ETFs

The 2012 Sleepy Portfolio Report Card

January 28, 2013

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Background

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:

Asset Type Security #s Price Current Value % Portfolio Target % Delta
Cash TDB8150 9144 $1 $9,144 6.34% 5.00% -1.34%
Bonds TSX: XSB 705 $29 $20,304 14.07% 15.00% 0.93%
  TSX: XRB 275 $26 $7,090 4.91% 5.00% 0.09%
Canada Equity TSX: XIC 1445 $20 $28,380 19.66% 20.00% 0.34%
US Equity VTI 440 $73 $32,063 22.22% 22.50% 0.28%
International Equity VEA 945 $35 $33,106 22.94% 22.50% -0.44%
Emerging Markets VWO 170 $45 $7,528 5.22% 5.00% -0.22%
Other TSX: XRE 392 $17 $6,711 4.65% 5.00% 0.35%
Total       $144,325    

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.

Q&A with Vanguard Canada

December 10, 2012

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It is now more than one year since Vanguard came to Canada by launching its first set of Exchange-Traded Funds (ETFs). Last week, I had a chance to chat with Atul Tiwari Chief of Vanguard Canada. I asked him a few of my questions and those of Canadian Money Forum members (here) about Vanguard’s plans for the future, ownership structure and securities lending policies.

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%.

Impact of Benchmark Change on Vanguard MSCI EAFE ETF (VEA)

October 16, 2012

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Recently, Vanguard announced that it will be switching the benchmark index for many of its Exchange-Traded Funds (ETF). In an earlier post, we took a closer look at what the benchmark change means for the Vanguard Emerging Markets ETF (VWO) and found a significant difference in past performance. In this post, we’ll take a closer look at the impact of the benchmark change on the Vanguard MSCI EAFE ETF (VEA).

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.

FTSE Developed MSCI EAFE Index
No. of stocks 1384 920
Total Market Cap $11.69T $10.26T
Average Market Cap $8.4B $11.15B
Median Market Cap $3.05B $4.9B

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.

Country FTSE Developed MSCI EAFE Index
United Kingdom 23% 23%
Japan 20% 19%
Switzerland 9% 9%
France 9% 9%
Australia 9% 9%

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:

Year FTSE Developed Markets MSCI EAFE Index Delta
2002 -15.1% -15.9% 0.8%
2003 39.4% 38.6% 0.8%
2004 20.8% 20.3% 0.5%
2005 13.9% 13.5% 0.4%
2006 27.6% 26.3% 1.3%
2007 12.8% 11.2% 1.6%
2008 -43.2% -43.4% 0.2%
2009 34.0% 31.8% 2.2%
2010 9.1% 7.8% 1.4%
2011 -12.1% -12.1% 0.0%
Total 171.1% 157.8% 13.3%

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.

Comparing Annual Returns of Developed Market ex North America Indexes