BlackRock Purchase of Claymore ETFs - Do the Smart Thing Please!

Today's announcement that BlackRock will acquire Canadian ETF provider Claymore could be a good thing for BlackRock and for ETF investors, if some smart, and not dumb changes, ensue.

Claymore charges quite high MERs - about 0.5 % too high - for its ETFs in comparison to those of BMO Financial, iShares and Vanguard. The takeover is a great opportunity for BlackRock, which already owns iShares in Canada, to lower the Claymore MERs and bring them in line. This will attract more investors and not cannibalize its iShares ETFS. In the USA, similar fundamental RAFI-based ETFs (e.g. Invesco Powershares US broad market equity fund trading under symbol PRF) have expense ratios about 0.3% lower than Claymore's, though even that is too high.

Why would BlackRock not lose by lowering fees? Claymore's ETFs are considered to be actively managed (though I do not agree with this characterization, that's the dominant public perception), more an alternative to actively managed mutual funds than to traditional passive market-cap weighted index ETFs. Let BlackRock take on the mutual fund industry with a much more compelling price proposition. After all, Claymore's ETFs already have most of the attractive features of mutual funds - auto & free DRIP and Systematic Withdrawal, Pre-authorized chequing purchases.

The dumb strategy would be to leave Claymore as is, with continued stagnation, or to raise fees, a recipe for investor flight. Claymore's ETFs are being left in the dust. For instance, the flagship Canadian equity fund Canadian Fundamental Index ETF (CRQ) has only $218 million in assets despite being started 3 years before BMO's Dow Jones Canada Titans 60 Index ETF (ZCN), which has $604 million in assets.

Mutual Funds Institute Ham-Handed Research Hurts Own Cause

Mutual funds in Canada have been under fire for their high fees and under-performance (hat tip to Canadian Capitalist). The industry body, the Investment Funds Institute of Canada has been attempting to shoot back at mutual funds' main competitor, ETFs. But its latest sloppy and slapdash salvo in the form of the July 2011 report Active and Passive Investing does more to discredit the IFIC and its cause than to help it. How so?

1) Consider the publication of the report itself. Is it secret or not?

• Not Secret - Though I received a copy from Ken Kivenko of CanadianFundWatch.com (thanks, Ken) who forwarded the email attaching it sent out under the signature of IFIC CEO Joanne De Laurentiis.
  
• Secret - The IFIC original email has the warning at the bottom "This e-mail (including attachments) is confidential and is intended solely for the addressee..." Oh really?
  
• Not Secret - Why then does the text from De Laurentiis' say "It is the objective of the Report to clarify and counter misperceptions associated with active and passive investing so that research organizations and public policy makers can be better informed...". That sure looks as though it is intended to be publicly disseminated.
  
• Secret - The IFIC website itself, however, seems not to show the report in any public area, only in a reserved members area (through this search link).
  
• Not Secret - This secret public report meant to be used per De Laurentiis "... as a reference authority in materials developed by you (e.g., articles, reports, etc.)" can actually be accessed through (marvels of the Google and the Internet!) a link at the bottom of this post on Arbetov.ca.

On the whole the image one is left with is that IFIC is trying to feed ammunition to its membership of fund distributors and sellers to have numbers to quote to clients but that it does not want to release the report to wider public scrutiny, including skeptical bloggers!

2) The suspicion of devious intent gets stronger once one looks at the flawed report itself. Its basic approach is to show that passive investing can be expensive, done by trying to show that ETF costs are higher than many people think. However,

• ETF does not equal passive investing (and the flipside is that Mutual fund does not equal active investing). The report throughout treats all ETFs as if they are the same as passive index investments. That might have been a fair generalization ten years ago but today ETFs have become very diverse. Many high cost, poor-quality, narrowly focussed ETFs have come on the scene, some even with explicit active strategies.
  
• Mixing all ETFs together and calculating average costs raises the apparent cost of a passive index (i.e. a broadly based market-cap) strategy. Transaction costs, bid/ask spread and tracking error, which the report says add up to 1.2% ETF under-performance relative to index, is at most 0.1% for a fund like Vanguard's Total (US) Stock Market ETF (VTI) or the grand-daddy biggest-of-them-all SPDR S&P 500 (SPY). The true lesson is not that passive indexing is expensive, it is that today investors need to be just as careful picking ETFs as mutual funds. ETFs that are too small, too narrow and only sample stocks instead of replicating an index are prone to index under-performance from large tracking error.
• The 1% that IFIC says goes to providing advice to mutual fund investors, which ETF investors do not get, and therefore causes ETF under-performance by that amount, rests on the dubious conclusion that investors get 1% worth of advice. The previous IFIC report The Value of Advice (which also seems to be hidden away in IFIC's website) it cites as evidence received a thrashing on its release in 2010 - e.g. see Canadian Capitalist's Readers Rip IFIC Report to Shreds.
  
• Risk, as expressed in volatility, is not or should not be an end in itself, so for IFIC to state that actively managed funds offer investors the risk exposure they wish is beside the point. As books like Richard Ferri's The Power of Passive Investing, David Swensen's Unconventional Success and many others have repeatedly documented in great detail, actively managed mutual funds have performed poorly on a risk vs return adjusted basis. It doesn't help to take on risk if you lose in doing so.
  
• As I said in my review of Ferri's book, the issue is not active investing vs passive investing in principle or in general, it is with the funds actually available to small individual investors and how they perform in reality. That's why I am currently testing the RAFI fundamental strategy, which I think is better in principle and has been shown to be so using (non-investable) index data, against cap-weight using actual ETFs available to investors. A key question is whether the higher fees on the RAFI funds overcome their theoretical advantage and give off lower net returns.
  

There is nothing wrong with mutual funds per se. I don't think that as a technical legal structure they are any better or worse than ETFs. The problem is simply that the current mass of available mutual funds suffer from too high fees that negate their value. They don't add enough value to earn their fees. This lackadaisical offering from IFIC doesn't inspire much respect or do much to help their cause.

New Innovative ETFs that Investors Really Really Need

Sure, there are lots of ETFs and more weird and wonderful concoctions seem to come out every day. Think the financial industry is running out of ideas for ETFs to appeal to every possible interest? Just in case, here are my suggestions for innovative ETFs that could hit the sweet spot for investors.

