portfolio advisory group - managed money reporter · portfolio advisory group summer 2009 3...

Portfolio Advisory Group

Summer 2009 1

Contents Page

Executive Summary

2009 Summer Outlook 3

Economic Outlook

What Kind of Recovery Will Shape Market Performance? 5

Portfolio Strategy

Global Strategy Outlook – Summer Update 9

Canadian Equity Strategy

Sprinting to Start a Marathon? 13

Feature Article

What You Need to Know About Exchange Traded Funds 21

Fixed Income Strategy

Where Are We Now, Where Do We Go From Here? 24

Preferred Share Market Update

As Confidence Increases Positive Returns are Generated Across the Board 28

Insurance

Recreational Property Succession Planning with Insurance 32

Guided Portfolios 34

Canadian Core 34

Canadian Income Plus 36

U.S. Core 38

North American Core 40

Core-Plus Fixed Income 42

Investment Portfolio Quarterly

2

The author(s) of the report own(s) securities of the following companies. Research In Motion Limited, The supervisors of the Portfolio Advisory Group own securities of the following companies. None. The Head of Equity Research/Supervisory Analyst, in his/her own account or in a related account, owns securities of the following issuer(s): Research In Motion Limited The Fundamental Research Analyst/Associate has visited material operations of the following issuer(s): Research In Motion Limited


Summer 2009 3

Executive Summary

2009 Summer Outlook Stewart Hunt — Managing Director, Portfolio Advisory Group

Whenever I write the outlook portion of the Investment Portfolio Quarterly (IPQ) I like to review the previous quarter’s comments in an attempt to maintain continuity and consistency when guiding our clients. In the spring outlook I noted my trip to the University of Pennsylvania’s Wharton School where I had the pleasure of hearing Professor Jeremy Siegel express his views on the market. Professor Siegel noted at the beginning of March 2009 the current S&P 500 Index was 3.5 standard deviations below the mean of its long-term trend line. The last time it was even close to being this low was 1981, which is considered to be one of the best times to buy stocks over the past 28-years. In addition, it was the first time in 50 years the dividend yield on stocks was higher then the 10-year Treasury yield. Professor Siegel said, “Stocks look very reasonably priced compared to historical levels and long-term investors will be very well compensated at current prices”. Interesting, investors who did participate at the beginning of March were handsomely rewarded as North American equity and bond markets bounced off the canvas with some very impressive returns.

Unfortunately, as Scotia Capital Strategist Vincent Delisle has pointed out, the majority of fund managers and retail investors stayed in the comfort of cash and money market instruments and thus missed the first upward leg of the market recovery. More importantly, for fund managers who stayed on the sidelines, they are now under performing the market and will have to either rely on the market retracing some of the current gains or deploy cash in fear of missing further market upside potential.

As we move into the second half of 2009 the, “sell in May and go away” combined with the peak in 10-year treasury yields suggests we are in for a period of market consolidation as investors look for the “green shoots” of an economic recovery before getting back into the market. For the fund managers who have stayed on the sidelines the opportunity to get back into the market may present itself as a period of consolidation or retracement and may allow them an entry level below the market highs of June. As Scotia Capital Strategist Delisle points out the coincident economic indicators, Institute of Supply Management for Manufacturing and Non Manufacturing businesses and leading economic indicators, are all pointing towards a recovery. Combined with stabilizing employment numbers these indicators should give greater comfort we are moving in the right direction. For investors who missed the opportunity to participate in the March market rally, you may find your chance to get back into the market in the summer or fall of 2009. Just remember there will be some fund managers looking for the same opportunity.

Here are some of the highlights of the Summer 2009 IPQ;

Scotia Capital Economists Derek Holt and Karen Cordes, while supportive that we will see an economic recovery in the months ahead, expresses their concerns about the sustainability of the recovery throughout 2010 and beyond. Holt and Cordes discuss three main concerns: resuming production provides only a one-time lift to growth; recovery to be limited by ineffectual monetary policy; limits to the powers of fiscal stimulus. Although these concerns could be on the horizon, they see the recent market pullback as an opportunity to buy cheap equities in anticipation of a rally later this year.

Scotia Capital Portfolio Strategist Vincent Delisle, as noted above, believes we are moving into recovery mode and has deployed his cash position into equities, preferring North and South America. While remaining relatively neutral from a sector perspective, Delisle is preparing to move from defensive sectors into cyclical sectors of the market, taking advantage of the equity markets preceding the economic recovery.

Gareth Watson takes us through some of the key points of consideration for getting the Canadian economic recovery on track. In addition, he addresses the key sectors of the Canadian equity markets and what investors should be considering when the recovery takes hold.


4

Paul Danesi provides our feature article on Exchange Traded Funds (ETFs), currently the fastest growing investment product in the market. Danesi writes about the ETF market, how it trades and is structured, the various ETFs available highlighting the benefits and risks associated with owning ETFs. There has been a significant amount of media coverage on this product and Danesi’s article is worth the read.

Tara Quinn gives an update on the Canadian preferred share market which has been one of the top performing asset classes in 2009. Quinn highlights the dramatic growth in the rate reset preferred market and the top performing issues year-to-date.

With credit spreads on corporate bonds having reached historical highs in the latter half of 2008 and early 2009, opportunistic investors who took advantage of the value being presented are now sitting on some tidy profits. Is now the time to sell? Chris Kennedy writes about our fixed income strategy as credit spreads and the yield curve begin to adjust as investors move away from panic mode.

Susan Forint provides some life insurance solutions when thinking about recreational property succession which could be extremely valuable for people wanting to bequeath their “heaven on earth” to their loved ones.

In conclusion, Steve Uzielli and Chris Kennedy provide their quarterly review and commentary on the performance of the Equity and Fixed Income Guided Portfolios.

Our Summer 2009 edition of Investment Portfolio Quarterly (IPQ) is designed to provide you with some ‘food for thought’ to activate your cash or diversify your portfolio. This is a great time to be contacting your advisor to determine what investments best suit your investment needs.

Stewart Hunt


Summer 2009 5

Economic Outlook

What Kind of Recovery Will Shape Market Performance? Derek Holt MA, MBA, CFA Karen Cordes, MA

It has been a no-brainer for forecasters to call for global, U.S. and Canadian GDP growth to go back in black later this year after a tumultuous ride since last fall, as we’ve been arguing since late last year. But, it is the sustainability and strength of recovery throughout 2010 and beyond that lie in much more serious doubt. That makes us skeptical of straight-lined here-to-Nirvana forecasts for growth and markets, and we therefore advise an active versus a passive approach to managing portfolios.

Frankly, up to a point, we think the economy will recover regardless of policy, and it will do so on technical distortions. Deleveraging is the first major synchronized, global and systemic shock to hit the just-in-time inventory and lean manufacturing model, and the result is that it takes the world from total shut-down mode in key industries during 2008Q4 and early 2009 toward a "recovery" phase when production recommences once excess inventories have been pared. Flicking the production switch off, and then back on again a few quarters later on its own could well be enough to pop GDP higher at least for 2-3 quarters starting later this year, and perhaps with one or two fairly impressive quarters mixed in. Such an observation hardly proves our mettle as forecasters. Economic recovery much beyond that, however, requires a significant improvement in private demand, and for fiscal and monetary policy to work. Our hopes and wishes are confronted by our concerns on each of these three counts.

1. Recommencing Production is Only a One-Time Lift to Growth

First, the impact of the start-up phase of production on GDP growth is likely a one-time lift followed by a structural overhang that will persist for years to come. The structural overhang is a consequence of the 2004-07 period when businesses and consumers transferred future sales to that time period on excessively generous financing terms. Too many consumers were put into homes and autos, and made complementary purchases, earlier than would have otherwise been the case. Furthermore, too many industries fooled themselves into believing that what they were doing was sustainable so they built capacity to that distorted peak in demand. As a consequence, we are now stuck in a period marked by a relative demand vacuum with vast amounts of spare capacity across many industries. That will remain disinflationary for years as commodities perhaps threaten headline inflation but core pricing power remains virtually nonexistent. Thus, our first concern is that recommencing production from very low levels of activity will then lead to a plateau in production volumes without significant sustained demand growth to carry the ball further, as consumers remain cautious and businesses face little reason to invest in more production capacity.

2. Recovery to be Limited by Ineffectual Monetary Policy

Second, monetary policy is so far having little effect on the real economy and credit flows because the U.S. faces a so-called liquidity trap. This is defined by the fact that stimulus that has so far been pumped into the economy is getting bogged down via cash stockpiling within the U.S. banking system as low interest rates and increased money supply fail to attract creditworthy borrowers. Rate cuts and credit purchases have worked to avoid a far more dire consequence relative to the unknown state of the markets and economy that we'd be facing if the Fed had not engaged in such actions. But, we think the evidence so far is that while prices and spreads have improved, properly measured volumes that don’t involve cherry-picking particular credit products have not. Money demand is simply proving to be insensitive to rates, and that limits the ability of monetary policy to stimulate the economy. That may change, but change for the better remains a future hope that is presently rooted in overwhelming evidence of a liquidity trap facing monetary policy.

Consider the evidence. Since the Lehman days, cash on hold at U.S. banks has soared by about $700 billion to over $1 trillion. U.S. banks have been significantly recapitalized and their funding positions have sharply improved as a first necessary step in dealing with the crisis, but the funds are bogged down


6

with a lack of creditworthy borrowers. As the Fed’s balance sheet has expanded, along with a 9% y/y gain in M2 money supply, most of the policy injections have come right back into the U.S. banking system's balance sheet via deposits that are included in M2 (Exhibit 1). Those excess deposits are feeding interest-bearing excess reserves on hold at the Fed as banks redeposit the proceeds (Exhibit 2). Small wonder banks are also paying back TARP, as they have few profitable opportunities for this cash glut, versus having a strong desire to cut ties to government that would otherwise entail taking directions on pay structures, and lending targets. In a pecking order sense, the highest cost of capital may well be attached to government-provided funds. The dearth of borrower opportunities is reflected in Exhibit 3, as government debt issuance may have soared but combined household and business borrowing in the private sector across all lending products combined has utterly collapsed and so has financial institution issuance despite some bright spots. There simply are no easy fixes to reallocating this cash glut, other than the passage of a great deal of time in which borrower balance sheets must be repaired before borrower appetite returns.

3. Limits to the Powers of Fiscal Stimulus

Third are fiscal policy concerns on three broad counts. First, its stimulative effects on growth are very short-lived over late 2009 and 2010H1. With existing stimulus plans, the speed with which fiscal stimulus peaks and then turns downward by 2010H2 and beyond has the potential to shave GDP growth by an offsetting amount to the earlier lift effect.

As well, bond markets threaten to neutralize the effects of fiscal stimulus because of concerns over the creditworthiness of governments and the amount of debt they are pumping into markets. To this effect, one simply can't be a bond bear and be simultaneously bullish on the impact of fiscal stimulus on growth, since if bond yields spike, then it will be the market’s actions toward pricing away fantasyland hopes for a free lunch to be had via the effects of fiscal stimulus. Fiscal stimulus won’t work if you’re back to paying north of 6% on a 30-year fixed mortgage. Ditto on corporate bond yields if the rise in sovereign yields offsets or surpasses improvements in spreads, leaving corporate bond yields at 7-9% or higher that impede hurdle rates on projects that likely have lower expected returns on excess industry capacity. The fact that bond yields have recently fallen again raises the hope that fiscal policy can meaningfully impact growth, but this effect could be short-lived if bond yields surge again by year end and into next year while the recovery evidence rolls in.

Exhibit 2: U.S. Excess Reserves at Depository Institutions

Source: U.S. Federal Reserve

Exhibit 1: Deposits at U.S. Banks

Source: Federal Reserve Board


Summer 2009 7

That free lunch also goes out the door if households continue to hoard almost all of the tax relief and spending measures, as they have so clearly done over the past year and a half. This is where Ricardian equivalence (from 19th century economist David Ricardo) may come into play, which is the notion that households will save deficit-financed government transfers in anticipation of having to pay it all back at a later date through higher taxes and/or lower transfer spending. As a result, the transfers do not end up representing net stimulus to the economy. Governments think they can stimulate consumption through net transfers to the household sector, but that relies upon households believing they’ve been on the receiving end of a free lunch and won’t have to pay for it later. Instead, households are indeed looking a gift horse in the mouth; in almost nickel-for-nickel fashion, U.S. households have taken new monthly fiscal stimulus at various points over the past year and a half and socked it away in deposit accounts (Exhibit 4). We’ve defined new monthly stimulus as equal to monthly changes in total taxes paid to capture varying influences of tax rebate cheques and end-of-year refunds, plus increases in gross social benefit transfers from governments to households. Indeed, the administration of U.S. President Obama is frankly doing its best to communicate expectations of a higher future tax and environmental policy burden. At best, they are likely to spend small portions of such stimulus, and sock away the rest to pay for future discounted taxes which would not lead to as large a pop in consumer spending as hoped. Although Ricardo himself did not ultimately give much credit to households for being so forward thinking and thereby discounted the masses as being not that bright after all, every theory has its day in the sun; today’s nearly historic period of deleveraging could well be such a period, and the evidence to date supports this.

So What Does it All Mean to the Markets?

The key investing implication is such that we think investors should use the opportunity presented by a risk aversion play this summer that entails taking profits on an earlier runaway spring rally to buy relatively cheap equities in anticipation of a rally later this year and early next at which point profits should be taken on double dip concerns that are likely to arise later next year and beyond. Throughout it all, we believe that inflation risks are grossly over-estimated within at least a medium-term time frame and defined as most central banks tend to look at it in terms of core inflation excluding commodities. In fact, if inflation risks are material, they’ll show up first in commodities, and higher commodities will crowd out pricing power for other industries in an environment in which household cash flows and credit access remain impaired. That would be further disinflationary on core CPI, and accordingly, the linkage between headline CPI inflation and core CPI inflation will remain as broken as it has been since the late 1990s (Exhibit 5).

