What’s Not To Love About ETFs?
The availability of exchange-traded funds is one of the best things to happen to investors in the last twenty years. What’s not to love about ETFs? Investors can get broad diversification on the cheap with just two or three funds. This simplicity is what tipped the scales for me nearly three years ago when I switched from a portfolio of 25 Canadian dividend stocks to my two-ETF solution (the four-minute portfolio).
But not all Canadian investors are as enamoured as I am with ETFs. While Canadian ETF assets climbed to a record $133.8 billion in assets under management (Canadian ETF Association – Aug 31 2017), the Canadian mutual fund industry claims a whopping $1.41 trillion in assets (Investment Funds Institute of Canada – Aug 31 3017).
That 10:1 ratio needs to change in a hurry, but there are still headwinds facing the average investor.
First of all, mutual funds have been around a lot longer than ETFs and their sales channels are more widely available. In plain language that means any Joe or Jane investor can go to an advisor and choose from a menu of in-house mutual funds, whereas if an investor wanted to build a portfolio of ETFs, his or her advisor might not have the right license to sell them, might not have access to an exchange to trade them, or might simply balk at the idea that a couple of low cost ETFs could outperform an actively managed portfolio of mutual funds.
Many investors are forced to go the do-it-yourself route like I did, learning on the fly from financial blogs, forums, and sometimes even the financial media about the benefits of investing in low cost ETFs.
Benefits of low cost ETFs
Despite these challenges, Pat Chiefalo, the new head of iShares Canada, sees a bright future for the ETF industry in Canada as investors seek lower price points and broader exposure to different markets.
“ETFs offer a simpler and cleaner approach to building a diversified portfolio and we see that diversification makes up the vast majority of investment returns,” said Chiefalo.
Indeed, fans of this blog and of the Canadian Couch Potato’s model portfolios will recognize products like iShares Core MSCI All Country World ex Canada Index ETF – also known as XAW. This ETF gives investors one-stop-shop access to U.S., international, and emerging markets – nearly 8,000 holdings in total – for just 22 basis points (0.22% MER).
It’s hard to believe a company can make money charging $22 for every $10,000 invested, but you won’t hear Canadian investors complain. That’s because a similar global mutual fund might cost $220 for every $10,000 invested (there’s that 10:1 ratio again).
How low will ETF costs go? Chiefalo says it’s tough for companies to compete on price, and with 14 new entrants to the ETF market in Canada in the last year alone (bringing up the total number of players to 24 firms) – something has to give.
“iShares’ BlackRock is the largest ETF provider in Canada, our global scale allows us to deliver cost efficiencies to Canadian investors,” says Chiefalo.
Building a better Dividend ETF
One question I often get from readers is about finding a good-quality dividend ETF, a product which has traditionally been expensive, poorly selected, and lacking high enough yield to appeal to hard-core income-seeking investors.
Dividends are becoming an increasingly important to a lot of investors, said Chiefalo, and earlier this year iShares launched a suite of passive dividend ETFs that the company hopes will appeal to investors looking for exposure to high quality dividend stocks at a reasonable price.
The Canadian version – XDIV – boasts an impressive 3.89% yield and costs just 10 basis points (0.10% MER). Only 23 stocks make the grade, and Chiefalo explains the methodology below:
The first screen looks for companies with above-average dividend yields that have also maintained or increased their dividends over the past five years. Then, those companies are further screened based on measures of financial quality such as return-on-equity, earnings variability and debt-to-equity. This helps identify companies that have a greater potential to sustain dividend payments over time. Finally, to avoid value traps, the methodology screens out the worst performers by excluding the bottom 5% of securities with negative one-year price performance.
There’s also a U.S. version, called XDU, which holds 126 stocks, yields 2.96%, and costs just 14 basis points (0.14% MER).
Finally, the Global version, XDG, holds 268 stocks, yields 3.13%, and costs just 20 basis points (0.20% MER).
Final thoughts
While ETFs start to catch on in Canada (though not as quickly as they have with investors south of the border), I’ll continue to beat readers over the head with the idea that building a simple, broadly diversified portfolio with low cost ETFs will lead to better outcomes.
What’s not to love about ETFs? Let me know in the comments what you’d like to see from the ETF industry.
I’m up on ETFs but down on the Canadian ETF industry. The products are not aligned with good portfolio building practices. Here are the gaps in my estimate:
1. Incomplete coverage of Sector Funds for Canadian Large Cap exposure. No Consumer Discretionary, Healthcare, Telecom.
2. No coverage of Canadian Mid Cap stocks.
3. Not enough granular exposure to international markets – sector, market cap, or region/country.
4. Too many products covering the US market. There are enough great products traded on the US markets that are better choices for RRSPs because they do not face withholding taxes.