1. Darwin's Centenarians - "Survival of the Fittest" is the theme of this ETF. Darwin told us that merely surviving is the definition of being fitter. If a company has survived 100 years or more, it has to be fit, right? Twelve Ultimate Buy and Hold Canadian Stocks lists the Canadian stocks to include. Wikipedia's List of oldest companies tells us that no less than 21,666 companies worldwide are centenarians or better exist. That choice is good because diversification through holding a basket of many companies is still required. Age does not guarantee survival - witness the demise in 2006 of Kongo Gumi the oldest continually operating independent company that had been operating for 1400 years. It was a victim of, you guessed it, too much debt.
2. Random Dartboard - We've all read that randomly throwing darts at a dartboard to select stocks works just as well as the average active mutual fund manager. So let's have that fund, please. In order to remove any human bias, and to give the fund a marketing handle, the fund management will consist of chimp Sammy Stockpicker (photo below) along with a human handler. Another advantage - the MER will be peanuts. . This will also help restore a bit of balance in markets, as apparently mathematicians like the one below are taking over trading in markets according to BBC's Quant Trading: How mathematicians rule the markets.
3. High-Yield Sovereign Debt ETF - Nicknamed the "Merkel Put Fund" in honour of the German leader who will be backed into "bailing out" Greece (i.e. having German taxpayers paying for Greek non-taxpayers), this fund will hold the debt of various countries with dubious ability to repay. There are already high yield corporate bond funds like Claymore's CHB so this new fund would only extend the concept. It might be a challenge to define what countries to include since the bond rating agencies' ratings of countries doesn't correspond systematically with countries that pay high yields e.g. Ireland pays quite hefty yields upwards of 8% despite its BBB+ Investment grade rating (see Wikipedia explanation) from Standard & Poors in this list of Credit Ratings by country in Wikipedia. I would propose the "if it looks like a duck and walks like a duck, then it is a duck" method of determining what is high-yield.
4. High Dividend Yield Country ETF - Nicknamed "the future will be like the past" fund, this one will invest in the market basket for the highest dividend yield countries. After all, if famous researchers Elroy Dimson, Mike Staunton and Paul Marsh tell us on page 21 in the Credit Suisse Global Investment Returns Yearbook 2011 (my review here) that an evenly balanced portfolio of the equity index for the highest dividend yield countries handily outperformed for 1900 to 2010 and multiple sub-periods within it, what could go wrong?
5. The Liquid ETF - The ETF Stock Encyclopedia lists a whole range of sector ETFs like retail, telecommunications, oil and gas, mining, utilities, pharmaceuticals, biotechnology, the list goes on and on. Why not set a new direction for themes with a fund that invests in the industries that produce liquids, i.e. a combination of water infrastructure, oil and gas, beer and wine producers. There must be excellent diversification potential as companies are likely to have little correlation with one another.
6. The Global Mega ETF - Finance theory tells us that an investor should hold the market portfolio, which consist of a holding in every available asset i.e. stocks and bonds in every country. Has anyone offered such a fund yet? The answer is No. Vanguard has something called the Total World Stock ETF (VT) but even that only includes 49 countries and no bonds at all. There isn't even a bond fund in its arsenal that tracks a total world bond index.
7. The Celebrity Dream ETF - We cannot all look like Angela Jolie (from Top Beautiful Women blog) or Brad Pitt (from Celebrific.com) but maybe we could invest like them. After all, celebs are wont to give us their opinion on politics, social justice, climate change, etc and with such beautiful faces and acting skills, everyone is convinced they are right. And so they will be regarding investments. Markets will follow them! Their stock picks and predictions will be self-fulfilling prophecies. Besides things always turn out fine in Hollywood. We should remember that though markets in the long term are weighing machines, in the short term they are popularity machines, as all technical traders know. Why bother with charts, statistics, patterns, moving averages and the like when we can go to the next step and actually lead the markets where we want to go? The only possible drawback is that celebs don't come cheap and fees may be high, though surely nowhere near as high as what the typical Canadian mutual fund now collects. So the ETF should still be competitive.

How about it, all you ETF providers out there, innovation has to keep moving ahead, n'est-ce pas?

Passive Indexing Trend Leading to Increased Investment Risk

Too much of a good thing for individuals can be bad for everyone collectively when it comes to passive index investing. James Xiong and Rodney Sullivan explain how this has come about in How Passive Investing Increases Market Vulnerability, available for download here at Top100Funds.com and here at SSRN.

Through a series of statistical tests on US equity data back to 1979, they show how the take-off of passive index investing since 1997 is strongly associated with their disquieting stock effects:

• "... the rise in passive investing meaningfully corresponds to a decrease in the ability of investors to diversify risk in recent decades" and
• "... the diversification benefits of equity investing have decreased for all styles of stock portfolios (small, large, growth, or value). The decline in diversification benefits can couple with increased market volatility and firm-specific volatility."

Passive index investments in mutual funds and ETFs by late 2010 reached about a 1/3 share, or $1.2 trillion, of the total in such funds of $3.5 trillion - active investment funds makes up only 2/3 of the total. (The paper also tells us that institutional investors now hold 70% of US equity stock vs 44% in 2000 and only 24% in 1980.)

The chart below from the paper shows the vertiginous rise in correlations between pairs of stocks. Note how the more passively indexed segment, the SP500 large caps, has higher correlations than smaller caps, the non SP500 stocks in the chart.

They checked that the effects were not only manifest during the recent periods of extreme market crisis - the dot com crash in 2001/02 and the credit crisis crash in 2008/09 - when all asset class correlations rose significantly. The same pattern of rising correlations continued through the other more normal years of the study period.

There may still be value for individual investors to buy those passive index funds but the free lunch of passive diversification now appears to be merely selling at a discount. One thing for sure, as I tried to suggest in the thought experiment post What Would Happen if Everyone Did Passive Indexing? the success of passive indexing, when it becomes big enough, does have an effect on markets. In another post last year, Index Investing Becoming a Victim of Its Own Success, I noted research by Jeffrey Wurgler on the S&P 500 that reaches similar conclusions. No wonder the avant-garde of risk-aware, efficiency-aware institutional investors is moving away from cap-weight passive index investing, some to private equity direct investing, such as the big pension funds and others to alternative-weighting indices.

Cool Tool: Stock and ETF Market Visual Heat Maps

Like to get a quick impression of how various stocks, sectors and ETFs are doing today or in the past year? Check out these heat maps, which show through colours - red down, green up - how markets have been doing. On most, you can drill down by clicking on individual trading symbols to get a lot more detail.