Exhibit 3: Only Government is Borrowing

Source: U.S. Federal Reserve Flows of Funds Accounts, Scotia Capital Economics

Exhibit 4: Americans: Saving Their Stimulus

Source: Bureau of Economic Analysis


8

A similar situation exists in Canada in that the real green shoots will not likely sprout until later this year and next but, given that Canada has lagged on inventory adjustments (Exhibit 6), economic recovery in Canada will likely lag growth in the U.S. in both timing and intensity. Less fiscal support will also limit Canada’s recovery. However, Canada does have an advantage given its resource-rich terrain, especially as both emerging and developed countries start to improve at roughly the same time, putting substantial upward pressure on oil prices. The country’s major stock market also speaks less to domestic fundamentals than to commodities and financials, both of which are likely to prosper as better cyclical data flows in. After a summer lull, this should all provide a lift to the Canadian dollar and help support the buy-Canada story in the medium-to-long term.

Exhibit 6: Canada Lags Inventory Adjustments*

Source: Statitics Canada and BEA

Exhibit 5: Inflation Disconnect

Source:BEA


Summer 2009 9

Portfolio Strategy

Global Strategy Outlook – Summer Update Vincent Delisle — Portfolio Strategist, Scotia Capital

Pro-Cyclical Stance Maintained

We believe the worst of the global recession is behind us and expect global growth to pick up in the latter half of 2009. Under that scenario, equities, cyclical sectors, and corporate bonds should extend their 1H/09 leadership, and outperform over the next 12-18 months. Admittedly, the capital market climate is filled with structural challenges that will have implications on the potential and durability of the recovery. For one, rising long-term bond yields and commodity prices threaten renewed optimism. Moreover, the Federal Reserve’s exit strategy promises to keep things very interesting. Nonetheless, we believe current perceptions – not to mention defensively positioned portfolios – are underestimating the 2010 possibility of economic and profit growth. The U.S. housing market has been showing signs of life recently, with affordability hitting all-time highs. In addition, the U.S. savings rate reached a 15-year high of 6.9% in May on the back of increasing disposable income. In our opinion, improving news flow will translate into funds flows being reallocated into equities, thus sustaining additional gains.

Although equities have posted robust gains in Q2 (MSCI World +21%), the rally lost momentum in June, and the broader market has been flatlining since early May. As depicted by our panic-euphoria indicator, the S&P 500 had reached extreme overbought levels in May and the rally was bound to consolidate. We believe improving fundamentals (rising EPS estimates) and technicals (S&P 500 golden cross was achieved late June) will support further gains in coming months. History suggests that S&P 500 rebounds from bear market lows gain steam after a golden cross confirmation. Since the advance from March lows has already been substantial, one could make the conservative case that we are at the halfway mark of the S&P 500 retracement. Nonetheless, this would peg the S&P 500 closer to the 1,200 level at its next peak.

Exhibit 1: Scotia Capital Financial Forecasts Scotia Capital Financial Forecasts

2008 2009 E 2010 EEquity

S&P/TSX 8,988 EPS 950 600 750S&P 500 903 EPS 49.50 55.00 72.00

Interest RatesBoC 1.50% 0.25% 1.75%CA 10-Yr 2.68% 3.70% 4.80%Fed Funds 0.25% 0.25% 2.00%US 10-Yr 2.21% 4.00% 5.10%

Currencies & Commodities (Yearly Average)

CAD (USD/CAD) 1.07 1.06 1.00EUR-USD 1.47 1.50 1.60USD-YEN 103 95 85USD-MXN 11.2 13.9 13.9WTI 99.92 63.00 90.00Natural Gas 8.90 4.25 6.00Copper 3.15 1.90 2.30Gold 872 940 925

12,000

1,150

Source: Scotia Capital, Scotia Economics

Exhibit 3: Scotia Capital Equity Mix – Summer 2009 Change from

Benchmark Recommended Last QuarterTSX 20% 24% 1%S&P 500 30% 30% -2%Int'l (Europe+Japan) 30% 23% 1%Emerging Markets 20% 23% 0%

Equity Mix

Source: Scotia Capital

Exhibit 2: Scotia Capital Recommended Asset Mix Change from

Benchmark Recommended Last QuarterEquities 60% 68% +3%

Bonds 38% 28% Gover nment 28% 15% Corporate 10% 13%

Cash 2% 4% -3%

Asset Mix

Source: Scotia Capital


10

Economic growth expected back in second half of 2009

In its most recent Global Forecast (June 4, 2009), Scotia Economics increased its GDP growth outlook for 2H/09 and 2010. As dire as the 2009 economic picture looks, capital markets are feeding on the prospects for 2010 and beyond. And since investors were pricing in a depression scenario earlier this year, moving back towards a recovery has inspired a spectacular rally in equities and corporate bonds since early March.

Lagging data (unemployment rates rising, negative revisions to 2009 GDP forecasts) remains challenging, but there have been numerous signs of stability/improvement in coincident data throughout the second quarter. The ISM and PMI indices have been rebounding globally, and the coincident-to-lagging ratio has turned higher since April. The latter indicates that we are in the very late stages of this U.S./global recession, and further validates the change in market leadership witnessed since March. Global leading indicators have also turned the corner and point to a return to growth in coming quarters.

Strategy View Unchanged: Adding Offence

Asset mix. Our 2009 strategy theme of overweighting cyclical assets remains unchanged. In our opinion, the risk-reward profile for equities is highly appealing and we expect improving data to provide support in coming months. Based on our belief that the Fed will start tightening by mid-2010, we are raising equities by 3%, to 68% (from 65%) and reducing cash to 4% from 7%.

From a tactical perspective, however, our three-month rolling S&P 500-to-bond chart points to some near-term caution. 200-day moving averages (888 on S&P 500, 9,350 on TSX) should represent strong support levels and great entry points for tactical investors.

Global equity strategy. Our global bias remains unchanged: overweight America (North & South) & Emerging markets; underweight Europe and Japan. We are further adapting our global equity strategy to a scenario where commodity-sensitive currencies will appreciate relative to the U.S. dollar by lowering our S&P 500 recommended weight by 2% to market weight and raising Canada by 1%. We are also adding 1% in Japan. The euro and Japanese yen are also expected to strengthen versus the greenback, albeit to a lesser extent.

Our geographical focus is also geared towards markets that combine relatively stronger domestic fundamentals and sensitivity to commodities. In our opinion, Canada, Brazil, and Mexico score higher than the United States in that regard. Moreover, the S&P 500 benchmark is roughly 33% weighted towards low beta/defensive sectors.


Summer 2009 11

Earnings & Targets

S&P/TSX. Our top-down S&P/TSX earnings model yields $600 (-37% year over year) for 2009 and $750 in 2010. TSX earnings were 33% above trend in 2008, but we believe the violent collapse in 2009 will bring profitability levels 20% below trend. Trend earnings should hit $805 in 2010. Using a 16x forward multiple on our 2010E earnings, we derive a 12- to 18-month target of 12,000 for the S&P/TSX index.

S&P 500. Our top-down S&P 500 earnings model yields US$55 for 2009 and US$72 in 2010. S&P 500 earnings were 25% above trend in 2007, but have fallen 25% below trend this year. Trend earnings should hit $76 in 2010, a level closer to our forecast. Using a 16x forward multiple on our 2010E earnings, we derive a 12- to 18-month target of 1,150 for the S&P 500.

Exhibit 5: S&P/TSX Trend Earnings

0

200

400

600

800

1000

1200

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

S&P/TSX EPS

CAGR (1956-2005): 5.9%

SC Forecasts2009E $6002010E $7502011E $825

Source: Scotia Capital estimates

Exhibit 6: Scotia Capital Top-Down S&P 500 Earnings Model

$72

$55

0

10

20

30

40

50

60

70

80

90

100

Dec

-71

Dec

-73

Dec

-75

Dec

-77

Dec

-79

Dec

-81

Dec

-83

Dec

-85

Dec

-87

Dec

-89

Dec

-91

Dec

-93

Dec

-95

Dec

-97

Dec

-99

Dec

-01

Dec

-03

Dec

-05

Dec

-07

Dec

-09

Dec

-11

S&P 500 EPS Model

S&P 500 Actual EPS


Exhibit 4: Scotia Capital Top-Down S&P/TSX Earnings Model

600

825

750

0

100

200

300

400

500

600

700

800

900

1000

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

0

100

200

300

400

500

600

700

800

900

1000

Model

TSX EPS

Forecasts

Source: Scotia Capital estimates; IMF

Exhibit 7: S&P 500 Trend Earnings (1900-1999)

55

72

87

0

10

20

30

40

50

60

70

80

90

100

1949

1953

1957

1961

1965

1969

1973

1977

1981

1985

1989

1993

1997

2001

2005

2009

2013

Trend Earnings: 1900-1999 CAGR of 4.7%



12

Sector strategy. Earnings momentum has materially shifted away from defensive sectors since March on the S&P 500. U.S. Financials, Discretionary, Technology, and Energy are posting superior relative earnings momentum. We believe this recent trend will extend into 2010. Plus and minus signs indicate if a sector is displaying superior/inferior relative earnings revisions.

Higher beta stocks/sectors have taken a breather in the last six weeks following an explosive early March to early May performance, but we expect them to lead indices towards our December 2010 targets. Global yield curves have been steepening visibly since late October 2008 and now stand at the steepest levels since early 2004. When growth picks up (ISMs >50), monetary rhetoric should change and slopes should start to flatten. This will likely be a 1H/10 event.

From an equity strategy standpoint, early cyclicals (Financials, Discretionary) tend to outperform throughout the steepening phase (now), and mid-/late-cycle sectors (Industrials, Technology, Commodities) continue to perform well in the early stages of flattening. Defensives (Staples, Utilities, Health Care, Golds) outperform when the curve is flat and inverted. Our sector strategy remains unchanged and is highlighted in Exhibit 9.

Exhibit 9: Scotia Capital Sector Allocation – Summer 2009

MSCI World Scotia S&P 500 Scotia S&P/TSX Scotia

Energy 12% 14% 12% 14% 28% 29%

Materials 8% 8% 3% 3% 18% 15%

Industrials 10% 12% 10% 12% 5% 7%

Consumer Discretionary 9% 11% 9% 11% 4% 5%

Consumer Staples 10% 7% 12% 9% 3% 2%

Health Care 8% 6% 14% 12% 0% 0%

Financials 21% 23% 14% 15% 31% 34%

Technology 10% 11% 18% 20% 4% 4%

Telecom 7% 6% 4% 3% 4% 3%

Uti lities 6% 3% 4% 2% 2% 1%

CanadaGlobal U.S.

Source: Scotia Capital; Bloomberg

Exhibit 8: Sector Relative Earnings Momentum – June 2009

Sector 1-M 3-M 6-M 1-M 3-M 6-M

Energy - - - + - -Materials + + - - - -Industrials - - + - - -Cons. Disc. + + + + + +Cons. Staples + + + - + +Health Care + + + - + +Financials + + + + - -Technology + + + + + +Telecom + + + - + +Utilities - + + - + +

Canada U.S.

Source: Scotia Capital; Thomson Financial


Summer 2009 13

Canadian Equity Strategy

Sprinting to Start a Marathon? Gareth Watson, CFA — Director, Portfolio Advisory Group

While I have never run a marathon, nor do I expect to do so in the near future, I imagine the last thing I would do is start such a race with a sprint because I’d quickly run out of gas. In our last Investment Portfolio Quarterly publication I reiterated our view that investors should not expect the markets to appreciate sustainably for the first six months of the year as we did not expect the U.S. economic cycle to bottom out until late 2009 at the earliest. As evidenced by the returns of the market thus far it would be easy to conclude that we were wrong about the Canadian stock market and that the next bull market as we know it is here to stay. But I would emphasize the word “sustainably” in our prediction. Just like my sprint would be unsustainable in a marathon, we believe the strength we saw in the second quarter is unsustainable in the short term. In the following report we hope to express our rationale behind this conclusion, but I must also emphasize that this conclusion is short term in nature and that we are on our way to meeting our longer-term predictions put forth at the beginning of this year in our Winter Investment Portfolio Quarterly.

The reason why I emphasize the “short term” is that we have actually witnessed the realization of a few of our 2009 predictions already, but feel that we realized them too soon. For example, we expected the TSX to post gains this year, albeit modest, and we have already done so; we expected oil prices to move higher, just not in the first half of the year and not by such a large margin; we expected the U.S. dollar to weaken but not at the speed or to the degree it did in the second quarter. We feel that the market has moved in the right direction, but is too far ahead of where it should be. As the saying goes “slow and steady wins the race”. Unfortunately “steady” is not a word which we associate with the markets right now as investor expectations have yet to adjust to these recessionary times. Over the past 10 months market expectations have been at opposite ends of the spectrum as behaviour has been either black or white when we should have seen some shades of grey.

But enough with the metaphors, let us focus back on the big picture. Instead of reiterating much of what we’ve been saying from a macroeconomic perspective for the past six months, I shall leave you with an overall conclusion -- that we cannot expect the Canadian and global economy to recover without help from the U.S. consumer. To illustrate why we believe such a statement, allow us to take you through a series of questions and perhaps our views will become more transparent.

Exhibit 1: S&P TSX Composite Index 1H/09

S&P TSX Composite Index 1H/09

7,000

7,500

8,000

8,500

9,000

9,500

10,000

10,500

11,000

Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09

Source: Bloomberg


14

Question #1: How do we get the Canadian economy back on track?

Answer: Get the U.S. economy back on track.

As illustrated by Canada’s economic decline, the idea of decoupling from the United States has been thrown into the trash bin. When you transact almost 75% of your trade with another country, especially one that makes up about a quarter of the world’s GDP, domestic economic direction will ultimately be determined by that country. In this case it means that Canada will continue to follow the lead of the United States. Therefore, in order for us to see economic expansion we will need to see similar expansion south of the border. With that established we now move on to the next question.

Question #2: How do we get the U.S. economy back on track?

Answer: Get the U.S. consumer spending again.

Since the beginning of this decade it is estimated that 70% of aggregate demand in the United States has come from the U.S. consumer. The growth witnessed in the U.S. up until 2008 was domestically driven; therefore, to return to such GDP growth rates the U.S. consumer is going to have to step up again after showing restraint following the market downturn last fall. But our next question is where the problem lies for the Canadian economy and therefore the equity markets.

Question #3: How do we get the U.S. consumer spending again?

Answer: We make sure they have a job, a home and money to spend.