5. Too many inefficient (from a tax standpoint) fund of funds ETFs, Vanguard being the biggest culprit.
Hopefully the producers will wake up and smell the coffee someday.
Hi TJ, thanks for sharing your thoughts. I’d argue points #1 and #2 highlight more of a gap in the Canadian market as a whole – there’s simply not much to choose from. Totally agree on points #4 and #5.
As far as seeing more granular exposure to international markets – that’s getting too far into the weeds for my liking, as I prefer to buy the whole pie rather than slicing it up based on which sectors/regions I think will outperform.
How timely! Just yesterday I was trying to beat Mr. Picky Pincher over the head with the benefits of a Vanguard ETF. Right now we’re still paying off debt, but I’m nervous that we aren’t using time on our side to grow wealth (meaning we’re pushing back our early retirement date!). Vanguard allows you to start investing in ETFs for the cost of 1 share (about $50), which was really appealing to me. We’ll see if I can get the hubs to play along. 🙂
That’s a tough one. While it’s good to focus your effort into paying off debt before deploying that money into other areas, there’s a psychological benefit to building up your savings balance even alongside of your debt. As long as the debt isn’t of the high interest variety, I say go for it! Start small, as you say, with $50 at a time and see where it takes you.
I’d like to see an Canadian domiciled emerging markets ETF that holds all it’s stocks directly, and a Canadian market small cap value ETF for those who want to tilt to small cap value. Such ETFs are available for US and international markets, but not for the Canadian market.
Hi Grant, good ideas! Hmm, is there any research on Canadian small cap stocks showing the same type of outperformance as U.S. small caps? I would think the market is a lot smaller and much more volatile, no?
I was thinking small cap value as the value premium is more concentrated in small cap stocks. I’m not aware of any research, but likely the size premium exists in the Canadian market. The problem is the Canadian market is already tilted somewhat to small caps, so further tilting is not likely to be worth the cost of XCS, the iShares small cap ETF. So maybe even a small cap value ETF would not be worth the cost, either.
Dear Robb,
I’ve been looking to invest in ETFs for some time (I’ve been looking at Vanguard but don’t have any cash in my RRSP and haven’t bought any in my taxable accounts due to the tax implications).
1. Do you hold XDIV? We will be living off our passive income in three years so I’m continuing to build it up. 3.89% looks good to me.
2. Is there are a rating for volatility/risk of an ETF (if it even exists)?
3. Are ETF dividends treated like other Canadian “Eligible” dividends (with respect to taxes)?
4. Which account would you hold your ETFs in and for what reason?
5. Can I purchase XDIV (or any other ETFs) from any brokerage account (I use TD Waterhouse)?
Thanks for the information.
Besos Sarah.
Hi Sarah, thanks for your comment. Here are my answers to your questions:
1. No
2. Yes, ETFs have risk ratings. Scroll to the bottom of this page and you’ll see XDIV rated as ‘Medium Risk’: https://www.blackrock.com/ca/individual/en/products/287823/
3. Canadian dividends are eligible for the dividend tax credit (inside a taxable account)
4. You can hold ETFs in any account (RRSP, TFSA, RESP, non-registered account). Read this primer on ETF strategies to help you decide which funds should go where, and why (from a tax perspective): https://beta.theglobeandmail.com/globe-investor/funds-and-etfs/etfs/etf-strategies-remember-the-tax-angle/article22842779/
5. Yes, you can purchase XDIV (or any other ETFs) from TD Direct Investing. There will be a cost of $9.99 per trade, just like with a stock.
Thank you so much for all the information and links. I really appreciate it.
I am curious about your personal opinion on the new XDIV and whether it would have been a good option for your situation if it had been around when you made the switch from dividend stocks to ETFs. I am currently in the dividend stock market and interested in switching to ETFs given that I have 3 kids and no time. Thanks!
Hi Nicole, that’s a great question. XDIV closely mirrors what I had (or was trying to build) when I was invested in divided stocks. It’s appealing because while I was running out of ideas and not wanting to spend the time managing a portfolio of two dozen or so stocks, XDIV takes a rules based approach to its dividend stock selection and best of all does it very cheaply. 10 basis points is really nothing for what you get access to.
Back when I made the switch, I was using iShares CDZ (dividend aristocrats) as my benchmark, but I found the methodology not that appealing (Canadian aristocrats only needed five consecutive years of dividend growth) and the cost was 0.66% MER.
How do you feel about it now? I’m using xdiv/xdu/xdg as my core holdings. I’m not looking for the “best” returns… I’m okay with sacrificing some total returns for monthly dividends. I’m not sure about you, but I feel it’s a great compromise between income and capital gains. The mer for all of them is almost the same as a market index ETF as well.