FinViz.com - S&P500 grouped by sector, Foreign Stocks (including Canadian) Traded on US exchanges, US-traded ETFs. Data includes performance today to 1-year, P/E, P/B, P/S. Dividend Yield, Earnings

StockMapper.com - NYSE Euronext stocks (which includes 66 largest Canadian stocks), S&P 500, World Regions. Data includes today's percent change, latest news

SmartMoney.com - US stocks "over 500". Data includes daily percent price change organized by sector.

Portfolio Cap-Weight vs Fundamental Test and Monthly ETF Distributions

The portfolio contest between traditional Cap-Weight and Fundamental Weight Index ETFs has become a little more tedious to track manually with the switch by both BMO and iShares to more frequent monthly instead of former quarterly distributions on more ETFs.

It also undermines one of BMO's advantages compared to iShares, namely the automatic, free DRIP program since now much smaller amounts are being distributed monthly, which in many cases won't be enough to buy whole shares. Even with a $100k portfolio, the January and February amounts for ZRE are not enough to buy even one share. Since for ZRR both portfolios have the same holding it won't any difference between them. Therefore, I will simply accumulate the cash for both portfolios until rebalancing at the annual anniversary date in mid July presents an opportunity to re-invest it. The spreadsheet at the bottom of the blog now includes the cash for both January and February distributions (which is anticipating a bit since BMO only distributes the cash March 7th but again it doesn't make any comparative difference).

Cash or no cash, it is quite interesting to see that the Fundamental portfolio has now opened up a significant lead of $1602 since the beginning of the year. It's easy to spot that it is because of the huge leap of the Developed Markets Fundamental fund PXF over its Cap-Weight rival VEU. Both portfolios have positive returns in every asset class! It's just that "some are more equal than others" with bigger gains. That includes Canadian Bonds where the price level of XBB is flat but the cash interest distribution would push its return into plus territory. Nothing is really close to the 1/4 share out-of-whack rebalancing trigger point though XBB is starting to get down there with 21.5% versus its target 25%. If interest rates start to rise then XBB is likely to start falling though equities might too.

The Next Step in Index ETFs: Risk Efficient Index ETFs

"The Moving Finger writes; and, having writ, Moves on"
The Rubaiyat of Omar Khayyam

Finance research fingers have written a lot on the various methods of indexing, poking holes in cap-weighting as being neither theoretically nor practically optimal for indexing, whether to use as a benchmark or an investment strategy. It's time to move on, apparently not to fundamental weighting or equal weighting, but to something called a Risk Efficient Index, which maximizes the reward/return to risk (Sharpe) ratio. The EDHEC Risk Institute came up with the new indexing method and provides a good FAQ here that explains the difference with the other indexing methods (and includes links to various papers with detailed comparison of the alternative indexing methods). The second-last question in the FAQ says the method could be used for an ETF. The new Index is where the institutional investors are or will be heading, so why not an ETF for individual investors?

Book Review: All About Index Funds by Richard Ferri

Disappointing. After reading the excellent All About Asset Allocation by the same author (my review here), I expected more of the same quality from All About Index Funds, especially since this book is a second edition. Alas, too many small slip-ups and an inconsistent approach bring down the value of much useful information and sensible enough investment suggestions.

Slip-ups - Is it too much to ask for a proofreader to eliminate typos and for an editor to help with sentence construction? Yes, it is true that no book is perfect and we can usually fill in the blanks but such carelessness undermines credibility.

Unfortunately, I believe that loss of credibility is justified at times. Take this statement on page 160: "The sad part about modified-weight funds is that the issues claim to have found a new indexing nirvana when in fact all they have done is create more funds titled toward value stocks." Huh? "issues" find something? Would a better word not be something like "proponent" or "advocate"? As well, "titled" instead of "tilted"? We know what Ferri is trying to say but these trivial errors belie a too-casual, too-brief treatment of a critical issue in indexing. That issue is whether cap-weight funds are better than modified-weight funds such as equal-weight or fundamental-weight funds. Mere summary dismissal by Ferri does not help the reader make up his or her own mind. The absence of any footnotes or citations of research that he deems would answer any doubts about his position leaves the reader with a take-it or leave-it situation.

I happen to believe that fundamental weighting is better for the individual investor than cap weighting, my definition of better being a higher return to risk ratio. Whether I am right or wrong (and to find out I have a little experiment going in the form of the test portfolios at the bottom of this blog), the answer as to which is better is an empirical question that Ferri does not address. He should. Putting two and two together from information in the book, we can see that the supposed purist indices that underlie such index funds as the S&P 500 Spider (SPY) do not conform very well to purist cap-weighting conditions (e.g. violations like free-float adjustment, arbitrary stock selection by a committee, buffer zones to minimize trading and prevent front-running by hedge funds). All index funds can be seen to be merely trading strategies. The question is only which works best.

Ferri might answer that the book is only a beginner book, whose aim is to provide the "easy way to get started", as the sub-title says. Fair enough, but that raises the other problem I find with the book.

Inconsistent Approach - If the purpose of the book is to give advice, a basic how-to manual, then huge chunks of the material where the details and descriptions of various indices and myriad sector funds become irrelevant and distracting. In fact, Chapter 15 could do nicely for the investor who just wants to know what to do. The chapter lays out sensible sample portfolios with the names of specific funds and percentages to allocate across the funds.

On the other hand, if Ferri's objective is to give the investor the tools and rules to make up his/her own mind, then the pros and cons of his positions and of the alternatives need to be laid out. For example, there is lots of descriptive detail of commodities (with some errors, like saying on page 196 that cotton is an Industrial commodity! - see the S&P GSCI) and associated indices and funds but nowhere do we have an assessment of which are better, nor even a suggested method for deciding the matter.

Content - The book is divided into three parts. Part 1 puts forward the case for basing individual investing on low-cost index funds. Part 2 describes the many categories of index funds, their underlying indices and lists most of the available ETFs/mutual funds as they existed in 2007 (so inevitably this is out of date as ETF proliferate - is a book the right way to catalogue ETFs?). Part 3 says how to combine and manage index funds in portfolios. The portfolios suggested should do investors fine. The portfolios are based on mainstream cap-weighted funds and should perform well enough, even if fundamental- or equal-weight index funds do better over the long term. They offer the key feature of avoiding loss of money through high-fee funds and through the protection from diversification.