While such an answer is overly simplistic it is also logical. Unfortunately, it is also something we are not witnessing in the U.S. at present. In our 2009 outlook we emphasized two very important factors in determining how we turn around the economy: 1) the credit markets and 2) the U.S. housing market. While the credit markets have improved since the fall they are still not as efficient as they once were and continue to be supported by government intervention. The housing market on the other hand has shown few signs of improvement and may be problematic well into 2010. Let’s address the three parts of our answer above:

Jobs

Bottom line is that Americans are still losing jobs and will likely continue to do so for the remainder of the year. Over 3 million jobs were lost in 2008 and at least that many have already been lost half way through 2009. The U.S. economy is simply not strong enough to support job growth and while we may have seen an improvement in job losses on a relative basis month to month, such job losses are likely to persist going forward.

A Home

If I were to tell you that your $500,000 house was now worth $250,000, how would you feel? Would you feel better if I also told you that your outstanding mortgage is $300,000 so you’re “under water” relative to the value of your home? Obviously, the answer is no as your wealth has been stripped away from you. Your natural response in this case is to save, not spend. How can you expect to grow your economy if you’re not investing in that economy? The answer is you can’t. This is exactly what so many Americans are facing in some of the most heavily populated states in the U.S. Not only have these consumers seen some of their wealth destroyed, some have simply lost everything as they are jobless, had their home foreclosed, or both. While some market observers have proclaimed that the bottom has been reached in the U.S. housing market, we simply don’t see any evidence of this as housing prices continue to fall on a year-over-year basis. Furthermore, there is much concern that a repeat of the sub-prime mortgage crisis could occur over the next two years with what are known as Alt-A and Option Arm mortgages. If these mortgages prove to be as problematic as sub-prime then more foreclosures could be on the way.


Summer 2009 15

Money to Spend

Americans likely fall into one of two categories at present – 1) they have money to spend, but choose to save it or 2) they don’t have money and can’t find anyone to lend it to them. Either way, consumption levels are poor and consumers that are in debt are likely to increase their indebtedness. U.S. banks have become more stringent in their lending practices, which is encouraging from a due diligence perspective; however, this process unfortunately hurts the economy because fewer loans are being granted and therefore consumption has declined even with interest rates at such low levels.

I could go on for pages about these three items in particular, but I think our point has been made clear – that growth requires investment and that investment has not been forthcoming. This is why we have been very hesitant about becoming too optimistic about the prospects for the U.S. and thus Canadian and global economies. We honestly feel that the economic data released in the first six months of this year justifies our point of view. While we are seeing some signs of improvement, it is not good enough for us to conclude that the economic and financial woes we face have come and gone.

Exhibit 2: Case-Shiller Home Pricing Index (% Change YoY)

Case-Shiller Home Pricing Index (% Change YOY)

-25

-20

-15

-10

-5

0

5

10

15

20

Jan-

01

May

-01

Sep

-01

Jan-

02

May

-02

Sep

-02

Jan-

03

May

-03

Sep

-03

Jan-

04

May

-04

Sep

-04

Jan-

05

May

-05

Sep

-05

Jan-

06

May

-06

Sep

-06

Jan-

07

May

-07

Sep

-07

Jan-

08

May

-08

Sep

-08

Jan-

09

Source: Bloomberg


16

With these thoughts in mind you can understand our surprise when the market rebounded with such ferocity from March to June. While a weaker U.S. dollar had a lot to do with this performance, it also had a lot do to with hightened expectations of a faster and more sustainable economic rebound. We feel such expectations were misplaced and exaggerated especially since the mood of the market in early March was particularly somber. While such negativity was also misplaced, the sheer euphoria that followed was not particularly logical. Again, I’d emphasize how market expectations moved from one end of the spectrum all the way to the other end when perhaps some middle ground would have been appropriate. Overall we are sticking by our expectation that the Canadian economy will begin to expand towards the end of 2009 at the very earliest and that perhaps the market may start to react to this expectation as we get further along in the third quarter. Let’s face the facts here, if it wasn’t for the U.S. government the global financial system would have collapsed. The financial system can not work efficiently on it’s own at the moment, so how can we truly expect sustainable and material economic growth until some of these financial problems are addressed?

The Canadian Dollar

Moving along to our outlook for the Canadian dollar, our 2009 views remain unchanged even though U.S. dollar weakness in Q2 far exceeded our expectations. We thought the almost 20 cent decline in the Canadian dollar last fall was overly punitive but we also believe its 15 cent rebound from mid March to the end of May was also overdone. In previous commentary we have highlighted three main factors in determining the direction of the Canadian dollar including: 1) commodity prices, 2) U.S. treasury selling/buying and 3) the health of the U.S. government balance sheet. However, very little changed from March to June that would change our view on these three factors. We still feel that commodity prices will get a lift towards the end of the year (rather than now) supporting the Canadian dollar, that money flows could exit U.S. treasuries with more market stability thus weakening the U.S. dollar, and that the U.S. government balance sheet will continue to deteriorate putting pressure on the greenback. We thought the loonie would remain range bound between US$0.75 and US$0.85 during he first six months of the year with the outside chance that we could reach US$0.90+ on a sustainable basis by year end. Although the market indicated otherwise when it reached US$0.925 in June, we don’t think our prediction is offside. The loonie has pulled back since its recent high and is approaching the US$0.85 level again perhaps providing us with some justification for our earlier prediction. However, our long-term view remains that the U.S. dollar is going to continue to weaken over the next year, which may unfortunately hinder economic expansion in our country. A higher Canadian dollar is great for Canadian consumers that cross the border, but it’s bad for the broader Canadian economy as we become less competitive and see money flows exiting our country.

Exhibit 3: U.S. Personal Income as a % of Disposable Personal Income (Savings Rate)

U.S. Personal Income as a % of Disposable Personal Income (Savings Rate)

-4

-2

0

2

4

6

8Ja

n-00

Jul-0

0

Jan-

01

Jul-0

1

Jan-

02

Jul-0

2

Jan-

03

Jul-0

3

Jan-

04

Jul-0

4

Jan-

05

Jul-0

5

Jan-

06

Jul-0

6

Jan-

07

Jul-0

7

Jan-

08

Jul-0

8

Jan-

09

Source: Bloomberg


Summer 2009 17

Now let’s revisit our outlook for various sectors of the Canadian equity markets.

Financials

Three months ago, in our last publication, we made three statements about Canadian financials:

1. Canadian banks were not going to cut their dividends

2. Canadian banks were well capitalized

3. Canadian life insurance companies should rebound when markets rebound

We feel that the performance of Canadian financials in the second quarter only served to justify and vindicate the statements above as share price performance has been impressive since March. In fact I will readily admit that our expectation that Canadian Financials would not rally sustainably during the second quarter proved to be far too conservative, but such performance did support our other recommendation that longer-term investors with a time horizon greater than one year may consider investments in this sector as Canadian Financials were/are positioned well on a relative basis for an eventual economic recovery.

Certainly at their highs during the second quarter we could have argued financials were performing ahead of where they should have been in the short term, but we believe such arguments are not that relevant for investors with a buy and hold strategy. Recent earnings out of the Canadian banks provided further evidence that Canadian banks are in better financial position than their international peers, that dividend policies were not in jeopardy, that risk was managed more appropriately in Canada, and that Canadian banks were profitable in a difficult economic and financial environment. While we still recognize that earnings growth will be very difficult to accomplish in 2009, Canadian banks are still executing well and could be in a good position to capitalize on any international consolidation as weaker institutions are forced to sell off high quality assets at reasonable prices.

Exhibit 4: C$/US$ Exchange Rate

C$/US$ Exchange Rate

$0.75

$0.80

$0.85

$0.90

$0.95

$1.00

$1.05

$1.10Ja

n-08

Feb

-08

Mar

-08

Apr

-08

May

-08

Jun-

08

Jul-0

8

Aug

-08

Sep

-08

Oct

-08

Nov

-08

Dec

-08

Jan-

09

Feb

-09

Mar

-09

Apr

-09

May

-09

Jun-

09

Source: Bloomberg


18

Energy

Our expectations for the Canadian Energy sector were thrown completely out of whack during the past three months because the U.S. dollar depreciated by a larger magnitude in a much shorter period of time than expected. We do not believe such a move was justified, but there is no doubt that a falling U.S. dollar put upward pressure on oil prices simply due to currency translation. Combine that effect with overly optimistic economic expectations and you saw the speculative premium in oil prices expand. Overall, the currency effect and the speculative premium pushed oil prices over US$72.00 per barrel. Strictly speaking from a fundamental perspective, focusing purely on supply and demand, we never thought oil should have reached such a level and as such we have been very cautious on buying the Energy sector in the short term. While we expected oil prices to move higher towards the end of the year as the economy improved, we never thought we should see US$70 per barrel in June. Not only was there a lack of evidence of increasing demand, many major energy forecasters were actually reducing their demand estimates for 2009, thus implying that oil prices had room to fall. As we approached the end of the second quarter and economic indicators did not support the overly optimistic expectations of the market, we started to see oil prices pull back in response and we believe such a trend will continue down into the US$50 per barrel range.

Materials

In our 2009 Outlook we noted that our view on the Materials sector was mixed as our outlook for base metals was uninspiring while our outlook for gold and fertilizers was much more positive. We continue to argue that the same arguments we make for the Energy sector apply to Base Metals due to their economic sensitivity. While we recognize that base metal commodity and equity prices did get a lift in the second quarter from U.S. dollar weakness and speculative premiums, fundamentally speaking we are not convinced that supply/demand fundamentals are strong enough to maintain such increases in the short term. In fact there are many market participants that believe most of the demand for base metals last quarter was due to restocking inventories in emerging markets such as China. Such participants are also cautioning that this restocking may have come to an end as inventories are at higher levels; therefore, investors may question where the demand will come from for the next three months since the economy is indicating that consumption will not be particularly strong. Overall, this leaves us very cautious on base metals in the short term, but we admit there could be some additional strength to this area toward the end of the year if the economic recovery shows signs of accelerating into 2010.

Exhibit 5: WTI Crude Oil Prices (US$ per barrel)

WTI Crude Oil Prices (US$ per barrel)

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

$140.00

$160.00

Jan-

08

Feb

-08

Mar

-08

Apr

-08

May

-08

Jun-

08

Jul-0

8

Aug

-08

Sep

-08

Oct

-08

Nov

-08

Dec

-08

Jan-

09

Feb

-09

Mar

-09

Apr

-09

May

-09

Jun-

09

Source: Bloomberg


Summer 2009 19

Gold prices weakened towards the end of the second quarter in this seasonally weak period for the commodity and we couldn’t be happier as we believe such weakness gives investors another opportunity to get exposure to this area of the market before we enter the seasonally strong demand period of the fall. While increased demand will help gold prices, our positive view on gold this year still hangs predominantly on our belief that the U.S. dollar will continue to depreciate further in 2009 and possibly 2010. While the depreciation may not happen in the immediate future, we believe this longer-term thesis will bring positive returns.

As for fertilizers, we still believe the long-term supply/demand fundamentals for food on this planet support these stocks; however, investors must be aware that the volatility of this area of the market is high since it is tied to soft commodities and energy prices. While there will be all kinds of short-term dips and jumps in stock price performance, the long-term fundamentals of these companies are strong. Our call here is only further emphasized by a falling U.S. dollar. Just like other commodity related stocks we’ve discussed thus far, the short-term performance for fertilizer equities remains uncertain; however, in the absence of a deep and prolonged global recession, we feel that fertilizer stock prices should be higher one year from now.

Defensives

As a reminder, defensive stocks/equities are those that perform well even when the economy does not. Such examples are Consumer Staples (drug stores and food stores), Utilities, Pipelines and Telecommunications. You still use the services and products provided by these industries even if we’re in a recession. You know from my previous comments that we’re expecting a more gradual recovery in the Canadian and global economies going forward and that the trough of the current economic cycle may not materialize until the end of this year at the earliest. As such, we continue to recommend that investors maintain defensives positions in a well balanced and diversified portfolio because the financial and economic headwinds we face are not going to disappear in the immediate future. Furthermore, many defensive companies in Canada also have strong balance sheets, good management teams and offer a sustainable and high relative dividend yield. However, we must make investors aware of the fact that if the global economy starts to show more signs of improvement as the year progresses you will see what

Exhibit 6: Gold (US$ per ounce)

Gold (US$ per ounce)

$800

$850

$900

$950

$1,000

$1,050

Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09

Source: Bloomberg


20

we call “sector rotation” as investors that bought defensive stocks last year will actually start to sell them and buy more economically sensitive cyclical stocks to position their portfolios for an economic recovery. Such a move can provide temporary weakness for defensives, but just because their share prices may fall does not mean they are bad companies and in most cases we see value investors step in and buy them if share prices fall too far. So while we recommend investors maintain exposure to these sectors of the market we do not recommend that investors overweight defensive industries as sector rotation will have an ongoing influence in the market for the next 6 to 12 months.

The Rest

Technology in Canada, or Research in Motion (RIM) as we like to call it, continues to meet our expectations as we recommend that RIM shareholders hold their positions for the long term. Recent earnings illustrate that Research in Motion has been successful in growing consumer subscriber additions even in this recessionary environment. The earnings also illustrate that we have been right to place some faith in this company and we continue to encourage long-term and higher risk tolerant investors to own this company going forward.

Consumer Discretionary. It should come as no surprise to investors that stocks in this sector find it difficult to grow revenues and earnings in a recessionary environment as retailers and media companies rely on the economy to grow their business. Naturally, opportunistic investors will want to buy these stocks before the economy improves, but if you buy them too soon you can definitely see short-term downside before the stocks begin to appreciate. Considering the economic data we’ve seen over the past three months, we continue to believe that you still have time on your side to step into these names, but more risk tolerant investors could start chipping away at this sector as long as their investment horizon is longer than one year.

Industrials will also tend to behave like the Consumer Discretionary sector in that investors are going to want to buy these stocks before the economy troughs so that they can reap the benefits from economic expansion. While we believe you can still hold off buying stocks in this sector, such as auto parts makers and airlines, we are starting to warm to industrial equipment providers. We still recommend that investors maintain their positions in the Canadian railroads and engineering services companies and if investors are underweight these areas we believe they might want to gradually increase their exposure as we progress through 2009.

