Monday, 24 November 2008

iShares Canada's New Portfolio ETFs - How Do They Stack Up?

Wealthy Boomer's Jonathan Chevreau recently reported that iShares Canada has launched four new ETFs made up of a collection of iShares ETFs in different sectors and asset classes. The intent is apparently to provide one- or two-stop shopping in building a diversified portfolio with ETFs.

The four new funds are:
  • XCR iShares Conservative Core Portfolio Builder Fund which is quite conservative with a high proportion of fixed income at around 70% and investments on the safe end throughout
  • XGR iShares Growth Core Portfolio Builder Fund which looks like a balanced fund with a split of about half and half between fixed income and equities
  • XGC iShares Global Completion Portfolio Builder Fund which has a curious mixture of non-Canadian equities and some ultra-conservative fixed income along with some volatile fixed income
  • XAL iShares Alternatives Completion Portfolio Builder Fund which has some ultra-conservative assets along with a majority of highly volatile assets
Bottom Line:
  • The only one that I would contemplate buying as a complete stand-alone portfolio is XGR. With a few tweaks in its composition and a reduction in MER to 0.4% or less, it would go from being merely ok to being a great product.
  • XCR is too heavy on the fixed income and is too concentrated in Canada which makes up about two-thirds of the fund.
  • XGC and XAL don't combine well with either XCR or XGR; a combination would be no better than XGC by itself as this chart of the composition of the basic new funds and possible combinations shows

The Details:
Here is what I think are the good and the bad points and some that could go either way, depending on your circumstances:

Diversification & Asset Classes
- this is the outstanding feature of the new funds due to the wide sub-division among many asset classes, especially in the case of XGR, which has no less than 21 different ETFs. There is large cap equity, small cap, foreign equity, some foreign exchange exposure, government and corporate fixed income, real return bonds, real estate, and even commodities. Such diversity will bring about a high degree of stability to the portfolio. Some may view allocations as small as 1% to an asset class (like SCZ Global Small Cap Equity) as a disadvantage because even big changes to that 1% won't have much impact on the portfolio's value. But that is precisely the point, spreading the total investment portfolio around to minimize risk. An investor with a small portfolio, say $20,000, could not practically envisage building their own portfolio from ETFs where a 1% holding = $200 when the brokerage cost might be $25 or $30.

XGR's Asset Allocation

XCR's Asset Allocation

Some quibbles -
- there is no Equity Value fund at all in the portfolio, despite the research-proven performance boost from this type of holding.
- instead of the IVV S&P500 fund, which is just a large cap fund, it would likely have been better to use something approximating the whole of the US market like IYY or IWV
- I see little benefit from the complication of four different Canadian fixed income funds (XSB, XCG, XGB, XLB) which just replicate the whole of market when iShares has one whole of market fund XBB; I've seen nothing that indicates a lack of correlation amongst the different fixed income sectors represented by the four funds that would provide a diversification benefit to justify the extra funds. In addition, three of the four funds have higher MERs (see chart below) that could have helped BGI lower the overall MER of the portfolio fund.
- similarly, I fail to see why the US fixed income fund is LQD, the corporate sub-sector fund, instead of iShares excellent total bond market fund AGG
- the last fixed income element that I find unsatisfactory is the use of the US real return fund TIP instead of simply using a lot more XRB, the Canadian real return fund. Though I don't have charts to prove it, I would be very surprised if the correlation of XRB and TIP were not close to 1 - i.e. perfectly correlated - and therefore there would no diversification benefit from holding the two different real return funds. On top of that, to limit foreign exchange exposure on TIP, the XCR and XGR managers do foreign exchange hedging on TIP, which adds cost.

Portfolio Policy - Active or Passive?
The iShares fund fact sheets leave the definite impression that these funds might be actively managed when it says on page 1 of the prospectus:
"Barclays Canada will use an asset allocation strategy, as further described below, and may change the iShares ETFs, other issuers and/or derivatives in which an iShares Fund invests, and the percentage of an iShares Fund’s investment in such iShares ETFs, other issuers and/or derivatives at any time and from time to time." It's the waffle words "may change" that concern any investor looking for a constant asset allocation policy for a portfolio of passive index tracking funds, which is what is inside the new funds. For such a portfolio construction and such a relatively low MER, I could not believe that Barclays would actually try to outperform by active management and changing funds or allocation percentages to any appreciable degree. How could they make exorbitant profits that way? They'd have to employ a bunch of highly paid people pretending to know better than the market when to overload on XIU, TIP or whatever.