The content is at a beginner level, with no math, not even arithmetic. There are lots of illustrative tables and charts. The appendix includes a short reading list with classic books like those of John Bogle, William Bernstein and Burton Malkiel. A number of low-cost fund provider website addresses are given (I wish it included the handiest one for quickly finding all the ETFs by category, the completely mis-named Stock Encyclopedia).

The target audience is squarely people in the USA. Canadians will find it useful for their US ETF investing, but need to ignore all content to do with taxes, account types and mutual funds. No Canadian ETFs are even mentioned, nor is any pertinent history (Ferri could have acknowledged that the first successful ETF, the TIPS was created in Canada in 1990, predating the 1993 SPY - see Wikipedia).

Despite the beginner orientation, there is lots of interesting content for more advanced investors. I got many blog ideas, for questions that came into my mind during reading (but which Ferri does not answer), such as:

• what would happen if everyone indexed?
• book says there isn't an index ETF for high-yield bonds ... there is now, Powershares' PHB
• past correlations of asset classes have not been stable and tended to peak during crises - can we construct a model of correlation effects for various crisis types? e.g. asteroid strikes earth = all assets perfectly correlated at 1
• some indices are based on free-float, others on full cap for weighting, so does it matter and what is the effect?
• why have index providers all discarded the definition of Value stocks as those in the bottom half of price to book for more complicated multiple factors and what difference does it make?

My rating: 3 out of 5 stars.

Disclaimer: Thanks to McGraw Hill for providing me with a copy for review.

Cap-Weight vs Fundamental: Live Realistic Portfolio Showdown

In recent months I've converted my passive index portfolio strategy from one based on capitalization-weighted ETFs to fundamentally-weighted ETFs in the expectation that this will pay off with higher returns and lower volatility. The theory and the back-tested data notwithstanding, the proof is in the pudding so I've constructed two parallel portfolios which are permanently posted at the bottom of this blog. I'll hopefully see how my new portfolio fares in comparison to what might have been - it's either public embarrassment or triumph that is in store for me down the road.

Since pudding is something you can actually eat, the portfolio will be as realistic as possible, what an actual investor will experience, as opposed to so-called index returns one typically sees in the financial press, which exclude various MERs, commissions, tracking errors, currency exchange fees, taxes etc.

Here is how these portfolios will operate:

• $100,000 Initial Capital - though most people must gradually build up a portfolio, I've started with a lump sum to invest; to convert my own portfolio I've actually had to pay an extra 7 trading commissions ($70) to sell off the cap-weight ETFs that no longer fit but I have ignored this cost.
• Trading Commission - $10 each trade, so the initial total value of the portfolio has lost $120 for the 12 trades to establish each portfolio
• Asset Allocation - both portfolios have the same basic percentages allocated by geography and asset class (see the breakdown in the tab AssetAllocation-ETFs) with one prime difference - the cap-weight portfolio includes Value ETFs for USA Small-Cap equity (VBR) and for Global Developed equity (EFV) following the cap-weight view of the world that one adds Value stocks as a tilt. Meanwhile, the Fundamental portfolio simply includes Smaller company ETFs, according to the fundamental metrics NOT cap-weight, for the same USA and Global geographies. In the Canadian REIT class, I have chosen the brand new BMO ETF (ZRE) which equally weights its holdings, since equal weighting also breaks the over-investment in growth stocks that corrupts cap-weighting. In several asset classes no fundamental ETFs are available so we are restricted to using cap-weight ETFs, like XMD (Canadian Small), RWX (Global REIT) and DJP (Commodities). This asset allocation difference is the essence of the divergent approaches.
• Real Prices - I used actual market quotes during the day yesterday June 9th as my buy prices. Note how the real investor cannot buy exactly the number of shares to place the exact amount allocated to each asset class. Through the magic of GoogleFinance and Google Docs, I have created a spreadsheet that automatically and continually retrieves current market prices so that a very realistic picture of the portfolios can be seen at any time.
  
• Rebalancing - will be reviewed once a year in mid July after semi-annual distributions have been received and rebalanced if holdings are more than 1/4 from their target value e.g. for RWX whose allocation is 2%, that is a 0.5% up or down deviation. Even with a fairly big $100k portfolio, it is not desirable to rebalance too often with too small buy-sell amounts - even 0.5% of the initial $2000 allocation is $500, so a $10 trade is a 2% cost. For 12 annual rebalancing trades or $120, the cost to the $100k portfolio is a 120/100000 = 0.1% extra annual cost. Such seemingly small differences do matter over the long run.
  
• Taxes - I am assuming the portfolios are within registered accounts that qualify as retirement accounts under US rules (RRSP, RIF, LRIF, LIRA but not TFSA or RESP) so that there is no 15% withholding tax deducted from distributions received from US ETFs
  
• Distributions - I will add cash distributions to the portfolios as they are received. To keep things a bit simpler I will assume that USD cash will remain as USD and not be converted into CAD (thus avoiding the attendant built-in currency exchange fee). This is in keeping with the slow trend by discount brokers (Questrade, RBC and some others do so today) to enable USD to be kept as USD in registered accounts.
  
• Foreign Currency - the value in Canadian dollars (CAD) is what counts to me and to most Canadians so the net value of USD-traded ETFs is converted back into CAD automatically through the use of the ETF CurrencyShares Canadian Dollar Trust (FXC), which tracks the value of CAD in USD pretty closely. None of the foreign holdings in either portfolio are hedged since I believe the costs of hedging and the tracking error of hedged ETFs outweigh the benefits in the long run. Conversion of CAD with USD is assumed to cost 0.9% (about what I seem to pay with my broker).
  
• DRIP - CRQ, ZRE and ZRB offer automatic free reinvestment of distributions so I will calculate that; for the others, the cash balance will accumulate for a year until rebalancing is done. Since I cannot figure out how much interest the cash would collect - a minimal amount if any these days - I won't include any interest for now but if interest rates start to shoot up, I'll try to do an estimate based on rates I see in my own account.
• Tracking Through the Months and Years - to get an idea of the relative volatility of the two portfolios (I don't expect too much difference since the fundamental indexers themselves have figured out that there is a high correlation between the ups and downs of the funds ... but we shall see), I'll take a month-end snapshot of the portfolio totals and begin graphing them. In ten years, it should be interesting! (If that seems too long, maybe we can take comfort in the fact that Charles Darwin took twenty years to continue his research before publishing his book after he had developed the theory of natural selection).
  

