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moneysense.ca, 8/06/09
Personal Finance Clinic: Unbundling ETFs & XIN versus VEA
In today’s post, I’ll try and answer two questions that were sent to the Personal Finance Clinic. You may also want to check out Money Gardener and Triaging my way to Financial Success, who have also been fielding questions that were sent to the Clinic.
Gaby of Toronto asks:
While ETF’s can provide some stability and peace of mind, would it be possible to do better by buying individually enough of an ETF’s main components that cover a big chunk of the holdings? For example, if the iShares Canadian Tech Sector ETF (XIT), is moving up, would it theoretically be possible to buy its top two or three components (Research in Motion, CGI Group Inc. – Class A, and Open Text Corp) and therefore weed out the smaller stocks holding the performance back?
You are talking about unbundling ETFs and buying the component stocks directly, which could work out cheaper due to $10 stock commissions and the concentrated nature of many sector ETFs. The StingyInvestor.com website has a nifty tool for comparing the cost of the ETF with buying the shares directly. If you are willing to live with the tracking error introduced when dropping some of the smaller names, unbundling the ETF could work out even cheaper.
Dennis from Toronto asks:
Are there any tax advantages/disadvantages in choosing iShares CDN MSCI EAFE ETF (XIN) over Vanguard Europe-Pacific (VEA)? I understand that the MERs are different and iShares hedges foreign currency exposure. However, are there different tax implications for choosing Vanguard versus Canadian iShares?
Yesterday’s post showed how holding Canadian ETFs that in turn hold US ETFs results in a withholding tax that cannot be recovered for registered holdings. In taxable accounts, ETFs such as XIN that hedge foreign currency exposure have a different problem: the gains due to currency hedging are taxed as capital gains on an ongoing basis. In other words, ETFs such as XIN that hold foreign ETFs have a tax leakage due to withholding taxes in RRSPs and a tax leakage due to ongoing capital gains in taxable accounts.
moneysense.ca, 8/06/09
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I’d just add that having a “tracking error” against the index is not necessarily a bad thing, that the returns can be higher or lower.
Of course the point of tracking an index, economy or sector is broad diversification from company risk. Even with perfect tracking results you are exposed to greater risk when you concentrate on fewer stocks.
Wow! This is exactly the area where I always argue for stock picking over choosing a mutual fund in philosophical debates!
The broader TSX index and almost all Canadian Equity Mutual Funds are dominated by the Big 5 Banks, Big 3 Insurance names, a couple of Utilities and a couple of Oil & Gas companies. In my opinion, you don’t even need to buy all of these companies to mimic the funds because most of these stocks move in lock step with one another. For example, just picking two of the Big 5 Banks (let’s say the ones with the better track records), plus one Big Insurance (you really only have Sun Life, Manulife and Great West to choose from) company would probably be adequate to mimic the Financials index. Almost all funds have significant holdings in names like BCE, TransCanada Pipelines, Encana – so why not buy and hold with 0% MER? A side note is that a merged Petro-Canada / Suncor Energy will overtake EnCana as our largest energy company when that transaction is complete.
And another of my favourite areas is REITs. I haven’t checked lately but the biggest has always been RioCan, H&R and one other (whose name eludes me) round out the Top 3, which I believe makes up well over half of the market weighted index. So, buying 3 names will allow you to mimic the real estate index.
I also don’t buy any bond funds because I’d rather have a maturity date where I’m nearly guaranteed to get my principal back. So, 100% of my fixed income investments are also in individual names, albeit mostly with government, crown corporations, chartered banks and CDIC insured GICs.
Anyways, it’s a great subject and I have a natural bias against all mutual funds. It’s just my one man’s opinion, but I think that once someone’s portfolio size exceeds $100K, that is the “economy of scale” where your annual MER is damaging to your portfolio in absolute terms. With a portfolio size below $100K, it is difficult to remain diversified as the trading fees for smaller blocks of stocks would eat into your returns on both a relative and absolute basis. Small portfolios are the only place where mutual funds may make sense (in my humble opinion) but it’s a catch-22 as most brokers don’t like to deal with people with small portfolios.
The interesting part of the first question is that it suggests smaller companies in an index are holding it back. I can understand just buying the larger stocks to avoid fees, but between smaller stocks typically playing a smaller part in the index and their greater growth potential I don’t see the advantage in excluding them from the performance – in fact a fundamentally-weighted index that allows them to have a greater impact might do better (with higher volatility of course, if that’s what you want).
The Farma/French model says there is risk/return advantage to owning small cap and value stocks.
So if you choose to narrowly focus on just a few stocks to avoid smaller companies, or you pick those with “better track records”, doesn’t that mean you are giving up the added return from small cap and value stocks which over a long term have been shown to outperform?
Also if you plan on making regular additional contributions then why not broadly diversify across more individual stocks, there isn’t any additional cost, what is the possible downside?
Sorry, I meant the “Fama/French” model.
I agree that in a narrow (just a few dominant sectors) and shallow (just a few dominant names) market such as Canada, buying stocks directly is an option. Like Phil mentions, it is entirely feasible to assemble a portfolio of 10 stocks that will more or less capture the Canadian market. Personally, I hold some banks plus XIU and my feeling is that I’d rather have the simplicity of holding one ETF (XIU) than assembling a portfolio of stocks that is going to have a risk / reward profile resembling XIU anyway. For example, a $100,000 portfolio of 10 Canadian stocks will probably cost $200 or less in commissions every year. The MER on XIU for the same portfolio is $170, which is slightly more expensive or less expensive depending on how frequently stocks are purchased etc.
The tracking error could be positive or negative by dropping the smaller names. It is hard to say what a handful of small-cap companies in a narrow sector such as IT would do. It is very possible that excluding them hurts performance. It is also possible that excluding them improves returns. It is hard to say because many of the sector ETFs in the Canadian markets have a handful of names to begin with.
If you are talking about the real broad market such as the TSX, I agree that dropping the small cap names might affect performance as small caps have historically provided better returns than large caps.
On the subject of small caps, that’s a much more complicated but flexible area for stock pickers. For people who don’t like to research stocks, you can always use a blend of having individual stock picks for the large caps and then a small cap mutual fund for the small caps. For people who do enjoy researching stocks, then we can choose exactly how much small cap exposure we want and which small caps we like.
Many of my small caps have historically outperformed my large caps, mainly because a few of the ones I’ve liked have been “taken out” by one of the big guys. But with that being said, I can’t count on some consistency to my small cap returns. One year a name can get -95%, another year a different one can be 300%. All over the board. For me, I personally accept the investment risk and I like many of these small and micro-cap names. But I also know the volatility isn’t for everyone and so I don’t like to recommend to any new investors to follow me down this path – there are just too many landmines!
I prefer to have broad exposure with limited company risk, and since I’m definitely not a stock picker I’ve only found unbundling the Canadian REIT Index XRE to be worthwhile. Even with this highly concentrated sector I own the top 6 names which gives me about 75% coverage of the index.
I use XIC for broad coverage, CRQ for a value tilt on the top 60 large caps, and XCS for a small cap tilt.
It’s actually smaller stocks that carry the premium over larger stocks not the other way around:
http://www.moneychimp.com/articles/index_funds/small_value.htm
I understand that with the Canadian market you have less to lose because of the limited choices available to invest in, but if you want to exclude stocks that will “obviously” underperform from an index, why not go all the way and get an actively-managed mutual fund?