Still, Canadian-listed ETFs that do not hedge currency will be valuable for investors who do not want to look for cheaper methods of converting Canadian dollars into US dollars and who do not want to pay the usurious foreign exchange fees charged by most discount brokers. Last year, Vanguard Canada introduced the S&P 500 Index ETF (TSX: VFV, MER 0.18 percent), a fund that tracks the S&P 500 index. Now, iShares has launched three new ETFs that started trading on the TSX yesterday. They are:

iShares S&P 500 Index ETF (XUS): Track the S&P 500 index, a market-cap weighted index of 500 large US corporations. MER is 0.14 percent. Note that the ETF is essentially a wrapper around the iShares Core S&P 500 ETF (IVV) that trades on the NYSE Arca exchange.

iShares MSCI EAFE Index ETF (XEF): Track the MSCI EAFE index, a market-cap weighted index that tracks stocks from Europe, Australasia and the Far East (essentially an index of developed market stock markets excluding the US and Canada). MER is 0.30 percent. The ETF is a wrapper around the iShares Core MSCI EAFE ETF (IEFA).

iShares MSCI Emerging Markets ETF (XEC): Track the MSCI Emerging Markets Index, a market-cap weighted index that tracks stock market performance of emerging markets. MER is 0.35 percent. The ETF is a wrapper around the iShares Core MSCI Emerging Markets ETF (IEMG).

Take-away for Investors

• These ETFs are great news for Canadian investors wanting Developed Markets ex North America and Emerging Markets exposure from securities listed in Canada but do not want currency hedging because the new ETFs are far cheaper than existing alternatives.
• Investors should keep in mind that owning a Canadian-listed ETF that holds foreign securities in their RRSPs means incurring a 15 percent withholding tax hit on dividends. i.e. an investor who holds $1,000 worth of XUS in a RRSP will incur a tax hit of $3 per year compared to holding $1,000 worth of IVV. Note that the withholding tax hit is only for RRSPs and RRIFs.

Related Reading:

• New iShares Emerging Market and World ETFs
• A Tour of ETFs: Vanguard Emerging Markets ETF
• Vanguard to Introduce Six New ETFs
• Investing in Emerging Markets
• Vanguard announces ETF pricing and ticker symbols

New Currency Unhedged ETFs from iShares is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

Budget 2013 proposes to put a kibosh on what it calls “character conversion transactions” such as the ones employed by Advantaged ETFs.

Character conversion transactions link a derivative investment with the purchase or sale of an otherwise unrelated capital property to form a derivative forward agreement. If the derivative investment were made separately from the purchase or sale of the capital property (i.e., as a cash-settled derivative financial instrument), any income from the derivative investment would be taxed as ordinary income.

To ensure the appropriate tax treatment of the derivative-based return on a derivative forward agreement, Budget 2013 proposes to treat this return as being distinct from the disposition of a capital property that is purchased or sold under the derivative forward agreement. This measure will apply to derivative forward agreements that have a duration of more than 180 days. Whether a particular property is held on income or capital account is largely a factual determination and is unaffected by this measure.

ETFs Affected by the Change

iShares Canada put out a press release saying that seven funds in its ETF line up will be impacted by the changes proposed in the Budget. It is interesting to note that all these ETFs used to be traded under the Claymore brand name. They are:

iShares Advantaged Canadian Bond Index ETF (CAB)
iShares Advantaged Convertible Bond Index ETF (CVD)
iShares Advantaged U.S. High Yield Bond ETF (CHB)
iShares Advantaged Short Duration High Income ETF (CSD, CSD.U)
iShares Global Monthly Advantaged Dividend Index ETF (CYH)
iShares Broad Commodity Index ETF (CBR)
iShares Managed Futures Index ETF (CMF, CMF.A)

ETFs Not Affected by the Change

Horizons also put out a news release saying that the Budget proposals are not expected to impact the popular Horizons S&P/TSX 60 Index ETF (HXT) because the ETF makes no distributions and hence there is no re-characterization taking place. Horizons confirmed that the Horizons S&P 500 Index ETF (HXS) is also not expected to be affected by the move. Nevertheless, investors should weigh the risk of an adverse change in tax treatment of swap-based ETFs against the tax advantage of earning total returns.