Over time, the Fundamental Weight ETFs should all sooner or later establish a lead over the Cap-weight ETFs - shown in Red numbers in the middle column of Fund-vs-CapWt-MktValue spreadsheet - that will eventually be large enough never to be overcome. That is my expectation, hope and prayer! Go Reds, go!

Two of the New BMO ETFs Worth a Look

Amongst BMO Financial Group's latest batch of new ETFs announced May 26th, are two that look pretty good - BMO Equal Weight REITs Index ETF (ZRE) and BMO Real Return Bond Index ETF (ZRR).

Why ZRE? First, real estate is considered (by most people and by me) to be a separate asset class, so unlike the growing number of sub-sector ETFs there is justification for a separate holding of a REIT ETF such as ZRE. ZRE competes with the well-established iShares REIT index ETF (XRE). Second, both have the same 0.55% MER but the crucial difference is that BMO will equally weight the REITs held within ZRE, instead of the traditional cap-weighting within XRE. For those who accept the evidence that cap-weighting is inferior to equal weighting (or fundamental weighting, as I said March 8th), ZRE becomes the best choice. (Disclosure: I've already sold off my XRE and replaced it with ZRE in my portfolio.)

And ZRR? For an investor who uses real return bonds as an asset class (see various links on the Real Return Bond page by Bylo Selhi) and wants to be able to rebalance easily, ZRR is better than iShares' real return bond ETF (XRR) on two important measures - lower MER of 0.25% vs 0.35% and the ability to reinvest interest received automatically at no cost - the BMO DRIP program which applies to all its ETFs. For more comparison, see HowToInvestOnline's Which Way is Best to Invest in Real Return Bonds - Direct, ETF or Mutual Fund?

Book Review: ETF Strategies and Tactics by Laurence Rosenberg, Neal Weintraub and Andrew Hyman

This book is betwixt and between audiences. It presents complicated trading strategies at such a simple level, that it is hard to imagine how it could be useful to either neophyte or expert. The neophyte may get a general understanding of what is possible but will not learn enough detail of how to apply the suggested methods to have any hope of doing it successfully. The expert will already know this stuff from applying the methods to regular stocks and futures trading to need any guidance provided by this book.

The first half of the book defines and describes ETFs - how they differ from mutual funds, their structure and regulatory framework, their indices, their categories. The second part of the book, to which the "Strategies and Tactics" part of the title applies, deals with short-selling, options trading, market timing, technical analysis, financial ratio analysis. All of it has to with speculative trading and none to do with portfolio construction, asset allocation, rebalancing, correlation and diversification for long term investors that I would have expected to see occupy a major part of the content.

The book inevitably suffers from the reality that it was written in 2007 and has been rendered fairly significantly out of date by the explosion of ETFs when it lists the range and breadth of ETFs currently available. Strangely, given its speculative trading focus, there is almost no mention of leveraged and inverse ETFs, which had already appeared on the scene at that time (all I found was one paragraph on page 155). There isn't even an entry in the book's index for leverage or inverse ETFs. The authors would have been better off giving links to websites where one can obtain current lists of ETFs (one of my favorites for a fairly complete and quick way to find what is available with links to the actual provider websites for details is Stock Encyclopedia).

A final complaint about an inaccuracy that I have seen repeated elsewhere .... on page 242 the book says the first ETF launched (in 1993) was the SPDR ( they mean the famous Spider, symbol SPY). Well, I hate to break it to them but it was not the first, or even the first successful ETF (though it is the biggest by far). The Canadian TIPS 35 (speaking of which, I wish they would bring that one back with its MER of only 0.04%) preceded SPY by several years (see The Development and Evolution of ETFs). TIPS 35, launched in March 1990, was the first successful ETF, till it got merged into what is now the TSX60 ETF (XIU) in March 2000 in a deal with Barclays, but even it wasn't the first. According to the excellent Atkinson book The New Investment Frontier III (see my review) the honour goes to an unsuccessful extinct animal called SuperUnits and SuperShares.

An ironic quote from the book: "Good luck in your ETF trading." Indeed, if speculative trading with ETFs is what you decide to do, I wish you luck too.

My rating: 1 out of 5 stars.

Thank you to McGraw Hill for providing a review copy.

Tax Breakdown of 2009 Distributions for iShares ETFs Now Available

It's nearing the time to prepare the 2009 tax return and iShares Canada has released the breakdown for tax purposes of the 2009 distributions of all its funds. Knowing the actual cash distribution received during the course of the year is not enough to do taxes since distributions are not the same as dividends. Some of the distributions are dividends (which themselves can be eligible or ineligible and taxed at different rates) but others are interest, capital gains or foreign income and there is also possibly credit for foreign taxes paid and deductions of Return of Capital to be made against the Adjusted Cost Base of holdings in taxable accounts.

The data is available for each ETF in the Distribution History link in the left hand margin of the individual ETF webpage (e.g. the TSX Composite ETF XIC) as well as a convenient pdf table of all the funds here.

The Myth that ETFs are Always and Necessarily Better than Mutual Funds

It's all about costs and investment strategy. Whether a fund is an ETF or a mutual fund doesn't matter all that much. If the costs to buy into, to manage and to run the fund are low and it passively invests in a broad market index, the results for the retail individual investor will be good. The fact that mutual fund fees in Canada have been high and net investor returns have been low as a consequence does not mean it has to be so. In fact, ETFs are catching up to mutual funds in both good and bad ways. The recent proliferation of new ETFs with active trading strategies, narrow asset groupings and leveraging, foretell that investor returns will be poor.

That it is possible for mutual funds to equal the original virtues of ETFs is evident at the US fund company Vanguard, which offers both ETFs and mutual funds.

Here is a sample of funds with identical holdings and thus returns, apart from fees. In fact, the ETFs of Vanguard are merely a share class of the same asset base.