Overall Conclusion

While a 3% decline for the TSX in the first quarter of this year did not surprise us, the subsequent 19% appreciation in the second quarter was surprising to say the least as market performance did not reflect actual economic and financial conditions. Don’t get us wrong, we’re not unhappy that the market appreciated, we just feel the appreciation came too soon and was too high. As such we could be setting ourselves up for a pullback if we’ve just sprinted the first kilometer of this market marathon to recovery. Therefore, we remain cautious in the immediate term on cyclical stocks namely Energy and Base Metals and are comfortable with defensive industries and Financials. But as we progress through the remainder of this year and see more evidence of improved availability of credit, an improved U.S. housing market and a possible economic trough, we believe our 2009 year long predictions will come to fruition. We believe strong financials, higher commodity prices towards the end of the year, a weaker U.S. dollar, and the possibility of positive but modest TSX returns are here or are on the way as we have likely seen the market lows of this cycle, but investors will simply need more patience to realize them.


Summer 2009 21

Feature Article

What You Need to Know About Exchange Traded Funds Paul Danesi, CIM — Director, Portfolio Advisory Group

What are Exchange Traded Funds?

An Exchange Traded Fund, or ETF, is a security that tracks an index, commodity or a basket of assets. They allow investors to efficiently gain or reduce exposure to countries, regions, sectors, investment styles, fixed income securities, currencies, and commodities. Exchange Traded Funds have features of both stocks and mutual funds. Similar to a mutual fund, ETFs are comprised of portfolios of stocks, bonds or other securities. However, they trade and settle like a stock on an exchange, can be purchased on margin, and borrowed and sold short. Unlike mutual funds, they have no load attached, but they do charge a management expense ratio (MER), which is typically much lower than for mutual funds of a similar class. The MER is typically deducted from dividend payments. They are also more transparent than mutual funds as investors have access to portfolio composition on a daily basis.

The ETF market has grown considerably since the first ETF was launched in 1993. Today there are almost 900 ETFs listed in the U.S. and nearly 100 in Canada.

Industry growth is being driven by:

Greater acceptance of the product among retail and institutional investors;

Growth in the number and range of indices from index providers which form the basis of new ETFs;

The number of fund companies issuing and managing ETFs.

The success of ETFs is not a retail phenomenon, as major financial institutions (banks and insurance companies) and institutional investors (pension funds, mutual funds, and hedge funds) have actively incorporated them into their trading and investment strategies. Almost every major mutual fund manger uses ETFs to some extent or another. One of the key uses is “cash equalization” whereby a portfolio manager at a mutual fund parks cash in the benchmark index via an ETF until they have determined which securities they intend to buy.

The five largest U.S. ETF managers in North America are shown in Exhibit 1:

Initially funds were launched to track major global benchmarks and key industry groups. As these segments of the market became saturated, fund companies targeted industry groups and subgroups such as energy and oilfield services, before ultimately turning to more niche-oriented funds targeting alternative energy and solar power. Fund companies also catered to investor demand for specialized offerings including currencies, leverage, inverse funds, laddered bond portfolios, completion portfolios and asset allocations. While the vast majority of ETFs are equity based, there are dozens of options for those wishing to invest in debt, commodities and currencies.

Exhibit 1: Five Largest U.S. ETF Managers

Asset Under Management(U$ billions)

Barclays Global Investors $232.0State Street Global Advisors $129.5The Vanguard Group Inc. $44.0ProShares Advisors LLC $22.5Bank of New York $19.0

Source: State Street Global Advisors


22

ETFs now account for roughly one-fourth of all trading in the U.S. and 40% of dollar valued traded, according to Credit Suisse. They believe trading in ETFs could represent a majority of the dollar-valued traded in 2010.

Basic Structure and Claim to Assets

Exchange Traded Funds are structured as separate investments trusts where each unit or share represents a partial ownership in the assets held in the trust. The assets of the fund are legally separate from the assets of the service providers to the fund including the trustee, index providers, and custodian. ETFs are therefore not subject to credit risk of any

of the service providers unlike Exchange Traded Notes discussed next. Generally, if an ETF is liquidated, investors will receive the net asset value less the associated costs (trading and other expenses) involved with winding up the fund.

Exchange Traded Notes

Exchange Traded Notes (ETNs) are similar to Exchange Traded Funds in some respects but differ in their structure. ETNs are a type of unsecured, unsubordinated debt security that differ from other types of bonds as their returns are based on the performance of a market index and they do not make coupon payments. Similar to other debt instruments, they have a maturity date and are backed only by the credit of the issuer; ETNs have credit risk. Unlike ETFs, there is no tracking error, which can be an issue with commodity-based ETFs. The largest issuers of ETNs are Barclays Capital (iPath), Swedish Export Credit Corp. (ELEMENTS), Deutsche Bank AG (DB), and UBS Securities (e-tracs).

Currency Exposure

Currency is one of the least understood aspects of ETFs. The largest misconception is that all ETFs denominated in U.S. dollars provide U.S. dollar currency exposure – that is not necessarily true. ETFs that track a U.S. market (S&P 500 Index, Russell 1000 Index, etc.) will have U.S. dollar currency exposure. When purchasing an ETF priced in U.S. dollars which tracks a foreign index (MSCI Japan Index, S&P Europe 350 Index, etc.) the currency exposure is to that of the underlying foreign market.

C$ x US$

US$ YEN

For Canadian investors initially holding Canadian dollars, the U.S. dollar is used only as a pass through currency. In the example above, investors use U.S. dollars to purchase shares of the fund and the fund in turn uses Japanese yen to purchase the Japanese securities in the index. Currency exposure is therefore to the yen and not the U.S. dollar as the U.S. dollar exposure is cancelled out.

Currency Hedged ETFs

iShares offers three Canadian-listed ETFs that provide U.S. and international exposure hedged to the Canadian dollar. This allows Canadians to invest internationally without foreign exchange costs and foreign currency risk, albeit there is a cost associated with hedging currency risk in the portfolio.

Exhibit 2: Assets Under Management by Category Assets

Category # of ETFs (U$ mm)

Size 33 $128,536International 116 $92,788Fixed Income 61 $65,650Commodity 22 $47,465Sector 114 $44,216Style 46 $43,433Inverse/Leveraged 106 $25,846Broad 10 $12,334Dividend/Fundamental 101 $8,108Specialty 85 $6,993Currency 19 $3,285Global 22 $3,056

Totals 735 $481,710

Source: State Street Global Advisors (March 2009)


Summer 2009 23

Liquidity

While ETFs may appear illiquid at times, equity ETFs are as liquid as the securities in the underlying index. The designated broker or market maker for an ETF has the ability to create or redeem units on demand. The designated broker can create units by delivering a basket of securities to the fund in a similar proportion to the index underlying the ETF. Similarly, the designated broker can acquire a large block of ETF units from an investor. This redemption/creation process keeps an ETFs market price close to its net asset value. This feature distinguishes ETFs from closed-ended funds.

Dividends

ETF unitholders are entitled to receive the dividends paid by companies held in the portfolio. However, similar to mutual funds, ETFs tend to deduct management fees from dividends and distribute what cash if any is leftover. Not all ETFs pay dividends on a quarterly basis. iShares ETFs pay dividends semi-annually in most cases. The Pharmaceutical HOLDRs Trust (PPH) pays dividends to shareholders as it receives them often leading to multiple dividend payments in any given quarter.

Leveraged ETFs

Leveraged ETFs are similar to other Exchange Traded Funds in that they are structured to provide returns that correspond to an underlying index and are traded on a stock exchange. However, that’s where the similarity ends. Through the use of derivatives or debt, they magnify the returns of an underlying index. The typical leverage ratio is 2:1, but last fall, Direxion Shares ETF Trust launched funds structured to provide leverage of 3:1 on a number of indices. In all cases, the fund’s objectives are to provide multiples of the “daily” investment results for a reference index, less fees and expenses. Seems straight forward enough, however, there are a couple of twists.

To begin with, the leverage factor applies on a daily basis only, and unless a client’s position is rebalanced at the end of the day, leverage changes over time. Due to this factor, leveraged ETFs are highly path dependent and an investor’s return experience beyond one day becomes highly unpredictable. The second point is they are also very sensitive to market volatility and the more volatile the market the less likely an investor will receive the expected return.

For more details on leveraged ETFs, ask your wealth advisor for our report titled “Understanding Leveraged ETFs” dated March 31, 2009.

Advantages of Exchange Traded Funds

Diversification: Exchange Traded Funds provide portfolio diversification through a single security. For example, an investor who buys a unit of the S&P/TSE 60 Index Fund gains exposure to the 60 securities in the index with one transaction.

Performance and Lower Fees: Fees for ETFs tend to be much lower than for mutual funds within a similar asset class. For example, the management expense ratio (MER) for i60 units is 0.17% versus 2.00% to 3.00% for a typical Canadian large cap equity fund. The high costs associated with the typical equity mutual fund leads to underperformance for the end investor.

Liquidity: ETFs offer the ease and liquidity of stock trading combined with the benefits of traditional index fund investments. Similar to a stock, an ETF can be bought and sold on an exchange at any time during regular trading hours. This allows investors to track and potentially capitalize on intraday price fluctuations. ETFs can be sold short or bought on margin, mutual funds cannot.

Tax Efficiency: Turnover tends to be lower than for actively managed mutual funds reducing distributions at the end of the year.

Portfolio Management: Another advantage of using ETFs is the ease with which a portfolio can be rebalanced. An investor’s assets can be reallocated across sectors, asset classes, or globally by simply reducing the position in one fund and adding to the position in another.


24

Fixed Income Strategy

Where Are We Now, Where Do We Go From Here? Chris Kennedy, CFA — Associate Director, Portfolio Advisory Group

Did We Just Witness The Greatest Corporate Bond Buying Opportunity in History?

“If the equity market was pricing in a recession in the fall of 2008, the bond market was pricing in financial Armageddon, the end of the world”.

This statement was a key point used in our many fixed income presentations for clients and prospects over the past six months. It set the stage for highlighting the tremendous selloff that occurred without prejudice across all areas of the credit market, and thus represented what appears to have been the best buying opportunity in history for high quality Canadian corporate bonds.

In the fall of 2008, corporate bond credit spreads, which can be described as the increased yield spread demanded by investors to take on the increased risk of corporate debt over Government guaranteed paper, ballooned to never before seen levels on the back of fundamental problems in the financial sector and an overall change to the market’s collective perception of safety. Quite simply, the unprecedented action in the world’s financial sector caught all capital markets off guard, irrespective of previous perception of safety, and therefore Canadian corporate debt, including high quality bank bonds were caught in the downward spiral, with very little fundamental justification behind the selling. Fear was the main driving force behind the market moves after the fall of Lehman Brothers in September 2008 – clients were selling everything, and buying only Government backed debt. Hence the Armageddon reference.

While six months later the market collectively sits with 20/20 rearview mirror vision, much earlier than this, the smart money had known the above scenario contained not only unprecedented fear, but unprecedented opportunity relative to the implied safety one receives on AA rated corporate debt such as the Canadian banks compared to the many other much riskier investments such as lower rated bonds, preferred shares, trust units, and common shares. We highlighted this major opportunity as our Fixed Income Strategy in this same publication in our fall 2008 edition. Those that heeded our advice and saw this as an opportunity to buy (thankfully many of our clients did), have been rewarded with handsome capital gains as rationality and confidence began to return to the market. The subsequent buying pushed overall credit spreads approximately 60% tighter from their October peaks. The attached graph highlights these points using the Canadian mid-term (5-10 year bond) credit spreads for overall, AA, and A corporate categories of risk for nearly the past 30 years.


Summer 2009 25

Two major points can be drawn from this picture. First, the credit spread peaks reached in October were by far the widest on record, approximately 100% wider than the last high in the early 80’s. Second, beginning in January of 2009, this chart shows the impressive spread tightening on each grade of debt, as institutions and to lesser extent retail clients, flooded their investments into opportunities of high yield relative to lower perceived risk. This move has delivered a year to date return of 10.34% on the overall corporate sector in Canada as measured by the DEX All Corporate Bond Index.

By far the largest moves in the corporate sector were seen in the higher volatility securities of bank bonds such as the subordinate fixed floating and Tier 1 Capital bonds. The latter of this group became quite popular as offering “equity like returns for less risk” near the beginning of this year. Using Royal Bank of Canada (RBC) as an example, the yield to maturity on a RBC Tier 1 Capital Security (TruC) 6.821% due 06/30/18 was nearly 9.00% absolute yield to maturity six months ago – including a credit spread over the risk free government bond of 6.24%. This equated to a price of approximately $89.66. Recently, the same bond’s credit spread has shrunk to approximately 2.5%, for an all in absolute yield to maturity of just under 6.00% and a price of $109.14. The difference in spread equated to major capital gains, giving an approximate 25% total return (including accrued interest) in six months time, extremely rare for the A or better rated bond categories.

Moving Forward: Realigning Expectations for Your Fixed Income Holdings

The most important message we can deliver to our clients going forward is to ensure your expectations for bond returns from this point onward are in the right place. We believe the dramatic spread tightening move of the past few months is over. The fast money has been made and with hindsight being 20/20, many including ourselves believe this was a gift. We have been recommending to clients, with some exceptions, that corporate bond spreads have tightened too much too quickly and may actually give back some of their recent gains, something we have already witnessed over the past few weeks.

Therefore, we caution any buy and hold clients that continue to expect high quality A and better rated bond positions will return 5.0-6.0% yield to maturity over a 5-year period. This is simply not the case anymore. In order to receive a yield to maturity of 5.0% or greater, clients would have to reach further out the yield curve and further down the credit quality spectrum into 6-year and greater maturities in BBB or lower rated bonds. While some clients have the appropriate risk tolerance for BBB and below rated

Exibit 1: Canadian Mid Term (5-10 year) A and AA Corporate Credit Spreads

Black Line – A rated corporate Debt; White Line – AA rated corporate Debt

Source: PcBond


26

bonds, most retail clients should stick to the A or better bond categories in Canada for the increased safety they provide.

