Unbundling Canadian ETFs
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Read the updated article: Unbundling Canadian ETFs 2008
iUnits ETFs were recently rebranded as iShares ETFs.
Index investing has become very popular over the last few years despite mediocre market performance. The main advantages to an index-based approach are low fees, diversification, and simplicity. The index investorís goal is to attempt to achieve average, or market performance, for very little cost.
The low relative cost of indexing is very powerful and the general approach was mentioned approvingly by Warren Buffett in his 1993 annual letter to shareholders: ďBy periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.Ē
These days index investors can buy a wide variety of low-cost index funds or exchange traded funds (ETFs). In fact, a fairly diversified equity portfolio could be constructed by buying only three country-based exchange-traded funds. Diversified Canadian exposure can be obtained with the TDís S&P/TSX Composite ETF (TSX:TTF) which tracks over two-hundred large Canadian companies. US equity exposure can be picked up by buying the Vangaurd VIPERs Total Stock Market ETF (AMEX:VTI) which tracks the five-thousand stocks in the Wilshire 5000 index. International exposure can be had by buying the RRSP-eligible iUnits EAFE ETF (TSX:XIN) which tracks the MSCI Europe Australasia Far East Index. An equity portfolio composed of these three exchange-traded funds is simplicity itself but is it inexpensive? The three exchange-traded funds charge less than 0.36% annually in management expense ratio (MER) fees. TTFís annual fee is 0.31%, VTI charges 0.15% per year, and XIN costs 0.35% per year. An equally weighted portfolio composed of these three exchange-traded funds would charge only 0.27% annually which is about a tenth the fees of a similar portfolio composed of actively managed mutual funds. It is this enormous level of comparative savings that provides the index investor with a significant competitive advantage.
While indexing can be a simple and inexpensive approach to building broadly-based equity ownership, not all index funds and exchange-traded funds are both low cost and broadly diversified. Some newer exchange-traded funds attempt to track small market segments represented by a particular sector or style. Fortunately the Canadian exchange-traded fund landscape has remained relatively simple and is dominated by the generally excellent iUnits family of exchange-traded funds offered by Barclays Global Investors Canada (www.iunits.com). iUnits ETFs are appropriate for many passive investors and represent a good investment option. However, an unusual class of long-term investor may be better off replicating the index by buying stocks directly.
Consider two options for the truly long-term index investor. The first option is to purchase an iUnit ETF and the second option is to buy the index's stocks directly. At first glance, the choice between buying a low-cost exchange-traded fund that holds many stocks or buying each of the stocks directly appears to be obvious. The exchange-traded fund is likely to be the better bargain. However, buying the stocks directly may be better for some investors because the Canadian stock market is very small and it is dominated by a few big names. As a result, one might reasonably approximate an index fund by holding only a few stocks.
Before looking at the details of each exchange-traded fund, I'll first set the time horizon for my hypothetical long-term index investor as being seven years. It turns out that seven years is about the length of time that the average equity mutual fund is held by Canadian investors. This surprisingly long holding period was determined by my fund-analyst colleague Dan Hallett who also writes for the Canadian MoneySaver.
With a seven-year time horizon in mind, we can now turn to an investigation of seven iUnits ETFs that are shown in Table 1. The most popular Canadian exchange-traded fund tracks the large-cap S&P/TSX 60 index (TSX:XIU) and has a rock-bottom annual fee (MER) of 0.17%. It is important to remember that exchange-traded funds trade like stocks and, under most circumstances, your broker will charge you a commission to buy and to sell them. Furthermore, an exchange-traded fund may pay dividends which are collected as the stocks in the underlying index pay dividends. This little wrinkle could cause a reinvestment problem in that the investor may be better off collecting dividends until a sizeable purchase can be made to avoid excessive brokerage commissions.
Now, letís take a closer look at select iUnits ETFs with Table 2 showing a variety of interesting statistics for each fund. The first row indicates how much of the index is represented by its largest stock. For instance, the iUnits Info Tech index is dominated by Nortel Networks which makes up a breathtaking 24.85% of the index. Incidentally, the largest stock holding allowed by most of the iUnits capped ETFs is 25% with adjustments made quarterly. The next data row of Table 2 indicates how many stocks are needed to make up 25% of the index. For instance, both the Royal Bank of Canada and Scotiabank combined represent 29.22% of the iUnits Financials index. Similarly, Table 2 also shows how many stocks are needed to form 50%, 75% and 100% of the index. You will notice that the iUnits REIT index only contains seven REITs which means that it is a very concentrated fund. In fact most of the sector based exchange-traded funds shown in Table 2 are not particularly well diversified and an investor can replicate 50% of each index by buying less than six stocks. Even the large-cap S&P/TSX 60, which tracks a total of sixty stocks, invests over half of its assets in only eleven of the largest companies. It should now be evident that some indices are not well-diversified and sector specific indices tend to be very concentrated.
The high level of concentration in Canadian sector specific indices opens up the possibility of buying the component stocks directly. For instance, suppose an investor is interested in holding gold stocks as a buffer against bad times. He could buy the iUnits Gold ETF for 0.55% per year (plus a commission to buy and sell) or he could approximate the index by buying the top three stocks which make up 55.27% of the index at a cost of six commissions (three to buy and three to sell). For simplicity sake, Iíll assume that each commission costs $30, the holding period is seven years, the initial investment is $20,000, there is no inflation, and dividends are not reinvested. Furthermore, Iíll make the gross approximation that the MER cost of the iUnits Gold ETF over seven years is simply 0.55% times $20,000 times 7 for a total of $770. The commission arising from the direct purchase of three gold stocks is $180 compared to the exchange-traded fundís total fee of $830. A savings is possible for investors who donít mind giving up a little more diversification. If 55.27% of the index is too little diversification for an investor then they could buy 81.17% of the index by holding eight of the nineteen gold index stocks with a commission cost of only $480. As a result, a long-term index investor who is willing to approximate the index may be able to save money. Naturally such savings may, or many not, exist depending on the size of the investment, commission costs, the level of index concentration, and the time period in question. Furthermore, one can never predict with 100% certainty which option will be the lowest cost approach because the exchange-traded fundís fee is based on the size of the investment which is likely to vary over time. Nonetheless, buying directly may be an interesting option for more aggressive index investors.
Direct stock purchases also allow investors to be more aggressive on the tax front. For instance, at the end of the year, stocks that lost money could be sold to collect the loss for tax purposes. The money obtained from the sale could then be put into other stocks in the index or the exchange-traded fund itself. Similarly, holders of a concentrated exchange-traded fund that has lost money may consider selling it, collected the capital gains loss for tax purposes, and replacing it with individual stocks in the index instead. Naturally, before embarking on such investment programs, investors should talk to their investment and tax advisors.
Overall, passive investing with low-cost index funds or exchange-traded funds can be a good option. While broad market index funds tend to be lower cost and well diversified, sector specific index funds are often higher cost and much less diversified. As a result, investors should be mindful that they may not be getting the level of diversification that they expect. Furthermore, in some instances, direct stock purchase may be preferable for truly long-term index investors.
First published in the July 2004 Canadian MoneySaver.
Use our new Canadian ETF Fee Calculator to calculate when it is cheaper to buy stocks in an ETF or the ETF itself.
Notes: Read the updated article - Unbundling Canadian ETFs 2008
In the meantime, iUnits has changed its name to iShares. TD's S&P/TSX Composite ETF (TSX:TTF) no longer exists.
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