• US Total Stock Market ETF (symbol: VTI) - MER 0.09%
• US Total Stock Market Index Fund (VTSMX) - MER 0.18% no purchase or redemption fee

• US total Bond Market ETF (BND) - MER 0.14%
• US Total Bond Market Index Fund (VBMFX) - MER 0.22% no purchase or redemption fee

• Emerging Markets ETF (VWO) - MER 0.27%
• Emerging Markets Fund (VEIEX) - MER 0.39% plus purchase fee 0.50% and redemption fee 0.25%

The mutual fund on-going MER fees are a bit higher but for someone trying to make regular small purchases through an automatic savings and investment plan, avoiding the payment of trading commissions on ETFs, even when they are $1o per trade from a discount broker (a $10 cost on a $1000 purchase is a 1% "fee") makes the two alternatives very similar. Add in the convenience of automatic dividend reinvesting (DRIP) and tax record keeping that mutual funds offer, and ETFs lose their advantage. Vanguard even has a handy ETF vs mutual fund calculator to compare which version you would be better off to buy, considering fees, holding period, frequency and amount of purchases and commission costs.

The big problem for Canadians, of course, is that Canadians are not allowed to buy US mutual funds.

To its credit, one Canadian ETF provider - Claymore Canada - has adopted useful mutual fund features by offering pre-authorized chequing contributions (PACC) for buying its ETFs, along with a DRIP and a systematic withdrawal plan (SWP), all at no transaction cost. And all of BMO'sETF family new offer DRIP as an option, though not the PACC and SWP (yet?).

If only some mutual fund visionary in Canada would catch up to good aspects of ETFs ....

ETF Combinations for Tax Loss Selling while Maintaining Asset Classes

This is the time of year when most people think of doing tax loss selling in taxable accounts. Larry Macdonald in Using ETFs for Tax Harvesting: Hidden Alpha? on Seeking Alpha has reminded us that ETFs are a handy vehicle for doing that and last year I posted my suggestions for doing it properly. (In case you are wondering why tax loss selling is worthwhile, something that is rarely demonstrated, check out Tax Loss Selling Explained: What, Why and How on HowToInvestOnline).

For the passive index investor like me, the objective is to stay invested. In order to do that and not run afoul of CRA's superficial loss rule of not buying back the "identical" property within 30 days before or after a tax loss sale, one key test with respect to ETFs is to buy back an ETF that tracks a different index. 30 days later you can buy back the original ETF if that's what you want to hold for the long run. Each trade costs commission of course, so figure out whether the round trip is worth it as a percentage of the holding.

Here is a starter list of some of the main asset classes where multiple ETFs track a different index but are in the same asset class. The functional test of whether it is in the same asset class is correlation - the same up and down performance - which can be quickly eyeballed using Google Finance and graphing the ETFs in question (see my example chart of US total market ETFs below). To save time and space, I've just identified the ETFs by their stock symbol.

Canadian Equity

• XIU - S&P TSX 60
• XIC - S&P TSX Composite
• ZCN - DJ Canada Titans 60
• CRQ - FTSE RAFI Canada; fundamental indexing will cause returns to differ significantly from the above market cap weighted ETFs
  

US Equity - since the large caps represent about 3/4 of the US market, one might consider swapping total market for large cap or vice versa, especially if it just for the short term
1) Total Market

• IWV - Russell 3000
• VTI - MSCI US Broad Market
• TMW - SPDR DJ Wilshire 5000
• IYY - DJ US Total Market

Source: Google Finance

2) Large Cap

• VV - MSCI US Prime Market 750
• IVV - S&P 500
• SPY - S&P 500
• IWB - Russell 1000
• ZUE - DJ US Large Cap, hedged to Canadian dollars - so returns will differ from above non-hedged ETFs; traded on TSX
  

US Bond Total Market

• AGG - Lehman US Aggregate Bond
• BND - Lehman US Aggregate Bond
• GBF - Lehman Brothers U.S. Government/Credit (holds both govt & corp bonds)

Emerging Market Equity
1) Traded on US exchanges

• VWO - MSCI Emerging Markets
• EEM - MSCI Emerging Markets
• PXH - FTSE RAFI Emerging Markets
• ADRE - BONY 50 ADR
• GMM - S&P Emerging BMI

2) Traded in Canada on TSX

• ZEM - holds VWO plus other funds, enough to make a substantial difference
• CWO - holds VWO but is 100% hedged
• XEM - holds only VWO but is non-hedged; whether currency exposure difference with CWO counts enough for CRA I cannot tell (and they will, in their inimitable fashion, not tell, if you ask them) but the returns sure will differ

US Real Estate

• VNQ - MSCI US REIT
• RWR - DJ Wilshire REIT
• ICF - Cohen and Steers Realty Majors
• IYR - DJ US Real Estate

Global Equity
1) Traded in US

• VEU - FTSE All-World ex-US
• ACWX - MSCI All Country World ex-US
• GWL - S&P/Citigroup BMI World ex-US

... Developed Country (i.e. ex Emerging Markets)

• EFA - MSCI EAFE
  
• ADRD - BONY Developed Markets 100 ADR (large cap)
• IOO - S&P Global 100 (large cap)
  
• EEN - Robeco Developed International Equity
  

2) Traded in Canada

• XIN - holds EFA only but hedged to Canadian dollar, so returns will differ from above two ETFs
  
• CIE - FTSE RAFI Developed ex-US 1000; fundamental index - returns will differ from market cap funds
• ZDM - DJ Developed Markets ex-North America ; hedged to Canadian dollar so returns will differ

For other (sub)asset classes not covered above, like commodities, small cap and value ETFs, a good place to look for ETFs and the index of each is Stock-Encyclopedia.com. It groups ETFs by categories which roughly correspond to asset classes and the index is shown in the summary for each ETF - e.g. see IOO.

There are some asset classes where I could not find any reasonable ETF combo alternatives - notably Canadian real estate and Canadian bonds. If anyone has any suggestions, please comment.

Some ETFs Don't Track Their Index Too Well

Investors like me who merely seek to replicate the returns of a broad index and not to time markets but merely passively track the index often use ETFs to do so. It's probably no surprise that ETFs vary considerably in how well they do the job of tracking the target index. The measure of the deviation from the index is tracking error.

Forbes' ETFs Behaving Badly article and accompanying 20 Best and 20 Worst slide shows describes results of a survey of 505 US-traded ETFs done by Morgan Stanley for 2008. In many of the worst cases the tracking error is several percentage points. The best have really tiny tracking errors.

Many of the worst trackers turned out to have out-performed or done better than the index in 2008. The article explains how some of those came about which gives me the sense that it's likely to keep happening. It's perhaps a nice accident that some results were better than the index in 2008 but in future years an uncontrolled or uncontrollable tracking error could well mean serious under-performance. Just give me the index please!

