both worlds.

BRITTANY PUGLIA:

That's great. And bringing it back to product. James, do you have any final thoughts for our listeners today?

JAMES HUNTER:

Well, first off, I know we have the right man in the job as our banking analyst when he says he's excited by financial regulation. So I'm glad, James, you're doing that job. And I'm not. But yeah, final words. I echo what James says. Like, if you're an investor looking for ... A: you might like the banks for whatever reason.

But their main reasons are they provide income. They've been growing that income historically have provided really good returns on top of that income. And if you're looking for a diversified way to do that, we think “T Bank” is an excellent product to have and we think you'll find value.

BRITTANY PUGLIA:

Definitely.

CHAD WOOD:

But I think the next step for a lot of our listeners, too, is - how can you purchase an ETF? And maybe you do this all the time, but at the end of the day, can you let us know, you know, what's the best way to purchase this ETF? How can you get access?

BRITTANY PUGLIA:

Sure can. So for those, do it yourself investors out there, you can trade “TBNK” through your discount broker. For the investors with financial advisors, you can ask your advisor about purchasing TBNK. And the great thing about utilizing an ETF is that because it trades on an exchange, they're so widely available right from the day they launch. For all of you listening, we thank you for tuning in and considering TD ETFs for your hard earned savings and investment accounts.

We at TD are fiduciaries and have the best interests of Canadians in mind. We manage money for Canadians by Canadians with the lens of the Canadian investor. Not all ETFs are created equal and we put a lot of thought and diligence in bringing to market solutions for investors problems. Thank you, James and thank you, Chad, for taking time today to dove into the Canadian banking sector and more specifically, diving into our TD Canadian Bank Dividend Index, ETF, TBNK or “T Bank,” highlighting the quality and strength of this product as built for Canadian investors.

BRITTANY PUGLIA:

For more information on TBNK or any of our TD ETFs, please visit “tdam.com/ETFs”. Follow us on Twitter at “tdam_Canada” or LinkedIn under TD Asset Management to stay up to date on all ETF related podcasts and more. Lastly, if you have any comments or suggestions on what you'd like to hear more of, please email us at ”td.tdamtalks@td.com”

Thank you all for joining. Have a great day.