Vanguard US ETF Benchmarks are Changing

October 3, 2012


Vanguard’s US-listed ETFs such as Vanguard Total Stock Market Index ETF (VTI), Vanguard MSCI EAFE ETF (VEA) and Vanguard MSCI Emerging Markets ETF (VWO) are popular among Canadian index investors because they offer a cheap way to diversify into global stock markets. Investors in these ETFs should take note of a recent announcement by Vanguard that these ETFs will shortly switch from tracking indexes provided by MSCI to indexes provided by Center for Research in Security Prices (CRSP) for the US market and FTSE for international markets.

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:

Year FTSE EM Index MSCI EM Index Delta
2002 -6.10% -6.17% 0.07%
2003 54.00% 55.82% -1.82%
2004 27.90% 25.55% 2.35%
2005 35.10% 34.00% 1.10%
2006 33.10% 32.17% 0.93%
2007 39.70% 39.39% 0.31%
2008 -52.90% -53.33% 0.43%
2009 82.60% 78.51% 4.09%
2010 19.80% 18.88% 0.92%
2011 -19.00% -18.42% -0.58%
Total 387.75% 366.14% 21.61%

Comparing 10-year Annual Returns of Emerging Market Indexes

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.

Country FTSE Emerging Index MSCI EM Index
China 16.72% 17.30%
South Korea   15.40%
Brazil 16.09% 13.15%
Taiwan 13.23% 10.95%
South Africa 10.56% 8.01%

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.

FTSE Emerging Index MSCI EM Index
No. of stocks 793 820
Total Market Cap $3.3 Trillion $3.4 Trillion
Average Market Cap $4.2 Billion $4.1 Billion
Median Market Cap $1.8 Billion $2.0 Billion

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.

Vanguard’s Dividend, REIT and S&P 500 ETFs are great news for ETF Investors

September 6, 2012


Vanguard Canada appears to have been listening to ETF investors. The fund company known for its low-cost, plain vanilla index products will shortly be adding five new ETFs to its existing line up of six ETFs. The new ETFs are:

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.

Is Black Swan Protection Worth the Cost?

June 12, 2012


Horizons recently launched two new Exchange-Traded Funds (ETFs) that provide passive exposure to the Canadian and US stock markets while overlaying an active options strategy that seeks to take advantage of sudden downward movements in stock prices.  The two ETFs are:

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.