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Newsletter Archive
Q1/6 Focus on ETFs
Q4/5 LW Canadian Equity
Q4/5 Saxon High Income
Q3/5 Saxon Small Cap
Q3/5 BG Income
Q2/5 Trimark Canadian
Q2/5 MB Fixed Income
Q1/5 BG Canadian Intrinsic
Q1/5 MB American Equity
Q1/5 Mawer N.C. Closure
Q4/4 Mawer Cdn Equity
Q4/4 Mawer Balanced RSP
Q3/4 Sceptre Equity Growth
Q3/4 Saxon World Growth
Q2/4 BG Small Cap
Q2/4 Mawer U.S. Equity
Q1/4 PH&N Cdn Growth
Q1/4 Leith Wheeler US Eq
Q4/3 iShares S&P500
Q4/3 BG Canadian Equity
Q3/3 North Growth US Eq
Q3/3 HSBC Mortgage
Q2/3 MB Cdn Eq Growth
Q2/3 Batterymarch US Eq
Q1/3 Saxon Stock
Q1/3 BG Balanced
Q4/2 Mawer New Canada
Q4/2 Perigee T-Plus
Q3/2 PH&N Dividend Inc
Q3/2 PH&N Bond
Q2/2 Leith Wheeler Cdn Eq
Q2/2 Perigee Diversifund
Q1/2 PH&N Cdn Equity
Q1/2 Mawer U.S. Equity







Focus on Exchange-Traded Funds

The last few years have witnessed a veritable explosion in the number of exchange-traded funds (ETFs) available to investors. There are now over 200 ETFs trading on U.S. exchanges and another 18 that trade on the TSX. Measured by assets under management U.S. ETFs have quadrupled since 2001 according to ETFTrends.com and they now control over $320 billion (US). Here in Canada, the main ETF provider, Barclays Global Investors, reports that it manages about $10 billion but this figure is also growing quickly. Barclays has also recently swapped its Canadian- ETF brand from iUnits to iShares.

ETFs differ from traditional mutual funds primarily in that their units are traded on a stock exchange. In many ways, ETFs resemble individual stocks. They can be purchased at any time during trading hours, which is in stark contrast to regular mutual funds which are priced at the end of each trading day (and in some cases even less frequently). ETF investors can also make use of more complicated stock trading techniques, such as short-selling (where investors profit when ETFs fall in price), which is something that can't be done with regular mutual funds.

From the Frugal Funds perspective, ETFs are attractive because their management expense ratios (MERs), or fees, are very low compared to actively-managed funds. Because major ETFs generally follow a passive investment strategy where they simply buy the stocks in an index, their turnover tends to be low which also helps to reduce the overall fee burden.

The manner whereby ETF units are created or redeemed contributes to keeping the value of the ETF close to that of the index. Briefly, ETFs can exchange a large number of units for a corresponding basket of stocks, which allows professional traders (called arbitrageurs) to profit should prices get slightly out of whack. As a result, ETFs rarely trade at a discount or a premium to what they should be worth.

A big beneficial consequence of ETFs' passive approach is that distributions of taxable capital gains are kept to a minimum because most ETFs buy and sell stocks infrequently. The major indices simply don't swap stocks very regularly compared to more active funds and thereby trigger capital gains less often. Mind you, ETFs that track specialty indices tend to swap stocks more frequently.

Is there a downside? Unlike no-load mutual funds which can be purchased without paying a commission, ETFs must be purchased through a broker who will charge a commission. To get the most out of the low MERs on ETFs it is best to avoid frequent trading and to buy through a discount broker to minimize any commissions.

A second drawback to ETFs, depending on one's perspective, is that an ETF won't do much better than its underlying index less the ETF's low MER. Nor will it do much worse. In fact this is a great advantage for fixed-income funds since most bond funds charge high fees which cause them to underperform the bond market. But what about equities? Do mutual funds do any better there? The sad fact is that most stock funds are also dragged down by their exorbitant fees and end up underperforming their benchmark indices. Naturally, there are notable exceptions to this trend. For example, we are happy to be able to say that nine of the Canadian equity funds on the Frugal List exceeded the returns of the S&P/TSX Composite Total Return index over the last five years.

ETFs are gaining in popularity because so many high-priced mutual funds have failed to outperform their benchmarks over the long term. Big financial institutions, sensing that ETFs are the next big thing, are falling over each other to offer ever more specialized ETFs. In addition to broad-market stock and bond ETFs, there are now ETFs that follow just about any niche sector you can think of. It is now even possible to buy ETFs that provide direct access to the commodities markets for certain precious metals and oil. Indeed, you can now hedge the cost of filling up your gas tank by buying units of the United States Oil fund which trades under the symbol USO on the American Stock Exchange.

Have we given up on active management? Certainly not. We still believe that investors can significantly improve their odds of beating the market by choosing high-quality mutual funds with low fees and a proven track record.

Nevertheless, we also like the low fees and greater flexibility of ETFs which are worthy of serious consideration by frugal investors. It is for this reason that we list select ETFs along with frugal active funds in our tables.