See also: Canadian Financial DIY’s and Canadian Couch Potato’s takes on this topic.

Related Reading:

• Performance of the Horizons Enhanced Income Equity ETF (HEX)
• iShares ETFs becoming more expensive
• Index ETFs: iUnits or iShares
• Changes to iUnits ETFs
• More New ETFs

Budget 2013 clamps down on Advantaged ETFs is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

It appears that many investors thought (or at least hoped) the higher yield from ZWB compared to a plain vanilla product like the BMO S&P/TSX Equal Weight Banks Index ETF (TSX: ZEB) would translate into higher total returns. Now that ZWB has a 2 year track record under its belt, we can analyze how ZWB’s returns stacks up against ZEB’s.

Performance for the 2-year period ending Jan. 31, 2013

BMO Covered Call Canadian Banks ETF (ZWB): 8.10%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 8.92%

We find that the Covered Call ETF under performs the Bank ETF by an annualized 0.82 percent over a two year period even though it is just 0.10 percent more expensive than the plain-vanilla ETF. In the following graphic, we break down the total returns from the two ETFs into income and capital gains.

The one year performance (for the period ending Jan. 31) of the Covered Call Banks ETF (ZWB) is compared with that of the Equal Weight Banks ETF (ZEB) in the following table:

If we look at the income generated by these two ETFs as a percentage of starting NAV, we get:

Income generated for the 1-year period ending Jan. 31, 2012

BMO Covered Call Canadian Banks ETF (ZWB): 9.2%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 3.5%

Income generated for the 1-year period ending Jan. 31, 2013

BMO Covered Call Canadian Banks ETF (ZWB): 6.8%
BMO S&P/TSX Equal Weight Banks Index ETF (ZEB): 3.6%

In other words, though an investor earned a significantly higher current income with ZWB, she would have earned lower total returns compared to an investment in ZEB over the past two years. Also, the income an investor receives from the covered call ETF has been dropping: the fund started off with an annualized yield of 10 percent but two years later, the yield is just 5.6 percent. Granted, a two year time frame is too short to make a fair comparison of ZWB and ZEB but the early results show that just as we initially suspected, there is no free lunch here.

NB: This post was initially published on Feb 20, 2012. It was updated on Feb 5, 2013.

Related Reading:

• Performance of the Horizons Enhanced Income Equity ETF (HEX)
• BMO Covered Call Canadian Banks ETF (ZWB)
• Horizon AlphaPro Covered Call ETFs: Enhanced Equity ETF (HEX) and more…
• Asset Class Returns for 2012
• An Introduction to Covered Call ETFs

A look at the Performance of the BMO Covered Call Canadian Banks ETF (ZWB) is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

I started the Sleepy Portfolio in 2005 to benchmark my personal portfolio, which at that time was mostly invested in individual stocks. The portfolio started off with an initial outlay of $100,000 but no new money has been added since. This is not simply a model portfolio; it reflects investment returns that can be obtained in the real world by accounting for costs such as spreads, trading commissions, MERs, foreign exchange conversion charges etc. For example, when the portfolio was first assembled in 2005, it cost $29 to make a trade and 1.5 percent to initially convert Canadian dollars to buy US securities. Note, however, that the portfolio is assumed to be held in a registered account, so it does not take taxes into account.

The portfolio has a target allocation of 5% cash, 15% short bonds, 5% real return bonds, 20% Canadian stocks, 22.5% US stocks, 22.5% Europe and Pacific, 5% Emerging markets and 5% REITs. The entire portfolio (apart from the cash portion) is invested in broad-market, exchange-traded funds (ETFs) trading in the Canadian and US stock exchanges. The cash portion is invested in a high-interest savings account that is available through many discount brokers.

4Q-2012 Update

The Sleepy Portfolio gained 2.52 percent since my previous update. During the calendar year 2012, the Sleepy Portfolio gained exactly 10 percent. It is instructive to compare the current portfolio holdings with that of year end 2011. We find that over the course of the year, positions in real return bonds and REITs were trimmed back and additions were made to positions in Canadian equity, Developed Markets ex US and emerging markets. Rebalancing the portfolio helped because developed markets and emerging markets were among the best performing asset classes of 2012.

