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Unbundling Canadian ETFs 2008

Indexing has exploded in popularity over the last few years and the development of new exchange traded funds has only added fuel to the fire. Exchange traded funds, or ETFs, can be bought and sold just like stocks. They generally charge very low ongoing fees and can be used to gain broad exposure to a diversified portfolio of stocks and bonds.

The first ETFs tracked major indexes like the S&P/TSX Composite or the S&P500. But, as ETFs became popular, more specialized ETFs were introduced to track a vast array of sub-indexes. While many of these new ETFs are quite interesting, they tend to suffer from relatively higher fees and may lack diversification. But before examining specialized ETFs, it is worth reviewing the case for investing in basic ETFs because they remain the best option for many investors.

Building an index-oriented portfolio starts with asset allocation. There are many rules of thumb when it comes to asset allocation but I happen to like Ben Graham's recommendation to put between 25% and 75% of your portfolio in stocks with the remainder in bonds. If you're younger, more aggressive, and can invest for long periods then you should favour stocks. If you're older, more conservative, or if you need the money in a few years then you should favour bonds. But individual circumstances vary and they can easily trump such generalizations. To focus on a concrete example, let's consider the case of a growth-oriented investor who wants to put 60% into stocks and 40% into bonds.

A good index portfolio is built with diversified and very-low fee index funds or ETFs. I'll focus on ETFs in this article. When it comes to bonds, the iShares Canadian Bond Index Fund (XBB) with a MER of 0.30%, an average yield near 4%, and a duration of 6.4 years is a good option. The annual fee (MER) charged by this ETF is less than 1/4 of that charged by most active bond funds. Those with larger portfolios can get a little fancy and split their bond holdings between short and long-term bond ETFs. Just keep an eye on the fees. I've noticed that investors can often obtain better yields from high interest savings accounts than from short-term bond or money market funds.

When it comes to stocks, an even split between Canadian, U.S., and international equities is most commonly recommended. Starting with Canadian stocks, the iShares Canadian Composite Index Fund (XIC) is a good option. It has an annual fee (MER) of 0.25% which is about 1/10th the cost of most active stock funds. It also provides exposure to 253 of the largest stocks in Canada. On the U.S. side, the SPDR ETF (SPY) is very popular and charges a rock-bottom fee of 0.08% annually for exposure to 500 of the largest stocks in the U.S. That's about 1/30th of the fee charged by most active U.S. stock funds. Internationally, the Vanguard FTSE All-World ex-US ETF (VEU) is a solid option with an annual fee of 0.25%. That's about 1/10th the cost of most active international funds. (Of note, this ETF holds about 5.4% of its assets in Canadian stocks. If you want to achieve a precise asset allocation, you'll have to compensate a bit by buying a little less of the Canadian stock ETF.) We'll just go with 20% in each of the XIC, SPY, and VEU ETFs to obtain our total 60% stock exposure.

As you've noticed, ETFs charge some of the lowest fees around. The annual fee on the equity part of our little portfolio averages just over 0.19%. Add in the 40% allocation to bonds and the fee on the total portfolio moves up to about 0.24%. That's a pittance compared to most actively managed funds in Canada. Indeed, it is about 90% lower than many actively managed portfolios. However, I've not included the brokerage commissions needed to buy and sell the ETFs. Thankfully brokerage commissions have dropped in recent times. Many discount brokerages now charge less than $10 per trade for large accounts (or more active traders). A $10 commission to buy each of the four ETFs represents a one-time cost of 0.04% on a $100,000 portfolio which is quite modest indeed.

A $10 commission per trade is quite low for large accounts and it opens up some interesting possibilities when it comes to more narrowly focused ETFs. But it is important to point out that brokerage commissions can represent a relatively large drag on smaller portfolios. Several ETFs pay dividends (or distributions) on a quarterly or annual basis. Reinvesting such distributions boosts overall costs. That's not a big issue for large portfolios. But those with more modest portfolios can always shunt distributions into a similar index fund. Alternately they can be collected for a while until a large purchase is justifiable.

It is easy to get a simple, low fee, and broadly diversified portfolio with ETFs. Most investors can safely stop here. But perhaps I can entice you to read on about a few specialized situations.

