The first Canadian ETF was created in 1989 and called the TIP-35, which tracked the TSE 35.  Since then, the ETF market has expanded considerably.  Currently, according to BlackRock, there are over 3,000 different ETFs available globally.

ETFs started out as a way for investors to tap into the returns of major stock markets using a nice, convenient package that traded like a stock – a miniature index.

With passive investment management, a computer could literally manage the portfolio because all it has to do is hold the same stocks that the market holds in the same proportion. In their purest form, ETFs provide low-cost diversification and efficient access for individual investors to various asset classes, industries and countries.

Related: Here’s my two-fund solution

Your returns equal whatever the index gains or loses minus a fee.  These fees look like a bargain compared to conventional mutual fund fees that can charge up to 2.5% or more.

A recent poll found that less than 20% of Canadians are familiar with ETFs, but once told about the benefits 74% said they would consider them.

34% don’t know how to get started or feel they lack the necessary knowledge.

65% would buy if they were as convenient to buy as mutual funds.

Which index?

An index is a group of stocks or bonds used to measure the performance of a particular market.  However, there are several different indexes and each performs differently.

Traditional stock indexes select the largest and most frequently traded companies and weigh them by their market capitalization (stock price times outstanding shares).  This is called a cap-weighted index and is the cheapest and most common.

Related: How behavioural biases kept me from becoming an indexer

The go-to index for the broad Canadian market has been the S&P/TSX Composite, which includes about 250 stocks.

There is an increasing trend towards creating ETFs using more active strategies designed to beat the market.  Managers may deviate from the index and change asset allocations as they see fit.

  • Fundamental indexes are based on a company’s total sales, cash flow and dividends.
  • Equal-weighted indexes allocate each security to a fixed equal weight.
  • Leveraged ETFs use a range of strategies such as derivatives, futures contracts and options to amplify the moves of the underlying index. They attempt to achieve daily returns of 2 or 3 times the index.
  • Inverse ETFs are similar, but opposite, meaning they will gain double or triple the loss of a market.

Currency Hedging

When you invest in a fund that holds US or international stocks you must take currency conversion into account.  If our dollar rises against US$ or other foreign currency the value will fall.  Conversely, a falling loonie will boost Canadian returns.

Currency hedging is designed to smooth out the fluctuations in foreign exchange and deliver the full return of the underlying investments.  It will say “Hedged to CAD” in its name and probably cost a bit more.  You can also buy ETFs without hedging and this is recommended for long-term investors, as currency ups and downs will cancel each other out over time.

Related: Why investors should embrace simple solutions

Some International equity ETFs simply hold the US-listed ETF rather than buying the underlying stocks directly.

Advantages

ETFs are listed and tradable on stock exchanges and can be bought and sold any time throughout the trading day.  Holdings are posted online and updated on a daily basis.

They have improved the investment choices available to individual investors and are generally the lower-cost option versus a comparable mutual fund.

Risks

Look at the nature and purpose of the underlying index.  Is it well understood, or is it some obscure “proprietary” or narrowly defined approach that is hard to understand or verify?

Is the ETF leveraged in some way in order to enhance returns?  Leveraged and inverse ETFs are often marketed at Bear and Bull ETFs. They are definitely not for long term holders.

Related: Invest like a billionaire? Not with these leveraged ETFs

Actively managed ETFs have the potential for higher taxable distributions.

Management fees

Keeping costs low is an essential part of index investing. There’s currently a price war going on and Canadian ETF management fees are now lower than ever.  A diversified portfolio can be held for as little as 0.12% in fees.

Too many investors just look at management fees and overlook their overall strategy and performance.  Cutting an extra .10% won’t make that much of a difference and switching can be expensive when your trading commissions wipe out any reduction.

Related: Why TD e-Series funds are not just for beginners

Don’t jump from one to another just because the fee is lower or holdings are larger.  Keep in mind transaction costs and possible capital gains.

The bottom line

The original purpose of ETFs was to passively track an index in a low cost, flexible, diverse and tax efficient manner.  Investors look for simplicity and transparency.  They know and understand what benchmark is being tracked.

The industry has very competent marketers, increasing the number and complexity of choices.

This may encourage investors to use them as part of an active trading strategy. Over-trading incurs unnecessary costs and reduces net returns.

Related: Score one for active management? Check out these index-beating funds

ETFs are not a cure-all.  They do bear risks, some of which may not be obvious or well understood.  Be sure to properly research any ETFs you are interested in and ensure it fits your purpose.

Carefully determine the appropriate risk level for your portfolio.  Make sure you have broad diversification.  Be disciplined and stick to your plan.

And, as always, be an informed investor.

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19 Comments

  1. Grant on January 6, 2015 at 8:49 pm

    Nice review, Marie. I prefer to stay with cap weighted indexes. Equal weighted and fundamental indexes have higher turnover and therefore higher costs and taxes. Their at times better returns are due to exposure to small cap and value stocks, which can be more efficiently accessed by cap weighted small and value ETFs, if one wishes to tilt their porfolio in that way. And, of course, leveraged and inverse ETFs are time bombs. The key is to keep it simple, keep costs low and stay the course.

    • Boomer on January 7, 2015 at 1:21 pm

      Thanks, Grant. Cap weighted indexes are the most common and simplest but can be heavily overweighted with growth stocks – TSX financials for example. Proponents of fundamental indexing (RAFI) claim to have better overall performance. Equal weight can be risky as in the current case of oil & gas indexes. Exploration and oil field service companies will be topped up to balance more stable companies such as Suncor and Husky.

      Leveraged and inverse ETFs are a clever marketing ploy for the unwary. Who can resist claims of double and triple returns. Too risky for the average investor.