Here’s how the portfolio looked as of December 31, 2012:

There will be no new transactions because all asset classes are now more or less on target.

Portfolio Expenses

It is worth noting that the weighted average MER of the portfolio is currently a miserly 0.21 percent. That means the portfolio incurs a MER cost of just under $210 per year per $100,000 balance. If the same portfolio were invested in typical Canadian mutual funds that charge a MER of 2.5 percent, the MER cost would be $2,500.

Of course, a portfolio composed of ETFs will incur trading costs. But the Sleepy Portfolio gets by with very little trading. During the last year, five trades were made in the portfolio for a total trading cost of $50. The portfolio also incurred costs involved in converting currency to purchase US-listed ETFs. These costs added up to about $51. Expressed as a percentage of average portfolio value during the year, trading costs amounted to just under 4 basis points. The total expenses incurred by the portfolio in 2012 was therefore just 25 basis points.

Related Reading:

• Sleepy Portfolio 3Q-2012 Update
• Sleepy Portfolio 2Q-2011 Report Card
• The 2011 Sleepy Portfolio Report Card
• Sleepy Portfolio 3Q-2011 Report Card
• Sleepy Portfolio 1Q-2012 Report Card

The 2012 Sleepy Portfolio Report Card is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

It is now over an year since Vanguard launched its first suite of ETFs. The flagship Vanguard MSCI Canada Index ETF (VCE) has just $91 million in AUM. Can long-term investors assume that Vanguard is committed to doing business in Canada?

We are very pleased with where Vanguard Canada is today, exactly one year (Dec. 6th) after our launch. We have $430 million in assets and accounted for 12.5 percent of inflow into ETFs in the categories of our 6 core products to date in 2012. Investors can be confident that Vanguard plans to be in Canada for a long, long time. That’s because Vanguard has expanded into new markets in a careful, deliberate fashion.

Any comment on upcoming ETFs?

We will be launching our third tranche of ETFs in 2013. We are looking into launching unhedged versions of Vanguard EAFE Index ETF (CAD-Hedged) (TSX: VEF) and Vanguard MSCI US Broad Market Index ETF (TSX: VUS) but our plans are not final.

Vanguard in the US offers extras to investors with $50,000 or more in assets such as commission-free ETF trading, financial plans etc. Are there any plans to launch similar services in Canada in the future?

Vanguard in the US operates a brokerage that allows it to offer clients commission-free ETF trading. We don’t have plans to offer such services in the near future. Canadian investors wishing to purchase Vanguard ETFs can currently do so through brokerages such as iTrade and others that offer them.

ETFs such as VEF and VEE which are wraps around US-listed ETFs. Will these ETFs hold component securities directly at some point in the future?

The issue is cost. It is very expensive to buy and take custody of foreign shares in Canada compared to the United States, which has the deepest capital markets in the world. Vanguard is aware that holding wrap ETFs in registered accounts incurs a cost and investors should weigh that against the benefits of not having to convert currencies and US estate tax implications. Withholding taxes should be only one of the factors you consider when you invest.

Can you comment on the ownership structure of Vanguard Canada? Is it similar to that of the US, where Vanguard is set up as a mutual company in which the company is owned by the funds and the interests of Vanguard’s are aligned with that of investors in its funds?

Vanguard Canada is set up as a subsidiary of Vanguard US. Since Vanguard in the US is set up as a mutual company in which the mutual funds own the fund company, and it operates on an “at cost” basis, it translates into lower costs for investors over time. Vanguard Canada will operate on the same principle. At present, we are in start-up mode, so essentially Vanguard US fund holders are subsidizing investors in Vanguard’s Canadian ETFs. As the ETFs gather more assets and the operations become profitable, the profits will, in effect, flow back to investors in the form of lower fees.

Can you comment on your securities lending policies? What about collateral? Is there a chance, however remote, that the collateral can turn illiquid or experience losses? (Interested readers may want to check out this paper on how Vanguard practises securities lending).