When it comes to ETFs I like to consider two options for long-term investors. The first option is to purchase the ETF and hold on. The second option is to bypass the ETF and buy the stocks that it owns. At first glance, the choice between buying a low-cost exchange-traded fund that holds many stocks or buying each individual stock appears to be obvious. The exchange-traded fund is likely to be the better bargain. However, buying stocks directly may be a good choice for some investors because the Canadian stock market is very small and it is dominated by a few big names. By holding only a few stocks you can reasonably approximate, or even fully replicate, some ETFs.

But let's start by looking at the various stock ETFs offered by iShares in Canada which are shown in Table 1. You'll immediately notice that many ETFs charge annual fees of 0.50% or 0.55% per year despite holding only a few stocks. The worst offender in the bunch is the iShares Canadian Tech Sector Index Fund (XIT) with an annual fee of 0.55% which holds only 8 stocks. Even more remarkably, as show in Table 2, the top two stocks in the Tech Sector ETF represent about 52.2% of its assets.

Table 1: iShares ETFs listed on the TSX
Exchange Traded Fund# Stocks in the ETFMER Fee
iShares CDN LargeCap 60 Index Fund (XIU)61 0.17%
iShares CDN S&P 500 Index Fund (XSP)5010.24%
iShares CDN Composite Index Fund (XIC)2530.25%
iShares CDN MSCI EAFE Index Fund (XIN)8180.49%
iShares CDN Dividend Index Fund (XDV)300.50%
iShares CDN Growth Index Fund (XCG)630.50%
iShares CDN Jantzi Social Index Fund (XEN)600.50%
iShares CDN Value Index Fund (XCV)80 0.50%
iShares CDN Completion Index Fund (XMD)1930.55%
iShares CDN Energy Sector Index Fund (XEG)580.55%
iShares CDN Financial Sector Index Fund (XFN)290.55%
iShares CDN Gold Sector Index Fund (XGD)350.55%
iShares CDN Income Trust Sector Index Fund (XTR)640.55%
iShares CDN Materials Sector Index Fund (XMA)540.55%
iShares CDN REIT Sector Index Fund (XRE)120.55%
iShares CDN SmallCap Index Fund (XCS)2110.55%
iShares CDN Tech Sector Index Fund (XIT)80.55%
Source: iShares.ca, Feb 21, 2008


Table 2: The percentage of the ETF portfolio represented by its top 3 stocks. (Part 1 of 2)
Top StocksXIUXCGXTRXCVXMDXCSXICXSPXIN
16.0%9.4%13.3%9.7%3.3%1.8%4.6%4.0%1.6%
211.3%18.7%20.7%18.4%5.8%3.2%8.7%6.9%3.1%
316.3%27.9%25.5%26.4%8.0%4.5%12.5%8.8%4.5%
Source: iShares.ca, Feb 21, 2008

Table 2: The percentage of the ETF portfolio represented by its top 3 stocks. (Part 2 of 2)
Top StocksXITXREXFNXDVXGDXMAXEGXEN
126.6%24.5%17.6%7.5%24.4%18.7%16.1%8.8%
252.2%40.4%33.2%13.8%39.8%35.3%30.0%16.0%
367.7%50.0%46.3%19.5%52.3%45.7%41.2%22.6%
Source: iShares.ca, Feb 21, 2008


To completely mimic the Tech Sector ETF you'd only have to buy 8 stocks at a total commission cost of $80 (assuming $10 per trade commissions). That's against fees of 0.55% per year plus a $10 commission to buy the ETF. For a one-year holding period, the cost of buying $12,727 worth of the ETF is about $80 assuming that the ETF does not gain or lose value. If you had more than $12,727 to invest then buying the 8 individual stocks would cost less. (Here I'm only including the commissions needed to buy and not those to sell.)

Longer holding periods make the math more compelling. Investors hold Canadian equity funds for an average of about 7 years. A 7-year holding period for the Tech Sector ETF pushes its breakeven cost down to about $1,800. Investors buying more than $1,800 worth of XIT and holding for 7 years would be better off buying the individual stocks. (Include selling costs and the break even portfolio size would be about $3,600.)