      I agree with you to keep it simple, keep costs low and stay the course.

  2. KC on January 7, 2015 at 12:08 am

    Great review. I haven’t done the DIY myself but have set up a practice portfolio while I’m learning the ins and outs of the ETFs. Thanks for the lesson!

    • Tom on January 7, 2015 at 5:36 am

      How do you do that, KC?
      spuds63@yahoo.ca

      • KC on January 7, 2015 at 12:42 pm

        Using Excel spreadsheets and mimicking exactly the way I would as if it was my money. That’s my practice run.

        • Boomer on January 7, 2015 at 1:23 pm

          Thanks KC. When do you think you’ll stop practising ? 🙂

          • KC on January 7, 2015 at 7:53 pm

            When my debt is free and clear and my emergency fund is saved up both of which will be completed by July. So, August is my starting date to wade into the world of DIY.

            I think I will always have a hybrid approach to investing as I currently have a great financial advisor but having a bit of back-up plan too.



  3. Barry @ Moneywehave on January 7, 2015 at 8:25 am

    I’m in the process of switching to ETF’s. I would have switched last week but dividends were paid out to my e-series in December and I have to wait 30days to avoid fees.

    I plan on just buying the standard index ETF’s following the couch potato strategy.

    • Boomer on January 7, 2015 at 1:23 pm

      Hi Barry: What made you decide to switch from index mutual funds to ETFs?

  4. Dave on January 7, 2015 at 2:59 pm

    As for the comment that fundamental ETFs have “high turnover and therefore higher costs” is hopefully the reason why they have the potential to generate returns in excess of their broad benchmarks. Check out FXM and WXM – these are value and momentum tilted ETFs that have dramatically beaten the TSX Composite and have almost a 3 year track record. Since they were introduced in February of 2012 to the end of 2014, FXM has returned 16.2% annualized and WXM 18.7% while the TSX returned 9.3%.

    • Grant on January 9, 2015 at 11:11 am

      Dave, you’d expect value ETFs to outperform the broad market during periods when the value premium is positive. However, FXM is more than just a value fund. It has significant exposure to the small and momentum premium as described in this post from Canadian Couch Potato, but more importantly there is significant unexplained alpha which means the large ourperformance may just be due to luck and therefore may not persist going forward.

      http://canadiancouchpotato.com/2013/11/07/looking-for-value-in-canadian-equity-etfs/

      • Dave on February 4, 2015 at 12:24 pm

        The returns of FXM and WXM may be attributable to luck – as of the end of January 2015, they had outperformed the TSX by 6.7% and 8.9% (annualized TR) since they were launched almost 3 years ago (Feb 15, 2012) – however just as likely they are the result of well constructed indexes that take advantage of proven market premiums like value, momentum and company size.

        • Grant on February 4, 2015 at 1:46 pm

          Funds ought to compared to an appropriate risk adjusted index – a value fund should be compared to a value index etc., not a total market index like the TSX. FXM has tilts to value, small and momentum, so unfortunately there isn’t a risk adjusted index we can compare it to. But because of it’s large unexplained alpha, it’s great recent performance could be due either to skill or luck – there is no way of knowing. I wouldn’t want to take the chance.

          • Dave on February 4, 2015 at 1:55 pm

            These ETFs are iterations of Morningstar/CPMS style portfolios which have long term (dating back to 1985 in Canada) track records of materially outperforming their benchmarks. Not sure how much history you’d need before “taking a chance”. Thus far the ETFs have been far less volatile and have more defensive than the broad market. I’m not sure it is valid to compare these indexes to “value” or “momentum” benchmarks since none currently exist aside from the underlying indexes of these ETFs. If premiums exist for value, momentum and/or size, why wouldn’t you want to tilt your portfolio to take advantage of them anyway? Ask anyone who currently uses Morningstar CPMS as a screening tool (though many would prefer to stay anonymous and not reveal they use it to pick stocks) if they think it’s a valuable tool.



  5. canadianbudgetbinder on January 7, 2015 at 11:20 pm

    Thanks this is just what I needed as I’m learning more about investing on my own etc.

  6. Carmen on January 9, 2015 at 3:53 pm

    I agree with the indexers and have taken the first step in transforming my registered portfolio from mutual to 4 indexes and a REIT index thru my broker. Now I am looking at opening a non-registered account. Since income will be taxable, I am looking for suggestions..dividends or more indexes (capital gains)? thanks
    Carmen

  7. Grant on February 5, 2015 at 12:07 pm

    Dave, these CPMS style portfolios achieve good results because of exposure to small cap and value factors, so will look good when compared to total market benchmarks. This same outperformance can be achieved, at least for US equites, by owning capweighted small cap and value ETFs. Unfortunately not so much with Canadian equities. Because FXM has such large unexplained alpha, I wouldn’t want to take a risk with that one.

    • Dave on February 5, 2015 at 12:21 pm

      If you’re suggesting that FXM is risky, how do you account for the fact it is lower beta has been much more defensive in downturns and has higher sharpe and sortino ratios? And if you want to tilt your portfolio to proven premiums like value, where would you find a similar vehicle. In the case of US equities the US value ETF XXM outperformed the S&P as in a year when both small cap and value underperformed. Just luck again I suppose.

  8. Grant on February 5, 2015 at 12:48 pm

    I mean risky in the sense of unknown – due to FMX’s unexplained alpha it is not known if it’s outperformance is due to skill or luck. In Canada there are large value ETFs such as XCV and XDV, but no good small value ETFs. In the US there are many. With regard to XXM, it did outperform the large value index, but I’d need to see a regression analysis of it to see if captured other premiums (like momentum that was strong last year)and whether it, too, had any unexplained alpha, in which case, yes it could have been luck.

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