Going forward, we believe corporate bonds are beginning to settle back into a pattern of normalcy where the larger part of their total return comes from income, rather than capital gains. While overall corporate credit spreads remain wider than their long-term average, and may have room to move tighter, the gains this would generate may be counteracted by losses due to rising benchmark interest rates.

The following chart depicts the 1-year forecast change for the Canadian yield curve as predicted by both Scotia Economics and Consensus Bloomberg, whom both forecast interest rates will rise over the next 12 months.

Therefore while credit spreads may continue to tighten, albeit at a much slower pace, it is likely, in line with the forecasts, that Government bond yields will begin to rise over the same period. Hypothetically, if credit spreads were to tighten by the same magnitude that a benchmark Canada bond yield increases, the absolute yield on the bond (made up of both credit spread and benchmark bond yield) would be unchanged, and therefore the return from holding the bond will primarily come from interest income represented by the bond’s coupon, which is generally paid every six months in Canada.

Start Looking for New Opportunities While The Market Continues to Settle

To summarize, we have seen impressive returns in the Canadian corporate market year to date, outperforming all other bond sectors. Going forward we believe this sector may give back some of its recent gains, and have been recommending active clients look to other sectors for relative opportunities. While the bond market has vastly improved in its functionality, and liquidity compared to six months ago, things are not yet what we would call normal and opportunities exist to take advantage of sectors that continue to offer relative value.

Exibit 2: Shape of Current Yield Curve and Where The Curve Is Forecast to Be In One Year

Shape of Current Canadian Yield Curve and Where The Curve Is Forecast To Be In One Year

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

0 5 10 15 20 25 30

Term

Yie

ld

Current Yield Curve

Scotia Forecast

Consensus Forecast

Source: Scotia Economics and Bloomberg


Summer 2009 27

Municipal Bonds

For the safety you receive from Canadian municipal debt, the relative return you can generate is impressive in the longer end of the maturity spectrum as credit spreads have not tightened to the extent of corporate bonds. For instance, municipal bonds rated AA/AAA 6-years to maturity and greater are giving either the same or greater yields than AA rated Canadian bank bonds. A 6-year City of Toronto bond offers the same yield to maturity of 3.84% as does a 6-year Royal Bank of Canada bond. For the protection you receive from a taxing authority of Municipal government guarantees versus a corporation, this presents an opportunity to diversify from the corporate sector.

Non-Bank Credit Card Asset Backed Term Debt (ABS)

A general lack of public understanding over the functioning and the protection these bonds provide, paired with a negative stigma surrounding asset backed debt since the third party asset backed commercial paper (ABCP) problems of 2007, has created opportunities in this sector. While the Canadian bank sponsored credit card ABS bonds are trading to yield very much the same as Canadian senior bank bonds, the non-Canadian bank credit card ABS spreads have not tightened in tandem, and offer yields of 1.40% or more than a Canadian bank deposit note for a three year term, while also carrying a AAA rating. Examples are Glacier Credit Card Trust (Canadian Tire’s Master Cards), Gloucester Credit Card Trust (MBNA Canada credit cards) and Algonquin Credit Card Trust (Capital One Bank credit cards). Scotia Capital Fixed Income Research recently released a credit update on this sector recommending that buy and hold investors who can sacrifice liquidity for yield should buy this sector.

Provincial Strip Coupons

Strip coupons are bonds that do not have a coupon and therefore do not pay interest income to the holder. The return an investor receives is simply the difference between the purchase price and the maturity value of par. While we have not seen availability in Canadian bank strip coupons of late, Provincial issuers of strip coupons continue to offer excellent yield to maturity in the 10-year or greater maturity space. For example, a Province of Quebec strip due January 2020 offers approximately 5.0% at time of publication. We remind clients that strip coupons, while they do not pay interest, continue to generate a tax liability each year, and should therefore be held in tax shelter accounts such as RRSP’s or Tax Free Savings Accounts (TSFA).

Finally, we note these broad recommendations are directed primarily towards passive “buy and hold” clients that are looking for principal protection, while also earning a reasonable rate of return, rather than clients looking to beat the market by enacting active trades. Active clients, during a period of expected rising interest rates, should indeed look to reduce duration in their portfolios, and remain in the shorter end of the maturity spectrum.

Call your ScotiaMcLeod advisor for more information, and to discuss these or any other fixed income solutions specific for your portfolio needs.


28

Preferred Share Market Update

As Confidence Increases Positive Returns are Generated Across the Board Tara Quinn, MBA — Associate, Portfolio Advisory Group

For those investors who have held Canadian preferred shares over the last quarter, or for that matter, over the first half of 2009, should be content to see the positive returns displayed in their portfolios. Year to date, the S&P/TSX Preferred Share Index is up by 12.64% and during the second quarter of 2009 posted an 11.28% return. The S&P/TSX Preferred Share Index is designed to serve the investment community’s need for an investable benchmark representing the Canadian preferred stock market. This index is comprised of preferred stocks trading on the Toronto Stock Exchange that meet criteria relating to minimum size, liquidity, issuer rating, and exchange listing. This index is also rebalanced twice a year.

The biggest contributors to the positive returns seen in the preferred share market has been both the low interest rate environment as the Bank of Canada’s overnight rate is at 0.25%, the lowest level on record, in addition to the tightening of credit spreads. Credit spreads can be defined as the yield pick-up over the relevant benchmark Government bond and are representative of investors' risk appetite. Over the last three months, we have seen investors reduce their exposure to Government of Canada bonds pushing yields higher and increase their exposure to riskier products such as preferred shares which offer a higher yield. This transition is indicative of confidence in the market and the increased demand for higher yielding products and preferred shares in particular has decreased the risk premium yield, and hence increased the price on these products.

Focusing on the Investment Grade level of preferred shares it has been the Fixed Floating, Floating rate and Straight Perpetuals which have impressively outperformed the general Canadian Preferred Share market.

It is interesting to see the Floating Rate preferred shares outperform, as these preferred shares pay their dividends based on a percentage of the current prime rate. Currently, most of these preferred shares are paying 100% of prime which equates to $0.56 (2.25% x $25) annually. Since prime is now at its lowest level (2.25%), investors are using this as an opportunity to hedge against future inflation by purchasing these preferred shares when the dividend is at its lowest level. As prime increases following the improvement in the economy, the dividend on these preferred shares will increase which should have a positive impact on price. Additionally as spreads tighten further, prices should continue to improve.

Exhibit 1: Total Returns for 2nd Quarter of 2009

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

To

tal R

etu

rns

Investment Grade 6.24% 10.33% 20.67% 29.46% 15.39% 8.30% 5.91% 3.21% 23.94% 7.48%

Non-Investment Grade 37.43% 8.95% 25.54% 17.05% 16.48% 11.87% 23.08% 14.73% 143.58% 34.73%

Retractables Rate Resets Fixed Floating Floating Rate PerpetualsSplits - Single

CommonSplits -

PortfolioSplits - Interest

Splits - Synthetics

All Splits

Source:Bloomberg


Summer 2009 29

Some of the returns over the last quarter have been substantial and the table below lists the top performing investment grade preferred shares categorized by type.

Exhibit 2: Preferred Share Performance – Q2 2009

DBRS S&P Price Price Q2 Total

Issuer TSE Symbol 6/30/2009 6/30/2009 3/31/2009 6/30/2009 Dividend Return

RETRACTABLES

Brookfield Asset 5.40% S 12 BAM.PR.J Pfd-2l P-2 $18.24 $22.57 $0.34 25.59%

CDN Genl. Invest. 3.9% CGI.PR.C Pfd-1 N/R $21.01 $23.75 $0.24 14.23%

Brookfield Asset 5.50% S 11 BAM.PR.I Pfd-2l P-2 $22.50 $25.00 $0.34 12.64%

Brookfield Asset 5.75% S 10 BAM.PR.H Pfd-2l P-2 $23.60 $25.70 $0.36 10.42%

Brookfield Asset 5.00% S 21 BAM.PR.O Pfd-2l P-2 $22.00 $23.70 $0.31 9.15%

RATE RESET

CIBC 6.5% Ser. 35 CM.PR.L Pfd-1 /*- P-1 (L) $22.25 $27.33 $0.38 24.53%

CIBC 5.35% Ser. 33 CM.PR.K Pfd-1 /*- P-1 (L) $20.80 $25.44 $0.33 23.92%

Industrial Alliance 6.20%, Ser C IAG.PR.C Pfd-2H P-1 (L) $22.25 $26.75 $0.39 21.97%

TD Bank 5.00% Ser. S TD.PR.S Pfd-1 /*- P-1 (L) $21.50 $24.99 $0.31 17.69%

BNS 5.00% Ser. 20 BNS.PR.Q Pfd-1 /*- P-1 (L) $21.80 $25.25 $0.31 17.26%

FIXED FLOATING

Brookfield Asset 4.35% S 9 BAM.PR.G Pfd-2l P-2 $11.25 $15.65 $0.27 41.53%

BCE Inc. 4.40% Ser. AF BCE.PR.F Pfd-3H P-2 (L) $14.60 $18.17 $0.28 26.34%

BCE Inc. 4.65% Ser. AI BCE.PR.I Pfd-3H P-2 (L) $14.85 $18.26 $0.29 24.92%

BCE 4.54% Ser. R BCE.PR.R Pfd-3H P-2 (L) $15.24 $18.05 $0.28 20.26%

BCE 4.331% Ser. Z BCE.PR.Z Pfd-3H P-2 (L) $14.41 $17.00 $0.27 19.85%

FLOATING

Brookfield Asset A Ser. 8 BAM.PR.E Pfd-2l P-2 $9.43 $15.00 $0.15 60.74%

Brookfield Asset A Ser. 4 BAM.PR.C Pfd-2l P-2 $7.61 $10.75 $0.11 42.71%

Brookfield Asset A Ser. 13 BAM.PR.K Pfd-2l P-2 $7.72 $10.90 $0.11 42.62%

Brookfield Asset A Ser. 2 BAM.PR.B Pfd-2l P-2 $7.90 $10.89 $0.11 39.18%

BCE Inc. Series AH BCE.PR.H Pfd-3H P-2 (L) $13.00 $17.00 $0.15 31.92%

STRAIGHT PERPETUAL

EPCOR Power Equity Ltd. 4.85% EPP.PR.A #N/A N/A P-2 (L) $13.70 $17.05 $0.30 26.67%

Power Finl. 5.10% Ser. L PWF.PR.L Pfd-1l P-1 (L) $16.45 $20.51 $0.32 26.62%

BMO 5.95% Ser. 10 U.S.$ BMO.PR.V Pfd-1 /*- P-1 (L) $20.00 $24.75 $0.37 25.61%

E-L Financial 4.75% Ser. 2 ELF.PR.G #N/A N/A P-2 (H) $13.72 $16.90 $0.30 25.34%

E-L Financial Corp. 5.30% ELF.PR.F Pfd-2l P-2 (H) $14.95 $18.17 $0.33 23.75%

SPLITS

BAM Split 4.35% Class AA BNA.PR.C Pfd-2L N/A $11.40 $16.05 $0.00 40.79%

ROC PREF Corp. 4.30% PRF.PR.A #N/A N/A P-2(H)/*- $19.50 $23.90 $0.27 23.94%

First Asset CanBanc Split 6.50% CBU.PR.A Pfd-2l N/A $10.00 $11.25 $0.16 14.13%

BAM Split Corp. 6.25% BNA.PR.A Pfd-2L N/A $23.00 $25.44 $0.00 10.61%

Cdn. Financials & Utilities CFS.PR.A Pfd-1 N/A $9.40 $10.25 $0.11 10.17%

Source:Bloomberg; DBRS; Standard and Poor’s

*- denotes credit watch negative


30

Rating Agency’s Review the Ratings of Canadian Bank Preferred Shares

As of April 20, 2009, DBRS placed the preferred shares of all the Canadian banks it rates Under Review with Negative Implications following changes made to the DBRS global banking methodology. Since then, on June 30, 2009, DBRS was the first rating agency to downgrade all of the Canadian preferred shares. The "Big Five" banks were all downgraded one-notch while other banks such as National Bank of Canada, HSBC Bank Canada and Laurentian Bank were downgraded by two notches as seen in the table below.

These current downgrades highlight the structural risk that exists in preferred shares. Given that they rank near the bottom of the capital structure, dividends and principal are at a greater risk than with other fixed income investments.

Additionally, Moody's has recently announced that it is refining its approach to rating Canadian bank subordinated capital, which includes preferred shares. Moody's has indicated that its methodology revision could trigger a downgrade of 1 or 2 notches for the preferred shares. It is anticipated that the rating decision will be announced late July/early August.

At this time, the news relating to the downgrade of the preferred shares by DBRS and the potential downgrade by Moody's has had limited negative impact on the preferred share market. We remain very confident in the Canadian bank’s ability to pay dividends on its preferred shares. In order for an issuer to suspend the dividend payment on the preferred shares they must first suspend all dividend payments for the common shareholders, and common shareholders of the “Big Five” banks have been paid consistently for over a century.

Fixed Reset Rate Preferred Shares Hit Their One Year Anniversary

The fixed reset rate preferred shares, were a new product introduced in March 2008 and have now been trading in the marketplace for over a year. This type of preferred share has become very popular and has performed well, up 11.68% during the first half of 2009. For those investors that became accustomed to the features of this type of preferred share when they were first issued have had the advantage of an abundance of new issuance over the past year.

So far in the first half of 2009 alone, there have been over $6.7 Billion worth of new issuance all of which were the fixed reset rate structure. In comparison, in 2008 there was a total of approximately $6.4 Billion of new preferred share issuance. In essence, 2009 has seen more new issuance of preferred shares than in 2008 and also more issuance than in previous years going back a decade. With this large quantity of reset rate preferred shares now trading in the market, there are a growing number of investors who have become comfortable with the features on these products, thereby increasing demand.