Vanguard does securities lending differently from other ETF vendors. First, there is no securities lending in fixed-income products. In equity ETFs, only a small percentage of a fund’s assets — between 1 to 5 percent, typically around 3 percent — are lent out. Vanguard lends out only scarce securities to earn better fees. For example, Vanguard ETFs will not generally lend a stock such as IBM that is easily available for borrowing. It should be noted that unlike other firms that allocate a significant portion of lending revenues to their management companies, Vanguard returns all lending revenues, net of broker rebates, program costs, and agent fees, to the funds for the benefit of investors. Vanguard invests the collateral in high quality short term instruments, such as Government securities or cash deposits and marks to market daily at 102-105%.

Related Reading:

• Reader Question: How to Open a Vanguard Account?
• Top 5 Investment Deals
• Vanguard’s Wishy Washy Take on Active Management
• Reader Question: How to Buy Vanguard ETFs?
• A Peek at Vanguard’s Australian ETFs

Q&A with Vanguard Canada is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

The Vanguard MSCI EAFE ETF (VEA) currently tracks the MSCI EAFE Index, a benchmark that tracks stock markets in developed markets in Europe, Australasia and Far East (EAFE). VEA will shortly start tracking the FTSE Developed ex North America Index. The FTSE index includes a lot more stocks than the MSCI index as you can see from the following table.

The top countries represented in each index look similar but there are two significant differences: Korea, which FTSE classifies as a developed country gets a 5.8% allocation and Hong Kong has a higher weighting of 4.7% in the FTSE Index compared to 3% in the MSCI EAFE Index.

Perhaps due to the differences in composition and country weightings of the two indexes, there are significant differences in annual returns over the past 10 years as you can see in the table below:

Though the FTSE Developed Markets ex North America Index has outperformed the MSCI EAFE Index over the past 10 years, the key point for investors is that the risk-return profile of these two indexes looks pretty similar. Investors holding VEA in their portfolios can expect it to perform the same role it did before: capture the performance of developed markets outside Canada and the United States.

Related Reading:

• Vanguard US ETF Benchmarks are Changing
• Asset Class Returns for 2012
• A look at the Performance of the BMO Covered Call Canadian Banks ETF (ZWB)
• The 2012 Sleepy Portfolio Report Card
• A Tour of ETFs: iShares MSCI EAFE Index Fund

Impact of Benchmark Change on Vanguard MSCI EAFE ETF (VEA) is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

Vanguard says that the change will help it save millions in benchmark licensing fees it currently pays to MSCI Inc (in response to the news MSCI’s stock dropped by more than 25%). In turn, due to Vanguard’s ownership structure, investors can expect the savings to pass through to them over time in the form of lower expense ratios. VTI, VEA and VWO currently charge a MER of 0.06%, 0.12% and 0.20% respectively and investors can expect these MERs to fall even lower!

A key concern when an index mutual fund or ETF changes its benchmark is turnover. Turnover negatively impacts investors through a one-time increase in trading costs and could trigger capital gains distributions. Vanguard does expect some extra turnover from the transition but says that it doesn’t expect any capital gains distributions.

Impact of Benchmark Change on Vanguard Emerging Market ETF (VWO)

Unfortunately, it does look like the change in indexes needs to be analyzed carefully. The new indexes that VTI, VEA and VWO will track look quite different from the MSCI indexes that they currently track. Let’s consider the case of VWO, which currently tracks the MSCI Emerging Markets Index and will start tracking the FTSE Emerging Index. Here’s a comparison of the annual returns of the two indexes for the past 10 years:

One of the reasons for the substantial return differential in some years could probably be attributed to the classification of South Korea, which has a 15.4% weighting in the MSCI Emerging Markets Index as a developed country in the FTSE indexes. Therefore, the country weightings of other emerging markets in the MSCI Emerging Markets Index are somewhat different from the FTSE Emerging Index.

Apart from the country weightings, the two emerging market indexes look fairly similar. This might explain the roughly similar risk-reward profile in the annual returns.

In future posts, we’ll take a look at the impact of the benchmark change on the Developed Market ETF and the US Total Stock Market ETF.