Most of both the best and worst lists are quite specialized ETFs. It's reassuring to see that among the best are Vanguard's Total US bond market ETF (BND) and iShares US TIPS Inflation-Indexed Bond Fund (TIP). A surprise is that some of the worst are several Vanguard offerings like their Energy Fund (VDE) and a Telecomms Fund (VOX) and an ETF heavyweight, iShares MSCI Emerging Markets Fund (EEM). There are also several bad country trackers, notably iShares' ETFs for Mexico (EWW) and Austria (EWO) and the SPDR S&P China fund (GXC).

Proposal for a New ETF: Shunned and Sin Stocks

There are ETFs for just about everything these days. Amongst the country, commodity, sector and bear/bull ETFs, there are Socially Responsible ETFs.

To cater to those who view the SRI funds as political correctness and who love to decry it, in the spirit of equal opportunity I would like to modestly propose the creation of another one that presents the opposite point of view - the Shunned and Sinner Index ETF. One has to admit, it has a certain ring to it, or more precisely, a TWANG - tobacco, weapons, alcohol, nuclear and gambling.

The S&S ETF investor need not sacrifice for his or her unpopular personal point of view. No indeed. In their paper, The Wages of Social Responsibility, found over at the Social Investment Forum (Ah, the world is full of ironies, isn't it. This very paper that won the 2008 Moskowitz Prize for Socially Responsible Investing confirms that you can make money by doing the opposite), researchers Meir Statman and Denys Glushkov found that "... we also find that ‘shunned’ stocks outperformed stocks in other industries". They cite another study by Harrison Hong and Marcin Kacperczyk called the Price of Sin that found "... that the realized returns of ‘sin’ stocks were higher than the returns of other stocks." These 198 baddies stocks include GE (weapons and nuclear), Coca Cola (alcohol ... so that's the secret ingredient!), Altria (tobacco and alcohol) and Harley Davidson (gambling ... really? riding a bike isn't that dangerous).

An S&S ETF would allow investors to add a Mean tilt to their portfolio to supplement the oft-noted Value and Small Cap tilts. It's time to jump in now, before the efficient market discovers the S&S effect and eliminates it through arbitrage.

We can all have our cake and eat it too though, since Meir and Glushkov also found that the SRI approach can do well by focusing on companies with good community and employee relations and high scores on environmental responsibility. Everyone wins, no one loses, now that's politically correct.

How about it, iShares, Powershares, Claymore isn't there an unexploited opportunity and a clientele to be served?

China ETFs and Mutual Funds - Any Difference?

The Contenders: the two largest by assets of each type

ETFs

• iShares FTSE/Xinhua China 25 Index Fund - NYSE: FXI
• SPDR S&P China - NYSE: GXC
• other China-only ETFs listed at Stock Encyclopedia's China ETF list
  

Mutual Funds

• AGF China Focus Class
• HSBC Chinese Equity Fund
• a bunch of others in GlobeFund's Greater China selection
  

1st answer: No, there is no difference
Though the ETFs are explicitly passive index followers and the mutual funds are presumably active managers trying to pick winners, their holdings all look remarkably the same. Take a look at the top ten holdings table below, where I highlighted with different colours the common companies in each fund. It is a very colourful chart!! There is only ONE company at most in each fund that is not found in at least one other. Six companies are in all four funds. Even the place of individual companies in each top ten looks quite similar. The funds are all heavily concentrated in their top ten, with the total assets devoted to the top ten ranging from 50 to 60%. Finally, even the mutual funds are more or less fully invested, with the maximum cash holding being HSBC's 4.5% - if active fund managers were to be able to time a market peak and pull back, would it not have been a good time a few weeks ago (the time of this data) when valuations seemed to be ambitiously high? Today's Globe article Shanghai exchange: Tea leaves might be helpful talks about a possible growing chinese bubble, which is after recent days' big declines.

The net result is that FXI and GXC track each other's market performance very closely (easily verified by a Yahoo stock chart). I bet HSBC's and AGF's would too, except for ...

2nd answer, Yes, there is a difference
Perhaps this is no surprise for observers of ETFs against mutual funds, but the ETF MERs are vastly lower:

• FXI - 0.74%
• GXC - 0.59%
• HSBC - 2.56%
• AGF - 2.94%

With the holdings being pretty well the same, the extra MERs will surely drag down the net performance for the mutual fund investor by about that 2% difference. Maybe a series of small trades could eat away that ETF advantage through trading costs but someone planning to buy infrequently and then hold with medium size amounts (e.g. $10 trade commission on an ETF on $1000 purchase is a 1% cost) would be much worse off in the mutual funds.

On the other hand, I have read that professional fund managers with resources to do proper research in less developed and therefore less efficient markets, such as China surely still is, can outperform and produce returns superior to an index (see this 2007 YouTube video of Random Walk Down Wall Street author Burton Malkiel - the market efficiency discussion starts at around 33 minutes).

Maybe the China mutual fund managers need to re-think their value proposition and either adopt outright passive indexing and drop their fees considerably, or start doing their job of company analysis and start earning their fees?

Gail Bebee asks: Has the death knell sounded for mutual funds?

Author Gail Bebee sent me the following message with the above dramatic title:

"New exchange-traded funds from a Big Five Canadian bank will compete with mutual funds

Toronto, June 17 – The Bank of Montreal (BMO) is getting into the exchange-traded funds (ETFs) business with an offering of seven funds which largely mimic existing products from ETF industry leader, iShares. Says independent investor and personal finance author Gail P. Bebee “ETFs, the low cost alternative to Canada’s high fee mutual funds, are making major inroads into the mutual fund business and BMO wants to profit from this trend. The good news is that a major bank is offering ETFs to clients, so more Canadians will learn about the benefits of investing using ETFs instead of mutual funds. Hopefully, BMO’s decision will motivate other Canadian banks to launch their own ETFs. Canadian consumers will be the winners.”

According to Bebee, ETFs offer several advantages over mutual funds:

1. Better returns than most equivalent funds

2. Lower management fees

3. Greater tax efficiency

4. Ability to buy and sell throughout the trading day.

For more information or to arrange an interview, please contact:

Gail Bebee

Personal finance speaker and author of No Hype - The Straight Goods on Investing Your Money

All the investing basics for Canadians from a savvy financial industry outsider

Tel: 416-733-0221

gbebee@nohypeinvesting.com

www.nohypeinvesting.com"

To which I would comment, I hope not a death knell since there is nothing inherently wrong with the concept and structure of mutual funds. It's just that the current fees are so darn high, they do not provide good value to investors. However, the ability of mutual funds to take small amounts of new money efficiently and to automatically reinvest distributions and keep track of tax info such as Adjusted Cost Base are worthwhile attributes. Some fund company in Canada needs to go the route of Vanguard in the USA by providing ultra-low cost index funds.