Exhibit 3: DBRS New Ratings versus Previous Ratings

Issuer Old Rating New Rating Bond Equivalent

Bank of Montreal Pfd-1 Pfd-1(l) A-Bank of Nova Scotia Pfd-1 Pfd-1(l) A-Canadian Imperial Bank of Commerce Pfd-1 Pfd-1(l) A-HSBC Bank Canada Pfd-1 Pfd-2(H) BBB+National Bank of Canada Pfd-1(l) Pfd-2 BBBLaurentian Bank of Canada Pfd-3(H) Pfd-3(l) BB-Royal Bank of Canada Pfd-1 Pfd-1(l) A-The Toronto Dominion Bank Pfd-1 Pfd-1(l) A-

Source: DBRS


Summer 2009 31

In the current low interest rate environment, certain reset rate issues continue to offer investors an attractive return, based on the yield-to-reset/call values. In general, we recommend choosing investments which are of good credit quality (rated Pfd-2 (l) or higher by DBRS, P-2 (L) or higher by S&P).

It should also be noted that credit spreads continue to remain at wider than average levels and are still above the 5-year average. With credit spreads at these levels, preferred shares should be considered relatively cheap and continue to offer investors an attractive return.

Please contact your ScotiaMcLeod advisor to discuss the preferred share opportunities and recommendations for your portfolio.


32

Insurance

Recreational Property Succession Planning with Insurance Susan Forint, MBA — Marketing Manager, ScotiaMcLeod Financial Services

If your family is one of the estimated one million plus households in Canada that own a recreational property, the most taxing thing likely on your mind in these dog days of summer is how bad the traffic may be on the return to the city. The steady climb in the cost of vacation properties in Canada has eased slightly over the past while and the demand for second homes could slow over the next decade (as baby boomers move past their peak cottage buying years). Generally, however, over the lifetime of ownership a recreational property will increase in value from the purchase price, often significantly. Although usually viewed as a benefit to one’s overall estate value, challenges can mount when it is time to pass the secondary property on to the next generation. Some forethought can help to manage these estate planning challenges.

Covering the Capital Gains Tax

There are many estate planning strategies that you should consider, but perhaps the most important planning challenge to address is the capital gains tax liability. If your cottage, cabin, chalet, camp, or country property has risen in value from the time of purchase and it is not your primary residence, it may eventually be subject to a substantial capital gains tax. Your secondary property can transfer to your spouse upon your death tax-free, if it is jointly held with right of survivorship. However, when your spouse dies and the property is passed on to your beneficiaries, the resulting and potentially significant capital gains tax must be paid before your heirs can enjoy the property. Unfortunately, sometimes this tax bill can be so overwhelming that other estate assets must be used or the vacation home is sold to pay the tax liability.

The following example illustrates the capital gain impact on a recreational property after 40 years from initial purchase:*

Life insurance is often the most cost-effective planning solution to cover this tax liability. The proceeds from a permanent life insurance policy, such as Term-to-100 and Universal Life insurance, in the amount of the projected tax liability can be used to cover the taxes at death, so the taxes can be promptly paid and the property can continue to be enjoyed by your family.

Exhibit 1: Capital gain on recreational property 40 yrs after purchase

Original Cost Growth Rate Future Value Capital Gain Tax Payable†

$100,000 8.00% $2,796,574 $2,696,574 $606,729

†Assumes 50% of Capital Gain is taxable at a personal rate of 45%

Source: ScotiaMcLeod Financial Services


Summer 2009 33

Equalizing the Inheritance

Most vacation homeowners hope that their property will be well received and enjoyed by all in the next generation. But what if all of your children are not interested in joint ownership of a recreational property? Perhaps one child now has a cottage of their own. Perhaps another child lives overseas or in another part of the country and would not be able to use the property to the extent of their siblings. Once again, an insurance solution can be used to ensure that all of your children receive an equal financial inheritance. Your child (or children) who is interested in keeping the vacation property would be named beneficiary of the property in the Will. A permanent life insurance policy would be purchased for the benefit of the remaining children; the amount of the death benefit can be equal to the difference between what their inheritance is and what it would have been if they had received their other share of the property.

Planning Ahead to Maximize your Investment

A recent survey on the attitude of Canadian towards recreational properties found that 64% of Canadians view vacation property ownership as a sound investment and that Canadians aspire to own recreational properties despite the downturn in the economy.** If you are planning on buying or already own a second home that you hope to eventually pass on to the next generation, it is important to do some succession planning to maximize the estate value for your heirs and to ensure that the increased value of the property you are likely to realize over time is not eroded. It is better to consider insurance strategies sooner rather than later to ensure insurability and to capitalize on lower premium costs associated with acquiring insurance at a younger age. Utilizing insurance solutions for your recreational property succession plan helps to see that your family’s needs are addressed, helping to efficiently pass on a cherished family asset to the next generation.

* Source: Manulife Financial, “Are you sure your family cottage with stay in your family?”; March 2009

**2009 Royal LePage Recreational Property Report

This article is for information purposes only. It is recommended that individuals consult with their own tax advisor before acting on any information contained in this article.

All insurance products are sold through ScotiaMcLeod Financial Services Inc., the insurance subsidiary of Scotia Capital Inc., a member of the Scotiabank Group. When discussing life insurance products, ScotiaMcLeod advisors are acting as Life Underwriters (Financial Security Advisors in Quebec) representing ScotiaMcLeod Financial Services Inc.


34

Equity Guided Portfolios Stephen Uzielli — Portfolio Manager, Portfolio Advisory Group

The Equity Guided Portfolios are models designed to provide investors with a convenient way of investing directly in individual holdings and building diversified portfolios composed of equity securities. The portfolios are actively managed by a dedicated Portfolio Manager with oversight from the Investment Committee of the ScotiaMcLeod Portfolio Advisory Group. Each portfolio has a specific mandate but they all have the common objective of providing investors with a consistent long-term rate of return through holding a portfolio of stocks comprised of industry leaders with franchises and strong management teams, combined with an attractive trend in profitability.

ScotiaMcLeod Canadian Core Guided Portfolio

Performance Update In almost a complete reversal from the trading pattern observed in the first quarter of the year, equities appeared to defy gravity in markets around the globe during the second quarter while continuing the rally that commenced following the bottom achieved in early March. Supported by decent Q1 earnings results and seemingly promising economic data, North American equity market returns more than erased the declines experienced during the previous quarter. Commodities and other cyclically oriented sectors saw higher prices in response to improving economic statistics that have been interpreted positively as they were less negative or not as bad as expected. It will be at least the fourth quarter before we see data that is positive in an absolute sense, but for now, "less bad" is satisfying the market. That being said, investors have emphatically concluded that the pessimism being discounted in stock prices during the lows of March was overdone and that the worst of the recession is behind us.

All but one sector moved higher during the period with market leadership coming from Technology, Financials, Energy, and Industrials; Telecommunication Services was the only group generating a negative return. Most commodities got a further boost during the quarter in response to selling pressure on the U.S. dollar. Crude oil futures rallied 30% and closed the quarter at US$69.89 per barrel. Natural gas futures have seen some volatility but remain under pressure due to continued high inventory levels; by the end of the quarter gas had declined almost 8%. Gold bullion futures were essentially flat, closing at US$927.40/oz. Most industrial metals were driven higher by a more optimistic outlook for growth in China: copper increased 22%, closing the month at US$2.27/lb; while the price of zinc climbed 15%, and nickel jumped 55%.

Despite our defensive sector allocation the Canadian Core Guided Portfolio outperformed the benchmark as it increased 28.4% on a total return basis while the S&PTSX60 moved up 20.1% during the quarter. As we wrote back in May, the portfolio is acting well in the current environment primarily due to some large increases by individual holdings in key sectors within the portfolio. Recall that although we built the current portfolio with a defensive bias, this means it is defensive in the context of the Canadian market that is inherently cyclical with approximately 75% of the market comprised of Financials, Energy, and Materials stocks. So when we are "underweight" the resources sectors, in aggregate we still maintain decent representation and still benefit when those groups are in favour. Shares of Nexen Inc., Suncor Energy, and Talisman Energy all increased approximately 25% during the quarter while the holding that enjoyed the largest increase was Teck Resources that rallied 163% after several announcements related to asset sales and balance sheet restructuring. Financial stocks also enjoyed significant moves higher during the quarter demonstrating their economic sensitivity but also how oversold they had become during the previous quarter: AGF Management shares rallied 54%; Bank of Nova Scotia increased 40%; Manulife Financial climbed 42%; and Royal Bank moved higher by 38%.


Summer 2009 35

Although the market became somewhat range bound during June, prior to that it appeared investors were pricing in a "V" shaped recovery which is an unlikely scenario as it doesn’t allow for any negative impact resulting from the ongoing housing slump in the U.S. and associated weak U.S. banking sector; the recent increase in mortgage rates further complicates any resolution to those problems. We are more inclined toward the view that the economic recovery, when it comes, will be bumpy and long as opposed to straight and quick and believe equity markets need time to allow fundamentals to catch up with share prices. With the S&PTSX60 Index up 18% in the first half, and more importantly up 37% from its lows earlier this year, the market appears due to sell off in the short term, or at a minimum move sideways for a period of time.

Changes

No changes were made to the Canadian Core Guided Portfolio during the quarter. We continue to monitor all current holdings as well as the portfolio composition to ensure that the portfolio reflects characteristics and attributes in line with the investment mandate which is to provide a consistent long- term rate of return. Our objective is to establish appropriate sector allocation and then to identify the best investment opportunities within each sector.

Exhibit 1: ScotiaMcLeod Canadian Core Guided Portfolio Risk Price Target Dividend Potential

Company Symbol Rating Ranking 30-Jun-09 Price Dividend Yield ROR

Interest Sensitive:

AGF Management Limited AGF.B 1-SO High $12.70 $17.00 $1.00 7.9% 42%Bank of Nova Scotia BNS 2-SP High $43.42 $46.00 $1.96 4.5% 10%Brookfield Asset Management BAM 1-SO Medium $19.90 $29.12 $0.65 3.2% 50%Fortis Inc. FTS 2-SP Medium $25.41 $27.00 $1.04 2.5% 10%Manulife Financial MFC 1-SO Low $20.19 $30.00 $1.04 5.2% 54%Power Financial Corp PWF 2-SP Low $27.65 $28.00 $1.40 5.1% 6%Rogers Communications RCI.B 1-SO Medium $29.90 $45.00 $1.16 3.9% 54%Royal Bank of Canada RY 1-SO Low $47.57 $58.00 $2.00 4.2% 26%Sun Life Financial SLF 2-SP Low $31.40 $33.00 $1.44 4.6% 10%

Consumer Products:

Shoppers Drug Mart SC 1-SO Low $49.99 $54.00 $0.86 1.7% 10%Yellow Pages Income Fund YLO.UN 2-SP Low $5.35 $6.00 $0.80 15.0% 27%

Industrial Products:

Canadian National Railway CNR 1-SO Medium $49.97 $54.50 $1.01 2.0% 11%

Resource:

Agrium Inc. AGU Restricted Restricted $46.45 R $0.11 0.2%Barrick Gold ABX 1-SO Medium $39.15 $56.47 $0.44 1.1% 45%Canadian Natural Resources CNQ 1-SO High $61.19 $80.00 $0.53 0.9% 32%Nexen Inc. NXY 1-SO High $25.27 $27.00 $0.20 0.8% 8%Suncor Energy SU 2-SP Medium $35.37 $38.00 $0.20 0.6% 8%Talisman Energy TLM 1-SO Medium $16.71 $22.00 $0.23 1.3% 33%Teck Resources Ltd. TCK.B 2-SP High $18.55 $27.00 $0.00 0.0% 46%TransCanada Corp. TRP 1-SO Low $31.32 $41.00 $1.52 4.9% 36%

Source: Scotia Capital; Bloomberg.


36

ScotiaMcLeod Canadian Income Plus Guided Portfolio Stephen Uzielli-Portfolio Manager, Portfolio Advisory Group

Performance Update Dividend paying stocks as measured by the benchmark Dow Jones Canada Select Dividend Index outperformed the broader Canadian market in the second quarter as Financials, which dominate the index representing approximately 65% of the weight, were particularly strong. For the same reason, the Income Plus Portfolio increased substantially during the period, yet still lagged the index, as Financials comprise only 33% of the weight in this diversified portfolio. The Dow Jones Canada Select Dividend Index increased 26.3% in Q2 while the Canadian Income Plus Guided Portfolio returned 17.9%.

Not surprisingly the best performers among holdings came from the Financial sector as in addition to the strength seen in Bank of Nova Scotia and Royal Bank, Great West Lifeco rallied 29% during the period while its parent company Power Financial moved higher by 34%, and Sun Life Financial jumped 38%. The singular mining related holding in the portfolio also got a lift in sympathy with higher metal prices as the shares of Finning International rallied 33%. Only two holdings suffered declines in the period and they were both found within the Telecommunications sector. Shares of TELUS Corp. fell 11% during the quarter after pre-releasing and ultimately confirming disappointing subscriber additions for the first quarter as the competitive landscape evolves in anticipation of new wireless entrants. BCE Inc. also came under modest selling pressure, falling 5%.

Changes

In May we made a switch out of Yellow Pages Income Fund (YLO) resulting from YLO’s decision to lower their annual distribution by 32% to $0.80 per unit due to weaker revenue and earnings visibility and a desire to shore up the capital structure of the company by paying down debt. By virtue of the Investment Policy Statement for this portfolio that triggers the automatic removal of any holding in the event of a cut in the dividend or distribution, we removed the position in Yellow Pages Income Fund and replaced it with a new investment in Shaw Communications Inc.

Shaw Communications Inc. (SJR.B) is a diversified communications company whose core business is providing broadband cable television, high-speed internet, digital phone, satellite direct-to-home television service, and other telecommunications services. Shaw has evolved into a dividend growth story after decades of capital spending had been required to build the telecommunications infrastructure necessary to support the current business model. The company offers predictable revenue and EBITDA growth demonstrating its resilience and, more importantly, providing confidence in its ability to sustain if not grow dividends.