Related Reading:

• Impact of Benchmark Change on Vanguard MSCI EAFE ETF (VEA)
• Asset Class Returns for 2012
• The 2012 Sleepy Portfolio Report Card
• A look at the Performance of the BMO Covered Call Canadian Banks ETF (ZWB)
• Claymore Broad Emerging Markets ETF (TSX: CWO)

Vanguard US ETF Benchmarks are Changing is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

Vanguard FTSE Canadian High Dividend Yield Index ETF (TSX: VDY)

The ETF will track an index of Canadian stocks that sport a high dividend yield. There is very little information on the index available currently other than it is market cap weighted and focused on dividend income. The management fee is 0.30%. It is worth noting here that the new dividend ETF will be 0.20% to 0.30% cheaper than popular Canadian dividend ETFs such as the iShares Dow Jones Canada Select Dividend Index Fund (XDV) and the iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (CDZ).

Vanguard FTSE Canadian Capped REIT Index ETF (TSX: VRE)

This ETF will track the FTSE Canada All Cap Real Estate Capped 25% Index. The index is composed of publicly-traded companies in the Canadian real estate sector with each constituent’s weight capped at 25%. The management fee is 0.35%, which is 0.20% cheaper than the popular iShares S&P/TSX Capped REIT Index ETF (XRE).

An interesting question is whether the new Vanguard REIT ETF is still worth unbundling to save on MERs. Let’s assume that an investor wants to hold five REITs in equal weights directly and rebalance once every year for the real estate portion of the portfolio. If the investor pays $10 per trade, the break-even point will be just $14,300.

Vanguard S&P 500 ETFs

The Vanguard S&P 500 Index ETF (ticker symbol VFV) finally provides Canadian investors access to a low-cost, US market ETF that does not hedge currency exposure. This ETF will provide investors with two advantages: (1) Eliminate the need to exchange Canadian dollars even if it is through low-cost currency conversion alternatives like the Norbert Gambit and (2) Provide Canadians with a way to avoid headaches with US Estate Taxes entirely. However, the Vanguard S&P 500 Index ETF will incur a drag of about 0.30% in RRSP and RRIF accounts compared to directly holding an US-listed ETF (See post on how withholding taxes affect the choice of international investments for an explanation).

The Vanguard S&P 500 Index ETF (CAD-Hedged) (TSX: VSP) is the currency-hedged version of the Vanguard S&P 500 Index ETF. Both ETFs will charge a management fee of 0.15% and both ETFs will simply hold the US-listed Vanguard S&P 500 ETF (VOO). VOO has an expense ratio of 0.05% but the Canadian-listed S&P 500 ETF management fees indicated are inclusive of VOO’s expenses.

Vanguard Canadian Short-Term Corporate Bond Index ETF (TSX: VSC)

This fund will track the Barclays Global Aggregate Canadian Credit 1-5 year Float Adjusted Bond Index, which is composed of investment grade corporate bonds with maturities ranging from one to five years. The management fee is 0.15%.

Note that the ETF MERs are likely to be slightly higher because certain operating expenses such as brokerage commissions and harmonized sales taxes will be charged to the fund in addition to the management fee. You can read the ETF prospectus here.

You can read Canadian Couch Potato’s take on the new ETFs here and a discussion on this topic on the Canadian Money Forum here.

Updated Nov. 8, 2012 with ticker symbols. Details here.

Related Reading:

• A Peek at Vanguard’s Australian ETFs
• Claymore Global Real Estate ETF (CGR)
• My Exchange-Traded Fund Wishlist
• Vanguard to Introduce Six New ETFs
• Vanguard announces ETF pricing and ticker symbols

Vanguard’s Dividend, REIT and S&P 500 ETFs are great news for ETF Investors is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

Horizons Universa Canadian Black Swan ETF (TSX: HUT), which will provide exposure to the S&P/TSX 60 Index and an actively-managed put options strategy that will be profitable when markets experience a significant decline. The management fee is 0.95 percent plus a performance fee of 20 percent of outperformance over the S&P/TSX 60 index with high watermark.