The rest of this issue is devoted to an indepth look at three ETFs. First, we consider the broad-market iShares Composite Canadian Equity ETF. Second, we examine the slightly more specialized iShares Dividend ETF. Finally, to reflect the increasing diversity and specialization of ETFs, we look at the streetTRACKS Gold Shares ETF.

iShares Composite Cdn Equity

The iShares Composite Canadian Equity Index fund trades on the TSX under the symbol XIC. It is a broad market ETF that aims to replicate the performance of the S&P/TSX Capped Composite Index. The index is made up of the same stocks as the S&P/TSX Composite index, but each stock's weight in the index is capped at ten percent of total market capitalization. The 10% cap is handy because it helps investors avoid dangerous concentration in any one stock (think Nortel). The fund simply holds stocks in the same proportions as they are found in the capped index.

Any taxable income or capital gains earned by the fund are distributed to unitholders on a quarterly basis for income and once a year for capital gains. In 2005 the ETF's capital gains represented about one-fifth of the total distribution.

The index currently includes 280 stocks and income trusts. The top three sectors in the index are Financials, Energy, and Materials. Together these sectors account for just over 75% of the index by market capitalization. The top three stocks in the index are Royal Bank, Manulife Financial, and Encana. The index's median priceto- earnings ratio (P/E) stands at 18.4 (excluding negative values), which translates into a 5.4% earnings yield. Its median price-to-book ratio is 2.8 and it sports a 1.2% dividend yield. The index is more richly valued than its has typically been in the past and therefore the same goes for the ETF.

With an MER of 0.25% the iShares Composite Canadian Equity Index fund provides access to a broad cross-section of Canadian stocks for a very modest price. The ETF is suitable as part of Canadian investors' core equity holdings.

iShares Dividend

Barclay's Canadian line-up also includes the iShares Dividend Index fund, which trades under the symbol XDV. A more specialized product, its investment objective is to replicate the Dow Jones Canada Select Dividend Index. Unlike the S&P/TSX family of indices, which are weighted by market capitalization, the Canada Select Dividend index is weighted based on its component stocks' dividends.

Stocks are selected for the index from a universe of dividend-paying stocks that have increased their dividends for at least five years in a row. The index is created by selecting the top thirty high-yielding stocks with relative weights determined by indicated annual dividends (not dividend yield). A higher dividend translates into a greater weight up to a 10% maximum. But keep in mind that changes in stock dividends will require relatively more frequent changes in the index than in a market-cap-weighted index. As a result, the fund will have a relatively higher turnover and may generate capital gains more frequently than a broad-market ETF.

Indices such as this, wherein components are weighted by some factor other than market capitalization, have grown in number as ETFs have gained popularity. However, indexing purists point out that the use of such indices represents a quasi-active rather than a passive strategy. The reason for this claim is rooted in Modern Portfolio Theory. By biasing index weights in favour of other factors, one is placing a bet against the 'wisdom' of the market as represented by each stock's market capitalization.

During the first quarter of the year, which was also the first three months of its existence, the ETF gained 3.2% and distributed $0.07 in income. At the end of March the fund's top three stocks were CIBC, Manitoba Telecom Services, and Royal Bank with dividend yields of 3.16%, 6.05%, and 2.93% respectively. Together these three stocks represented over 21% of the ETF. The highest yielding stock in the index provided 6.05%, the lowest 1.93%, and the average yield was 3.4%.

Like most other specialty ETFs, the iShares Dividend Index fund sports a MER that is substantially higher than those of broad-market ETFs. Indeed, at 0.5% the fund's MER is twice that of the XIC fund. Why? Because as a specialty fund it is never expected to attract as much money as a broad market ETF and even ETF companies need to make money. Indeed, at just over $100 million in assets the Dividend ETF remains small and economies of scale are likely as yet unavailable.

Still, with a focus on high-quality dividendpaying stocks, the iShares Dividend Index fund is a worthwhile addition to a frugal portfolio. Just be sure that you understand the fund's strategy and how it differs from a broad-market ETF. The iShares Dividend Index fund is suitable as a core equity holding for more conservative investors.

streetTRACKS Gold Shares

Now let's take a walk on the wild side. The streetTRACKS Gold Shares fund, which trades on the AMEX under the symbol GLD, offers investors direct access to the shiny metal. Specifically, it is designed to track the value of an amount of gold bullion held by the fund for the benefit of investors. This is very different from investing in gold stocks because the fund's only asset is gold (plus a small amount of cash). Obviously investment returns will be linked to gains in the value of gold but the vagueries and potential complications of gold shares are avoided. After all, who really knows how much gold is in a mine? Moreover, unlike dealing with conventional commodities, there is no need, even in principle, to take delivery of, store, or insure the gold represented by units of the fund because all of this is handled for you.

How has GLD fared since its launch in November of 2004? From inception to the end of the first quarter, the fund returned a total of 32.04% while the price of gold appreciated 31.97%. The small difference of 0.07% represents a premium compared to the fund's net asset value per share. All in all GLD seems to be fulfilling its stated objective and has certainly benefited from the recent bull market in the price of bullion.

The trust currently holds 11.4 million ounces of gold bullion representing 99.4% of its assets. With 114.9 million shares outstanding one GLD unit represents about one-tenth of an ounce.

Traditionally, gold is used as a hedge to preserve purchasing power during market downturns or in periods of rampant inflation. For investors who want to hedge their bets, or who just want to speculate, the streetTRACKS Gold Shares fund offers a cheap way to add gold bullion to one's portfolio. Just keep in mind that gold has had a very good run and it could well reverse course over the long haul.

FF: Q1 2006

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