Summer 2009 37

Exhibit 2: ScotiaMcLeod Income Plus Guided Portfolio Risk Price Target Dividend Potential


Interest Sensitive:

BCE Inc. BCE 2-SP Medium $24.00 $30.00 $1.54 6.4% 31%Bank of Nova Scotia BNS 2-SP Medium $43.42 $46.00 $1.96 4.5% 10%Fortis Inc. FTS 2-SP Medium $25.41 $27.00 $1.04 4.1% 10%Great West Lifeco GWO 1-SO Low $22.80 $27.00 $1.23 5.4% 24%Power Financial Corp. PWF 1-SO Low $27.65 $28.00 $1.40 5.1% 6%Rogers Communications Inc. RCI.B 2-SP Medium $29.90 $45.00 $1.16 3.9% 54%Royal Bank of Canada RY 1-SO Low $47.57 $58.00 $2.00 4.2% 26%Sun Life Financial SLF 2-SP Low $31.40 $33.00 $1.44 4.6% 10%TELUS Corp. T 2-SP Medium $30.85 $39.00 $1.90 6.2% 33%

Consumer Products:Thomson Reuters Corp. TRI 1-SO Low $33.85 $47.00 $1.28 3.8% 43%Shaw Communications SJR.B 2-SP Low $19.58 $21.00 $0.84 4.3% 12%


Finning International FTT 2-SP Medium $16.80 $17.75 $0.44 2.6% 8%

Resource:

Enbridge Inc. ENB 1-SO Low $40.36 $48.00 $1.48 3.7% 23%Inter Pipeline Fund LP IPL.UN 1-SO Medium $8.71 R $0.84 9.6%TransCanada Corp. TRP 1-SO High $31.32 $41.00 $1.52 4.9% 36%

Source: Scotia Capital; Bloomberg.


38

ScotiaMcLeod U.S. Core Guided Portfolio

Stephen Uzielli-Portfolio Manager, Portfolio Advisory Group

Performance Update With a modest increase achieved in June, U.S. equities concluded the second quarter with a fourth consecutive positive monthly performance. Every sector of the market moved higher, but in a reversal from the previous quarter, leadership was found among more cyclically oriented industries like Financials, Information Technology, and Industrials, while more defensive groups underperformed. All told, the benchmark S&P500 Index moved higher by 15.9% including dividends, while the U.S. Core Guided Portfolio generated an 18.5% total return. Financials got a boost from the result of "stress tests" which revealed that 9 of 19 senior institutions were deemed sufficiently solvent to withstand a significantly worse recession without requiring more capital. In fact many of these companies subsequently returned loans made by the U.S. Treasury Department as part of the TARP bailout program.

Much of the move up in commodities that occurred in the quarter stemmed from a growing consensus that strength in emerging markets, led by China, is more likely to lead the domestic economic recovery than the U.S. consumer, which has historically held that responsibility. This was particularly evident in the move seen in shares of Freeport McMoRan Copper & Gold which increased by 32% during the quarter and have more than doubled in price since the beginning of 2009. The two Energy holdings also had impressive increases due to the rising price of crude oil. With the view held by some market participants that the economy might recover more quickly than investors had anticipated, Walt Disney shares rallied 29% on expectations for improvement among their media properties. Technology stocks also performed well in response to a more positive economic outlook, but also resulting from merger and acquisition activity in the period. Oracle Corp. shares increased 19% after announcing an all-cash friendly takeover bid for Sun Microsystems and cash-rich Microsoft Corp. shares rallied 29% after making several strategic announcements.

Although we remain cautious in the near term and would only be inclined to add to cyclical stocks on a pullback, it is significant to observe that earnings momentum has recently turned positive which will support continued market strength after some initial retracement. We have argued all year that analysts' earnings estimates were too optimistic for 2009 and were subject to downward revisions. Consensus estimates have declined dramatically since Q1 earnings were released but recently have begun to inch higher again in response to increased confidence in an economic recovery beginning in the second half of 2009 and gaining strength in 2010. The sustainability of that recovery however will be most important in determining the longevity of any market rally.

Changes

Near the end of the quarter we made two changes in this portfolio: 1) Sell JP Morgan; Buy State Street Corp.; and 2) Sell Eli Lilly & Co.; Buy Pfizer Inc. Although we consider JPM among the strongest and best positioned diversified financial companies in the U.S., we determined that the stock was too expensive and thus particularly vulnerable to a pullback in the context of a broader equity market correction. We sold the position, capitalizing on the 130+% rally from the March low, and replaced it with a new position in the shares of State Street Corp. (STT). State Street is one of the leading providers of institutional financial services ranging from custody to investment management. The company's core business provides mutual fund and pension fund back-office processing including accounting, foreign exchange, cash management, securities lending, as well as investment solutions for hedge funds, private equity, and other alternative risk products. The business model for STT is more conservative and lower risk in the current environment than JP Morgan as the company generates fee-based revenues by servicing client assets through providing custody services and asset management. The company's business is less exposed to the unpredictability inherent in traditional banking activities by virtue of volatile credit markets.


Summer 2009 39

Despite Eli Lilly (LLY) having essentially delivered on every major milestone since being added to this portfolio, the stock was not rewarded commensurately and had underperformed its peer group. Starting in 2012 the company faces patent expiry on a number of their products which would reduce future revenues and the company has suggested that an acquisition might be pursued to help make up the gap; in the absence of that event, revenue and earnings growth will be muted. We took advantage of the run-up in the stock price and switched into another big pharma player who has already announced an acquisition to address their patent cliff issues: Pfizer Inc. Pfizer (PFE) is the world's largest research-based biomedical and pharmaceutical company. Some of Pfizer's top-selling products include treatments for high blood pressure and heart failure, osteoarthritis and rheumatoid arthritis, Alzheimer's disease, infectious diseases, epilepsy, depression, and anxiety. PFE recently announced a definitive merger agreement with Wyeth in which "Pfizer will acquire Wyeth in a cash-and-stock transaction. The combined company will create one of the most diversified companies in the global health care industry, with product offerings in numerous growing therapeutic areas, a strong product pipeline, and leading scientific and manufacturing capabilities." This acquisition is accretive to earnings and strategically sound in that it addresses the fall off in revenue that PFE faces with the pending patent expiry of Lipitor and other remedies making them subject to generic competition.

The Guided Portfolios returns are not calculated according to CFA Institute "Performance Presentation Standards". Returns are calculated on a total return basis (including dividend income). The returns are used to gauge our performance by comparing the returns of the Portfolios to benchmark total return indices such as the S&P/TSX 60 and the S&P 500. Historical performance of the Guided Portfolios is not necessarily indicative of future performance. Each client's return will vary depending on the number of shares purchased, as well as the timing of purchases or sales. The Guided Portfolios themselves should not be used as benchmarks with which to compare our clients' portfolios.

Exhibit 3: ScotiaMcLeod U.S. Core Guided Portfolio Risk Price Target Dividend Potential

Sector Symbol Rating Ranking 30-Jun-09 Price Dividend Yield RORInterest Sensitive:

AT&T Inc.* T Not Rated Low $24.84 $30.00 $1.64 6.6% 27%Edison International EIX Neutral Medium $31.46 $30.00 $1.24 3.9% -1%MetLife, Inc. MET Outperform Medium $30.01 $38.00 $0.74 2.5% 29%State Street Corp STT Outperform Low $47.20 $54.00 $0.04 0.1% 14%

Consumer Products:

Becton, Dickinson & Co. BDX Outperform Low $71.31 $78.00 $1.32 1.9% 11%Colgate-Palmolive Co.* CL Not Rated Medium $70.74 $74.00 $1.76 2.5% 7%CVS Caremark Corp CVS Outperform Medium $31.87 $37.00 $0.31 1.0% 17%McKesson Corporation MCK Outperform Low $44.00 $52.00 $0.48 1.1% 19%Nike Inc. NKE Outperform Medium $51.78 $65.00 $1.00 1.9% 27%Pfizer Inc. PFE Outperform Low $15.00 $20.00 $0.64 4.3% 38%Wal Mart Stores WMT Outperform Low $48.44 $53.00 $1.09 2.3% 12%Walt Disney DIS Outperform Medium $23.33 $28.00 $0.35 1.5% 22%


Cisco Systems CSCO Neutral Low $18.65 $22.00 $0.00 0.0% 18%Microsoft Corp MSFT Outperform Low $23.77 $27.50 $0.52 2.2% 18%Oracle Corp ORCL Neutral Low $21.42 $16.25 $0.20 0.9% -23%United Technologies Corp* UTX Not Rated Low $51.96 $58.00 $1.54 3.0% 15%Waste Management Inc. WMI Outperform Medium $28.16 $33.00 $1.16 4.1% 21%

Resource:

Freeport McMoRan Copper FCX Outperform Medium $50.11 $70.00 $0.00 0.0% 40%Occidental Petroleum OXY Outperform Medium $65.81 $68.00 $1.32 2.0% 5%XTO Inc. XTO Outperform Medium $38.14 $42.00 $0.50 1.3% 11%

*Currently Credit Suisse does not provide research coverage - target price based on consenus data.

Source: Scotia Capital Credit Suisse; Bloomberg; Value Line


40

ScotiaMcLeod North American Core Guided Portfolio Stephen Uzielli-Portfolio Manager, Portfolio Advisory Group

Update The ScotiaMcLeod North American Core Guided Portfolio is suitable for growth investors seeking consistent long-term rates of return from a portfolio of high quality Canadian and U.S. companies. The current portfolio holds 25 equal-weighted (4%) positions. Country allocation within the portfolio is determined in a bottom-up, stock-specific fashion as opposed to making any particular country “call.” Generally speaking, but not exclusively, resource holdings will likely come from the Canadian universe, and Health Care, Information Technology, and Consumer stocks will usually be drawn from the U.S.

Just as equity markets bottomed on March 9, the U.S. dollar peaked against the Canadian dollar on the same day and has been trending lower ever since, albeit with a modest recovery in June. Although the U.S. dollar has been dropping against most every global currency, the impact of rising crude prices propped up the Canadian dollar and thus enhanced the U.S. dollar depreciation versus the loonie; since the peak in the U.S. dollar index, which measures the greenback against a basket of global currencies, the U.S. dollar has dropped 10.1% as compared with a 10.5% decline versus the Canadian dollar. In the second quarter the U.S. dollar dropped 8.0% against the Canadian dollar; the negative currency move reduced portfolio performance for U.S. holdings after foreign exchange translation thus mitigating some of the gains in the period. As in the Canadian Core Portfolio, top performers were found among Financial and Energy holdings including Bank of Nova Scotia, Manulife Financial, Suncor Energy and Talisman Energy, but again the biggest contributor to portfolio performance was Teck Resources. Only two holdings declined during the period: AT&T Inc. and Barrick Gold which dropped 4% despite gold bullion remaining essentially flat for the period.

Changes

In early June we made a change in this portfolio whereby we sold the position in Eli Lilly & Co. and replaced it with a new holding in Pfizer Inc. The rationale for this switch is described earlier in the commentary for the U.S. Core Guided Portfolio and is equally valid for the purposes of this portfolio.


Summer 2009 41

Exhibit 4: ScotiaMcLeod North American Core Guided Portfolio Risk Price Target Dividend Potential


Financials:Interest Sensitive:Bank of Nova Scotia BNS 2-SP Low $43.42 $46.00 $1.96 4.5% 10%Brookfield Asset Management BAM/A 1-SO Medium $19.90 $29.12 $0.65 3.2% 50%Manulife Financial MFC 1-SO Low $20.19 $30.00 $1.04 5.2% 54%Royal Bank of Canada RY 1-SO Low $47.57 $58.00 $2.00 4.2% 26%Sun Life Financial SLF 2-SP Low $31.40 $33.00 $1.44 4.6% 10%

Telecommunication Services

AT&T Inc.* T Not Rated Low $24.84 $30.00 $1.64 6.6% 27%Rogers Communications RCI/B 1-SO Medium $29.90 $45.00 $1.16 3.9% 54%

Utilities

Edison International EIX Neutral Medium $31.46 $30.00 $1.24 3.9% -1%

Consumer Discretionary

Walt Disney DIS Outperform Medium $23.33 $28.00 $0.35 1.5% 22%

Consumer Staples

Colgate-Palmolive* CL Not Rated Medium $70.74 $74.00 $1.76 2.5% 7%Shoppers Drug Mart SC 1-SO Low $49.99 $54.00 $0.86 1.7% 10%

Health Care

McKesson Corporation MCK Outperform Low $44.00 $52.00 $0.48 1.1% 19%Pfizer Inc. PFE Outperform Low $15.00 $20.00 $0.64 4.3% 38%

Industrials

Canadian National Railway CNR 1-SO Medium $49.97 $54.50 $1.01 2.0% 11%United Technologies Corp* UTX Not Rated Low $51.96 $58.00 $1.54 3.0% 15%

Information Technology

Cisco Systems CSCO Neutral Low $18.65 $22.00 $0.00 0.0% 18%Microsoft Corp. MSFT Outperform Low $23.77 $27.50 $0.52 2.2% 18%Oracle Corp ORCL Neutral Low $21.42 $16.25 $0.20 0.9% -23%

Energy

Occidental Petroleum OXY Outperform Medium $65.81 $68.00 $1.32 2.0% 5%Suncor Energy SU 2-SP Medium $35.37 $38.00 $0.20 0.6% 8%Talisman Energy TLM 1-SO Medium $16.71 $22.00 $0.23 1.3% 33%TransCanada Corporation TRP 1-SO Low $31.32 $41.00 $1.52 4.9% 36%XTO Inc. XTO Outperform Medium $38.14 $42.00 $0.50 1.3% 11%

Materials

Barrick Gold ABX 1-SO Medium $39.15 $56.47 $0.44 1.1% 45%Teck Resources Ltd. TCK/B 2-SP High $18.55 $27.00 $0.00 0.0% 46%

*Currently Credit Suisse does not provide research coverage - target price based on consenus data.

Source: Scotia Capital Credit Suisse; Bloomberg; Value Line


42

ScotiaMcLeod Core-Plus Fixed Income Guided Portfolio Chris Kennedy, CFA — Associate Director, Portfolio Advisory Group

Investment Objective

The ScotiaMcLeod Core-Plus Fixed Income Guided Portfolio (Core) is designed and managed for our clients with a moderate to higher risk investment profile, whose investment horizon and objectives focus on both current income and a reasonable level of returns to protect against future inflation. Based on these criteria, the portfolio’s objective is to meet or exceed the performance of the portfolio’s benchmark, the DEX Universe Bond Index. Typically, this rate of return is not achieved every year but rather it is the desired average performance over the longer-term time horizon. Approximately 75% of the portfolio is placed in a 10-year laddered bond portfolio and 5% is placed in inflation-protected instruments, comprising the core holdings of the portfolio. The balance of 20% of the portfolio is focused on active value added trade strategies that attempt to help the portfolio outperform the benchmark.