Horizons Universa US Black Swan ETF (TSX: HUS.U), which will provide exposure to the S&P 500 index and an actively-managed options strategy. The management fee is 0.95 percent plus a performance fee of 20 percent of outperformance over the S&P 500 index with high watermark. The ETF is denominated in US dollars and does not hedge the currency exposure.

The interesting part of these ETFs is the options overlay provided by a firm called Universa, which counts Nassim Nicholas Taleb as an advisor. In his book Fooled by Randomness, Nassim Taleb defined Black Swan (the term refers to the once prevalent old world belief that all swans are white, which was proven false when black swans were discovered in Australia) as a rare event that is (1) unexpected (2) carries an extreme impact and (3) believed to be predictable in hindsight. In financial markets, a Black Swan event is one which causes a sudden and dramatic decline in stock prices such as the terrorist attacks of 9/11 or the bankruptcy of Lehman Brothers.

The Black Swan ETFs aim to take advantage of a sudden decline in equity prices by purchasing out-of-the-money put options. A put option gives the investor the right but not the obligation to sell a security at a certain price within a certain period. The fund managers aim to reduce the cost of buying put options by also selling puts further out of the money. Here’s an example provided by Horizons: The S&P500 index is currently trading at 1,350. The ETF will buy a put option with a strike price of 1,100 and sell a put option with a strike price of 1,000 and the net cost of the put options is $1.10.

The Black Swan ETFs can be expected to lag a long-only strategy by the net cost of the options strategy in bullish and slightly bearish markets. The ETFs are expected to outperform plain-vanilla ETFs when the monthly losses exceed 10 percent with the maximum gains accruing when equity values decline 25 percent.

There is some value in eliminating the negative fat tails in equity returns but it is unclear whether the advantage of outperformance in severe bear markets will be worth the cost of insuring the portfolio against dramatic declines at all other times. A Black Swan event is, by definition, rare, which means that most of the time the put options will expire worthless but will occasionally pay off in spades. The question facing investors will be whether the dollars earned once in a blue moon will be worth the nickels spent in option premiums and extra fees.

Related reading:
Horizons Black Swan ETFs Prospectus
Bloomberg story featuring Universa, the sub-advisor to the Horizons Black Swan ETFs.
The Wall Street Journal story on the sudden popularity of Black Swan products.

Related Reading:

• The Frequency of Black Swan Events
• An Introduction to Covered Call ETFs
• Horizon AlphaPro Covered Call ETFs: Enhanced Equity ETF (HEX) and more…
• Horizons BetaPro S&P/TSX 60 ETF (HXT): Cheap but not simple
• Past Performance of the CBOE S&P 500 BuyWrite Index (BXM)

Is Black Swan Protection Worth the Cost? is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

This limitation of the TSX Composite Index is one reason why passive investors diversify their portfolios globally. The US Total Stock Market, for instance, offers much better diversification. The three dominant sectors in the Canadian market make up less than a third of the US stock market. The US stock market also offers exposure to sectors such as Information Technology, Healthcare and Consumer goods that have a much smaller representation in the Canadian index.

The MSCI EAFE Index which provides exposure to developed stock markets in Europe and the Pacific region is also well diversified across sectors. Financials and resources make up just 40 percent and the index has significant allocation to stocks representing Consumer goods, Utilities and Telecommunication services.

A globally diversified index portfolio such as the Sleepy Portfolio, which is split between Canadian, US, EAFE and Emerging Markets has a much better balance between sectors when compared to the Canadian stock market. The allocation to financials and resources drops to less than half the portfolio compared to three-quarters for the Canadian-market only index investor. And the allocation to sectors such as Consumer goods, Information Technology and Healthcare is also boosted substantially.

Related Reading:

• A Tour of ETFs: Horizon AlphaPro Equal Weight 60 ETF (HEW)
• Reader Query on Asset Allocation
• From the archives: Horizon AlphaPro Managed S&P/TSX 60 ETF (HAX)
• Reducing Exposure to Commodities
• Interview with Dan Solin

Sector Breakdown of Diversified Portfolios is brought to you by Canadian Capitalist -- Helping you to invest & prosper.