So I phoned up and the customer service personnel for the hoi polloi like me and you (i.e. those lowly folks who might not really know what is going on at Barclays in the fund management end of things, so their answer may be wrong) did assure me that the asset allocation was meant to stay relatively constant and that quarterly rebalancing would bring the percentages back into line. As to why the prospectus doesn't say that, their explanation was that such wording is required for flexibility. It just sounds like the lawyers did their usual thing and made the prospectus impervious to future lawsuits ... and clarity suffers. That's just stupid marketing and communication by Barclays IMHO.

The challenge for an individual investor,even someone with a portfolio as large as $1 million, is that rebalancing a whole bunch of funds in a multi-asset class portfolio, can be expensive and complicated. As amounts increase, it is likely multiple accounts - RRSP, LIRA, RRIF, regular and soon TFSA - will add to the complexity. With smaller total portfolio amounts, the cost of rebalancing would be horrendous for someone who tried to replicate all these asset classes. If a 1% holding of $200 increased by 50% to $300, would it be worth a double (one sell, one buy) $10/25/30 brokerage commission to rebalance that $100? Barclays is offering something worthwhile.

Quibble: The advertized quarterly rebalancing is un-necessarily frequent. The research I've seen and previously posted about says once a year at most provides better returns.

Foreign Exchange Hedging
The use of many foreign holdings, which provides useful diversification, also introduces the risk of shifts in foreign currencies. XGR has about half its portfolio in non-Canadian fund investments and XCR about a third. Foreign currency exposure is itself a form of diversification benefit but without hedging, the portfolio effect can be overwhelming so most portfolio design includes hedging part of that amount. Both XGR and XCR hedge about half their foreign content, partly through using funds that are themselves already hedged, like XSP and XIN, but also through separate hedging operations. This proportion is in line with what I've read about how much hedging Canadians investors should do. The extra hedging is another value-add for the purchaser of the new funds since it would be complicated and more expensive to do on one's own.

Those investors who build their own portfolio and want some hedging have to limit the number of funds and asset classes they use, e.g. when using TD e-Series funds or iShares' ETFs.

Management Expense Ratio (MER)
Is the 0.6% MER for XCR and XGR too high? To find out, I first reconstituted the MER of XCR using the proportional sum of the individual component ETFs - it comes out to about 0.303%. Then I calculated what an investor could pay using best/cheapest in class funds for each asset class in XCR and XGR, which mainly means using Vanguard funds. You or I can make our own versions of XCR for 0.245% and XGR for 0.253%. In contrast, the 0.6% doesn't look great ... except we have to include the value/cost of rebalancing and hedging both in direct dollars and time/hassle/effort. Rebalancing costs vary by number of trades and size of portfolio. For $100,000 portfolio with 10 buy/sell trades a year at $10 each totalling $100, the MER equivalent is 0.1%. For a smaller portfolio the MER burden would be higher. Hedging cost is harder to figure directly but as a guide iShares' unhedged EFA has 0.35% MER while the hedged XIN has a 0.49% MER, a 0.14% difference. Using that, the MER value of hedging plus rebalancing could be 0.1+0.14=0.24%. I figure the MER of XCR and XGR are a bit too high - somewhere in the area of 0.4% would be more attractive because I have a bigger portfolio and I do less rebalancing.

XGR's MER Analysis

XCR's MER Analysis

Account Types and Taxes
One problem for which I cannot see a solution is that come the issuance of tax slips after year-end, these new iShares funds will distribute all types of income - interest, dividends and capital gains - for registered or non-registered accounts willy-nilly. If all you have is registered accounts then this doesn't matter. But if your portfolio spans both registered and unregistered accounts it is an important issue. It will not be possible to optimize for taxes by keeping all the interest income from bonds in registered accounts while directing less-taxed dividends and capital gains to the non-reg taxable account. This is perhaps the biggest drawback for me personally. By buying individual funds, I can put XRB with its interest income in my RRSP and cap gains-producing XIC in the taxable account.

Having only one fund to buy that is denominated in Canadian dollars, though it contains holdings from US exchanges in US dollars means that it is possible to avoid having to pay the currency exchange fees in registered accounts for those brokers who do not allow cash to be kept in US dollars. That is a benefit on initial purchase and when rebalancing.

Others who have reviewed and commented on the new funds:


Anonymous said...

Thanks for the mention.

It doesn't make sense that the reason for not specifying asset allocation targets is that the prospectus wording requires "flexibility". Claymore's documents clearly mention a target range. I'm not sure what's going on here.

CanadianInvestor said...

cc, you are right it doesn't make sense. The cust service rep either didn't know or just told me anything to get rid of me. Barclays really should put some explicit target ranges on the funds.

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