Of course the math is only approximate. Buyers of any ETF expect that it will increase in value. If it does, the dollar value of the fees charged by the ETF will increase over the life of the investment. (The opposite is of course true should the ETF lose value.) The cost of reinvesting the dividends (or distributions) from the ETFs, or individual stocks, has been also been neglected. As you can imagine, the holding period is very important. If you're a day trader then ETFs are likely to be the better way to go. But very long-term investors will probably favour individual stocks.

Instead of picking on the runt of the Canadian ETF litter, let's consider the much more popular iShares Canadian Dividend Index Fund (XDV) which charges an annual fee of 0.50%. This ETF invests in 30 of the highest yielding stocks in Canada. Its portfolio is stuffed full of Canadian banks, insurance companies, and other blue-chip firms. The ETF is of particular interest to investors due to its emphasis on blue-chip stocks paying hefty dividend yields. Indeed, it would be easy to think of moderately well-to-do investors plunking down $25,000 or $50,000 in this ETF and holding it for the long term.

Let's take a look at the fee math for a $50,000 investment in the dividend ETF with a holding period of five years. It costs $10 in brokerage commissions to buy the ETF and then 0.5% per year thereafter assuming that the fund doesn't change in value. That's a one-time cost of $10 plus $250 (0.5% times $50,000) per year for five years. For a total of $1,260 assuming once again that the fund doesn't gain or lose value. A fee of $1,260 is more than a bit of spare change. Alternately, buying the thirty stocks in the ETF costs $300 (with $10 per trade commissions). If you were to sell both portfolios at the end of five years then it would cost another $300 to sell the thirty stocks (and $10 more to sell the ETF). Nonetheless, you'd still see considerable savings by just buying the stocks directly.

Such savings only become more attractive if you're willing follow a particular ETF less precisely. Let's say you only buy the ten largest stocks in the dividend index. Call it an alternate to the Dogs of the TSX approach. That cuts the brokerage commission to buy the ten stocks down to $100. It also happens that the largest ten stocks in the dividend ETF make up 50% of its portfolio. As a result, the fee savings can be quite attractive.

As a handy reference, the number of stocks that you'd have to buy to mimic 25%, 50%, 75%, and 100% of each ETF is shown in Table 3.

Table 3: The number of stocks needed to replicate different fractions of ETF portfolios. (Part 1 of 2)
% of portfolioXIUXCGXTRXCVXMDXCSXICXSPXIN
25%5333172371527
50%1271184558195390
75%251527179110850151257
100%61636480193211253501818
Source: iShares.ca, Feb 21, 2008

Table 3: The number of stocks needed to replicate different fractions of ETF portfolios. (Part 2 of 2)
% of portfolioXITXREXFNXDVXGDXMAXEGXEN
25%12242224
50%234103459
75%477187121117
100%812293035545860
Source: iShares.ca, Feb 21, 2008


Direct stock purchases also allow investors to be more aggressive on the tax front. For instance, at the end of the year, stocks that have lost money can be sold and the loss booked for tax purposes. The money obtained from such sales can then be put into the other stocks in the index or the exchange-traded fund itself. Similarly, holders of a concentrated exchange-traded fund that has lost money may consider selling it, collecting the capital loss for tax purposes, and replacing it with individual stocks instead.

Over the years, discount brokerage commissions have declined nicely and I hope that the trend continues. If it does, buying stocks directly will be more attractive. Indeed, Interactive Brokers offers $1 per trade commissions (with a $10 minimum fee per month) which makes it possible to consider buying all 60 stocks in the S&P/TSX60 index or even the 253 in the S&P/TSX Composite.

Unbundling ETFs and buying stocks directly can be attractive to investors who pay low commissions with large portfolios that are to be invested for long periods. You can find out if the math works for you by using my online Canadian ETF Fee Calculator.

But for most investors, particularly for those wishing simplicity and ease of implementation, the basic indexing approach that uses low-fee and very-diversified index funds, or ETFs, represents a good option. Those seeking more specialized funds and methods ought to carefully consider their merits over individual stocks.

  • Explore a similar technique by reading Active Fund Performance At A Passive Price

    First published in the May 2008 edition of the Canadian MoneySaver.

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