While the ladder portion of this strategy typically entails holding until maturity, we made a change last quarter to take advantage of a significant opportunity. Leading up to the middle of June, we had seen unprecedented positive returns on Tier 1 Capital Security bank debt, as credit spreads (the yield pick up over Canada bonds) has tightened significantly, driven by significant investor demand for exposure to the corporate bond sector. With most investors being overweight corporate debt, we believed the sector had become expensive, and having realized a significant gain of 23.9% since December 08, we decided to sell our ladder position of the RBC Capital Trust 6.821% due June 30, 2018. With Municipal government credit spreads not having tightened to the degree of corporate debt; we felt there was not only safety, but excellent relative yield in this sector. Hence, with the funds from the RBC position, we purchased the Metro Toronto 5.60% due 12/18/18. Metro Toronto is rated AA by Standard & Poor's Rating Agency, Aa1 by Moody's Investor Services and AA by DBRS.

Current Active Strategies

There has been one change to our active strategy last quarter. The Citigroup 4.78% came due on 06/15/09. The position was added in September 2008, and has returned 3.45% since this time, outperforming the benchmark which returned 3.38% over the same period. Going forward, given the significant recent volatility in the capital markets, we are happy to remain in a cash position to await better potential opportunities to create alpha to outperform the benchmark. Therefore with the funds from this maturity we invested in a three month Bank of Nova Scotia Bankers Acceptance position. We continue to hold our other portion of the active strategy, the Glacier Credit Card (GCC) Trust 5.027% due February 20, 2013.

Performance Update

The Core Plus Portfolio returned 2.76%, outperforming the return on its benchmark, the DEX Universe Bond Index, which returned 1.25% ending June 30, 2009. The main factors driving the performance difference were the portfolio's term and sector composition versus the benchmark. The Core Plus is naturally overweight the short and mid term sectors of the index (1-10 year bonds), and with longer-term bonds outperforming the shorter end of the market last quarter, there was a natural drag on the performance of the Core Plus relative to the benchmark. However, sector differences played a larger factor towards performance last quarter giving a greater boost to the Core Plus returns. The corporate sector weighting in the Core Plus was nearly double that of its benchmark at the end of June. In a quarter where confidence and risk appetite continued to return, the corporate sector outperformed nearly all its counterparts, and the overweighting caused much of the positive performance of the Core Plus last quarter.


Summer 2009 43

Each of our active trades performed well last quarter. The Citigroup 4.78% coupon which came due 06/15/09 returned 1.01% from the end of last quarter until its maturity. This position outperformed the benchmark which returned 0.41% over the same period, due to confidence returning to the U.S. financial sector following the release of the stress test results, and as the bond amortized towards par at maturity. Our second active position, the Glacier Credit Card Trust 5.027% due February 20, 2013 had an excellent quarter, returning 4.44%, outperforming the benchmark which returned 1.25% ending June 30, 2009. The overall securitization sector has begun to play catch up to the strong returns seen in the financial bond sector year to date. We continue to believe the securitization sector has further room to improve as investors realize the value of this sector, particularly in high quality credit card receivables compared to alternative corporate bonds, and are comfortable to continue holding this position.

Going forward, given the large rally in Canadian corporate sector relative to government sectors (the DEX All-Corporate Bond Index has returned 10.39% year to date, while the DEX All-Government Bond Index has returned 0.37%), we believe the corporate sector may give up some of its returns over the short term, something we are already witnessing. There is not only volatility in underlying benchmark government bonds on the back of current economic news, and fears of new supply, but credit spreads drift wider over the short term on worries of financial market difficulties going forward. Instead we are happy to look for other areas to outperform while sitting in cash.

Exhibit 1:Core-Plus Fixed Income Guided Portfolio

Issuer Name Coupon Maturity Date Weighting* Rate of Return* Benchmark

Core Positions

Export Development Corp. 5.75 1-Jun-11 7.46% 0.39%Canada 5.00 1-Jun-14 7.44% -2.65%CMHC 4.35 1-Feb-17 7.45% -2.97%Canada RRB 3.00 1-Dec-36 5.08% 0.21%Bell Canada 5.50 12-Aug-10 7.44% 2.61%Royal Bank Fixed Floater 5.45 4-Nov-13 7.44% 5.13%Canadian Tire Corp 4.95 1-Jun-15 7.45% 8.61%Metro Toronto** 5.60 18-Dec-18 7.78% 1.79%Manitoba 5.25 3-Dec-12 7.43% 0.15%Saskatchewan 4.50 23-Aug-16 7.56% 0.80%Quebec** 4.50 1-Dec-19 7.60% 2.26%Active PositionsBankers Acceptance** 0.00 8-Sep-09 9.99% 4.44%Glacier Credit Card Trust 5.03 20-Feb-13 9.88% 0.03%

Total 2.67% 1.25%

*For quarter ending June 30, 2009** Position and returns since June 15, 2009

Source: ScotiaMcLeod Portfolio Advisory Group


44

Notes


Summer 2009 45

Notes


46

The author(s) of the report own(s) securities of the following companies. Suncor Energy Inc., Talisman Energy Inc., Teck Resources Limited, Bank of Nova Scotia, Royal Bank of Canada, Manulife Financial Corporation, Fortis Inc., Rogers Communications Inc., Sun Life Financial Inc., Shoppers Drug Mart Corporation, Yellow Pages Income Fund, Canadian National Railway Company, Barrick Gold Corporation, TransCanada Corporation, Great-West Lifeco Inc., TELUS Corporation, BCE Inc., Thomson Reuters Corporation, Enbridge Inc., United Technologies Corp, The supervisors of the Portfolio Advisory Group own securities of the following companies. Bank of Nova Scotia, Manulife Financial Corporation, Canadian National Railway Company, TELUS Corporation, BCE Inc., Colgate-Palmolive Co, Scotia Capital Restriction -- U.S. (American) Agrium Inc., Bank of Nova Scotia, Teck Resources Limited Scotia Capital Restriction -- Canada Agrium Inc., Teck Resources Limited The Fundamental Research Analyst/Associate, in his/her own account or in a related account, owns securities of the following issuer(s) under his/her coverage: Bank of Nova Scotia, Manulife Financial Corporation, Power Financial Corporation, Royal Bank of Canada, Sun Life Financial Inc. The Head of Equity Research/Supervisory Analyst, in his/her own account or in a related account, owns securities of the following issuer(s): Agrium Inc., Bank of Nova Scotia, BCE Inc., Canadian National Railway Company, Canadian Natural Resources Limited, Enbridge Inc., Finning International Inc., Fortis Inc., Great-West Lifeco Inc., Manulife Financial Corporation, Nexen Inc., Power Financial Corporation, Rogers Communications Inc., Royal Bank of Canada, Shoppers Drug Mart Corporation, Sun Life Financial Inc., Suncor Energy Inc., Talisman Energy Inc., Teck Resources Limited, TELUS Corporation, Thomson Reuters Corporation, TransCanada Corporation The Portfolio Strategist/Associate, in his/her own account or in a related account, owns securities of the following issuer(s): Agrium Inc., Sun Life Financial Inc. The issuer paid a portion of the travel-related expenses incurred by the Fundamental Research Analyst/Associate to visit material operations of the following issuer(s): Barrick Gold Corporation, Finning International Inc. Scotia Capital Restriction Agrium Inc., Bank of Nova Scotia, Teck Resources Limited Scotia Capital Inc. and its affiliates collectively beneficially own in excess of 1% of one or more classes of the issued and outstanding equity securities of the following issuer(s): AGF Management Limited, BCE Inc., Brookfield Asset Management Inc., Enbridge Inc., Finning International Inc., Fortis Inc., Great-West Lifeco Inc., Inter Pipeline Fund, Manulife Financial Corporation, Power Financial Corporation, Rogers Communications Inc., Royal Bank of Canada, Shaw Communications Inc., Sun Life Financial Inc., Teck Resources Limited, TELUS Corporation, Thomson Reuters Corporation, TransCanada Corporation, Yellow Pages Income Fund The Bank of Nova Scotia (“the Bank”) is the parent company of Scotia Capital Inc. (“SCI”). This Report includes comparative information regarding a substantial number of competitors of the Bank where such comparable information is known or ascertainable by SCI and in equal prominence to the information in respect of the Bank. Bank of Nova Scotia The Fundamental Research Analyst/Associate has visited material operations of the following issuer(s): Barrick Gold Corporation, Brookfield Asset Management Inc., Canadian National Railway Company, Shoppers Drug Mart Corporation, Thomson Reuters Corporation, Yellow Pages Income Fund Within the last 12 months, Scotia Capital Inc. has undertaken an underwriting liability with respect to equity securities of, or has provided advice for a fee with respect to, the following issuer(s): Agrium Inc., Bank of Nova Scotia, Barrick Gold Corporation, Brookfield Asset Management Inc., Canadian National Railway Company, Enbridge Inc., Fortis Inc., Great-West Lifeco Inc., Inter Pipeline Fund, Manulife Financial Corporation, Power Financial Corporation, Rogers Communications Inc., Royal Bank of Canada, Shaw Communications Inc., Shoppers Drug Mart Corporation, Sun Life Financial Inc., Suncor Energy Inc., Talisman Energy Inc., Teck Resources Limited, TELUS Corporation, Thomson Reuters Corporation, TransCanada Corporation


Summer 2009 47

ScotiaMcLeod is a division of Scotia Capital Inc. (“SCI”). This report has been prepared by SCI on behalf of the Investment Executive. Opinions, estimates and projections contained herein are our own as of the date hereof and are subject to change without notice. The information and opinions contained herein have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. Neither SCI nor its affiliates accept liability whatsoever for any loss arising from any use of this report or its contents. This report is not, and is not to be construed as, an offer to sell or solicitation of an offer to buy any securities and/or commodity futures contracts. SCI, its affiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securities and/or commodities and/or commodity futures contracts mentioned herein as principal or agent. SCI and/or its affiliates may have acted as financial advisor and/or underwriter for certain of the corporations mentioned herein and may have received and may receive remuneration for same.

The content may have been based, at least in part, on material provided by Credit Suisse First Boston Corporation (“CSFB”), our correspondent research service. CSFB has given ScotiaMcLeod general permission to use its research reports as source materials, but has not reviewed or approved this report, nor has it been informed of its publication. CSFB may from time to time have long or short positions in, effect transactions in, and make markets in securities referred to herein. CSFB may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any company mentioned in this report.

This research and all the information, opinions and conclusions contained in it are protected by copyright. This report may not be reproduced in whole or in part or referred to in any manner whatsoever, nor may the information, opinions, and conclusions contained in it be referred to without in each case the prior express consent of SCI. SCI is a wholly owned subsidiary of a Canadian chartered bank. SCI is a member of The Securities and Futures Authority Limited.


48

ABBOTSFORD (604) 864-3750

BARRIE (705) 725-0300

BELLEVILLE (613) 968-6459

BRAMPTON (905) 796-2424

BRANDON (204) 729-3362

BRIDGEWATER (902) 543-8293

CALGARY (403) 298-4000

CAMBRIDGE (519) 740-4300

CHARLOTTETOWN (902) 566-3225

COMOX (250) 890-3570

COMOX II (250) 890-3579

CORNER BROOK (709) 637-4747

EDMONTON (780) 497-3200

FREDERICTON (506) 450-6465

GRAND PRAIRIE (780) 513-3505

GUELPH (519) 763-0371

HALIFAX (902) 420-2220

HAMILTON (905) 570-7960

KANATA (613) 271-6600

KELOWNA (250) 868-5500

KENTVILLE (902) 678-0777

KINGSTON (613) 531-6300

KITCHENER (519) 571-3700

LAVAL (450) 680-3100

LETHBRIDGE (403) 317-4835

LONDON (519) 660-3214

MARKHAM (905) 947-0933

MEDICINE HAT (403) 529-6565

MISSISSAUGA (905) 848-1300

MONCTON (506) 867-0700

MONTRÉAL (514) 287-3600

MONTRÉAL Capital Branch (514) 287-2900

NEW GLASGOW (902) 755-8509

NEW LISKEARD (705) 647-2044

OAKVILLE – Church St. (905) 377-6301

OAKVILLE – Kerr St. (905) 842-9000

OTTAWA (613) 563-0991

OWEN SOUND (519) 371-6496

PETERBOROUGH (705) 876-1373

POINTE CLAIRE (514) 428-8400

PRINCE GEORGE (250) 614-2080

QUEBEC – Montreal Immigrant Investor Program (514) 287-4504

QUEBEC (418) 686-8666

QUEBEC – Rive-Sud (450) 463-5500

REGINA (306) 352-5005

RICHMOND (604) 713-7888

ROSEDALE

(416) 335-6340

SAINT JOHN (506) 634-8021

SALMON ARM (250) 804-2125

SASKATOON (306) 665-5300

SCARBOROUGH (416) 296-0043

SIDNEY (250) 389-2125

SOUTH GRANVILLE (604) 731-7744 ST. CATHARINES (905) 641-7700

ST. JOHN’S (709) 576-1305

SUDBURY (705) 674-8558

THUNDER BAY (807) 626-5180

TORONTO – Scotia Plaza 11th Floor (416) 862-3110

TORONTO – Scotia Plaza Head Office Branch 15th Floor (416) 863-7272

TORONTO – Scotia Plaza 48th Floor (416) 945-4048

TORONTO – Eglinton (Uptown) (416) 945-4840

TORONTO Personal Inv. Management Group (416) 865-6400

TORONTO – North Toronto (416) 226-9505

TRURO- (902) 896-7741

VANCOUVER (604) 661-7400

VANCOUVER – North (604) 981-7600

VANCOUVER – West (604) 913-7000

VERNON (250) 549-3411

VICTORIA (250) 389-2110

WELLAND (905) 732-7200

WHITBY (905) 444-4500

WHITE ROCK (604) 531-3500

WINDSOR (519) 258-1050

WINNIPEG (204) 944-0025

YARMOUTH (902) 742-0040

ScotiaMcLeodScotiaMcLeod

portfolio advisory group - managed money reporter · portfolio advisory group summer 2009 3...

Documents