The flight from mutual funds that Bebee refers to may just be a good thing. It reminds me of the situation many years ago when Canada's wine industry (which was more aptly described as the whine industry) contentedly produced horrible stuff in high volume until free trade opened up competition and the industry successfully shifted to high-value, high-quality niche wines. I hope the surge of ETFs is a wake-up call to mutual fund providers.

Is Claymore Being Sneaky about Showing Fees on Its ETFs?

In looking through Claymore Canada's website, one comes across the curious fact that there seem to be two sets of numbers for the management expenses of the various ETFs.

The first number is the one visible on the website's description for each fund, e.g. the Canadian Fundamental Value Index Fund (TSX: CRQ) says the fund's "Management Fees" are 0.65%. (The other fundamental equity index funds - International, US and Japan have the same annual fee.)

The second number appears on page 19 in the Prospectus. CRQ in 2008 had a "Management Expense Ratio" (MER) of 0.70% in 2008 and 0.69% in 2007.

The difference between the Management Fee and the MER is not directly explained but it seems to be that the MER also includes other costs (i.e. MER = Management Fee + Other Expenses). Page 18 of the Prospectus says such expenses come directly out of the fund and they include: "... expenses related to the implementation and on-going operation of an independent review committee under NI 81-107, brokerage expenses and commissions, income taxes and withholding taxes, transaction costs incurred by the Custodian and extraordinary expenses."

Maybe there is a cap on fees to limit what comes out of the fund, which is what it actually costs a Claymore investor, but I could not find this stated anywhere in the Prospectus. It is the MER that counts to the investor and Claymore should post the MER front and center on the ETF's webpage. Better yet, they should do as iShares does (see the iShares Prospectus e.g. page 23 last paragraph) and simply cap the fees.

The danger of Claymore's approach is the confusion evident over at Morningstar, where the CRQ Management Fee has been relabelled the MER).

The same problem applies to the other Fundamental Equity Funds:

• Japan - 2008 MER 0.80% vs Management Fee 0.65%
  
• US (Hedged) - 2008 MER 0.82% vs Management Fee 0.65%

Then there is a strange one

• International (TSX: CIE) - 2008 MER 0.56% ... but Claymore charges 0.65%? Huh? How can it be that the investor pays less than the Management Fee charged, which doesn't even include all expenses?

It doesn't seem to be a typo since the 2007 MER was 0.53%. Maybe it is due to the use of derivatives to substitute for directly investing in the 1000 companies of the target index. The fund is tiny at about $51 million in assets so could not hope to buy 1000 different stocks. Maybe it has to do with the fact that the two main holdings of CIE are the Claymore Japan and Canada ETFs. Dunno, any theories would be welcome.

Update ... on page 36 of the Prospectus, Claymore says that when funds like CIE hold other Claymore ETFs within them, it is bound by securities regulations not charge management fees twice. If they excluded the fees charged within the Japan and Canada funds - about a quarter of the holdings - from the calculation of CIE's expenses, that would lower CIE's fees by about a quarter. Adding back that missing quarter (0.56%/0.75 = 0.74%) would bring CIE's MER up to around the same level as the other funds.

Claymore's Emerging Markets ETF (TSX:CWO) - Good and Bad Points

About a month and a half ago, Claymore Canada announced the launch of a new ETF with broad emerging markets equity exposure sold on the TSX under symbol CWO. At the time, Canadian Capitalist posted a brief assessment and so did his readers with excellent comments. With due recognition to CC, here is my summary, along with some extra bits on the currency hedging method used by CWO (my analysis) and investor costs (input from Som Seif, President of Claymore, who was kind enough to respond to my email enquiry).

The Good:

• broad emerging markets exposure in a Canadian ETF - this is a new thing, though Canadians could have bought Vanguard's emerging markets fund in the US (NYSE: VWO), which is in fact the same thing since CWO's holdings consist 100% of VWO
• fund is Canadian domiciled, i.e. is a Canadian not a US security, for US tax purposes, which prevents this fund from being subject to US estate taxes for high net worth investors - those with estates of more than c.USD$3.5 million (I wish!) according to PriceWaterhouseCoopers' U.S. Estate Tax Exposure for Canadians (updated April 2009)
  
• MER of 0.65% is reasonable considering trading and currency transaction fees, especially those doing regular rebalancing and using a broker who won't allow wash trades or USD in a registered account. Som Seif sent this comparison of a Canadian buying VWO and holding it three years:

  When you buy and sell, you pay 1-1.5% exchange rate spread.
  
  So, cost to you for buying and then holding for 3 yrs is 1%+3x25bps+1%=2.75%. That's 90bps a year.
  
  If you do any trading in between the 3 yrs for rebalancing, the cost goes up even more.

The Bad

• currency hedging in CWO is CAD vs the USD not CAD vs the various currencies of the emerging markets countries starting with India (19% of the portfolio), Brazil (15%), Korea (12%) etc. What Claymore does is called proxy hedging - the USD is used as a proxy / replacement for the basket of CWO's currencies on the supposition that as goes the USD, so goes the basket. The reason for doing proxy hedging is that few world currencies are liquid enough to easily and cheaply hedge. Som Seif says it works, but being ever the skeptic, I took a closer look, using the top ten countries which comprise 90% of CWO as my sample. My simple analysis in the chart below suggests that over the last 1-year and 3-year periods, the USD and the CWO currencies have not gone up and down together against the CAD. In fact, the CWO currencies as a whole have hardly changed at all vs the CAD, suggesting that hedging isn't necessary at all! Individual currencies have had big shifts but they have almost completely cancelled each other out. Meanwhile the USD has had much larger swings. Granted, this is a short time period so CAD might gain against the emerging world for the next twenty years, and reduce the CAD value of those foreign holdings as a result, which would make hedging worthwhile. But hedging USD vs CAD seems to be a poor way to hedge VWO. CWO's tracking errors against the MSCI index it is supposed to mirror are likely to be very large.