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.

TSX Market Darlings & Dogs in March 2011

It is always worthwhile to compare the iShares TSX S&P 60 Index ETF (XIU) with Claymore Canada's Fundamental Index (CRQ). CRQ selects and weights its constituents according to historical accounting data while XIU does so based on the market value of companies. As such, the comparison tells us which sectors are popular and where the market expects future excess profitability and growth will come from - i.e. when XIU has more weight in a company or sector than CRQ.

Here's what my comparison table below tells me:

• Dogs (in Red on the table): Financials are still unpopular (less weight in XIU than CRQ) as a sector and across the board company by company with one exception, the Royal Bank, whose weight in XIU is slightly more than in CRQ. CRQ's 13.5% greater weighting than XIU in Financials and its overall weighting of 45% in that sector makes it extremely dependent on it. Incredibly, CRQ's Financial weighting has even increased since my last comparison. Inklings of popularity amongst banks and insurance companies are beginning to glimmer as most of them have gone up slightly in their weight within XIU from last August to today. Even Manulife and Sunlife, though still way less weighted in XIU than CRQ, have become less doggy i.e. have gained a little ground within XIU.
• Darlings (in Green, naturally): Energy (as in petroleum) has not only maintained its popularity, it is continuing to rise in XIU, both relative to CRQ, where it was already a heftier component, and to past August within XIU. The biggies are Suncor, Canadian Natural Resources and Cenovus and they have all gotten bigger. They must be making more money than other sectors since they have gone up within CRQ too.
• Waning Darlings: The Materials sector is still a grossly over-weight in XIU compared to CRQ but some slimming has occurred. Gold companies Barrick Gold and Goldcorp both lost ground as did Potash Corp of Saskatechewan. By the end of the day, uranium producer Cameco (CCO) (not shown on the table as it is too low down the list) might be considerably less as a proportion of XIU (it is down c. 6% as of 11:30am). CRQ has less to lose that way as Cameco is only have the size within CRQ as it is within XIU.
• CRQ's sector weightings have evolved much more slowly than in XIU. None of CRQ's sectors has changed as much as the 1.5% increase in Energy's weight, or Materials' 1.2% drop, in XIU. Accounting profits, sales and the like do not change as rapidly as market expectations, or should I say, today, market panic.

iShares XTR Changes from Passive to Active

The steady disappearance of the income trust sector as a result of the looming 2011 federal tax change has forced iShares' hand in an interesting way regarding the now formerly-named iShares Income Trust Index Fund (symbol: XTR). Following a shareholder vote (press release here), the fund's name, strategy and investment objective have changed fairly radically - from passive index tracking of income trusts to active management of any and all income bearing investments under the new title iShares Diversified Monthly Income Fund.

As significant as the change is a non-change - the management fee will remain at 0.55% including, as the press release takes pains to point out, any embedded fees arising from XTR owning other ETFs. Though there probably will be higher costs for XTR shareholders (which we will be able to find out only later when annual reports are issued) from more frequent trading due to active management, I find it refreshing that active management will in this case be associated with low fees, a situation found all-too seldom in Canada. I hope that the modified presence of XTR as a reasonable size fund ($200 million in assets) within the leading ETF provider puts some pressure for change to lower fees in the Canadian fund industry. Maybe the low fee will in itself be good to control excessive trading by XTR portfolio managers - they won't get paid much so why would they bother spending a lot of time on it and as we all know, excessive trading lowers returns.

It looks as though XTR is changing into a fund of funds since it will "... invest primarily in income-bearing Canadian iShares Funds". There may be duplication or overlap with its own iShares Conservative Core Portfolio Builder Fund (symbol XCR, MER 0.60%). As of September 2nd, the XTR fund holdings have not changed away from income trusts so I'll have to check back in a month when Blackrock says it will have completed the changeover to see how alike XTR and XCR may be. XCR is so small, with only $8 million in assets, that maybe they should just fold XCR into XTR.

The S&P TSX 60 Index vs Claymore Canadian Fundamental ETF and Active Stock Picking

Take a look at the holdings of the supposedly passive iShares S&P TSX 60 Index ETF (symbol: XIU) and you will not find a number of companies that I would expect to see based on the philosophy of not actively selecting stocks but simply mimicking the overall stock market according to relative market value or capitalisation. The description of XIU on the iShares website says "The Index is comprised of 60 of the largest (by market capitalization) and most liquid securities listed on the TSX ...". Go into GlobeInvestor, do a stock search of all common stocks, then sort by the handy Market Cap column heading, compare the top 60 there with the XIU holdings and you are in for a surprise.

Missing from XIU are no less than eight stocks listed on the TSX amongst the 60 largest by market cap according to GlobeInvestor as of close of business September 1st:

• Newmont Mining (symbol: NMC) in 13th spot by market cap
• Great West Lifeco (GWO) 18th,
• Power Financial (PWF) 28th
• Boliden AB (BLS) 29th
• Domtar Canada Paper (UFX - that's what GlobeInvestor says, though maybe it should be UFS) 32nd
• IGM Financial (IGM) 45th
• Ivanhoe Mines (IVN) 51st
• Fairfax Financial (FFH) 52nd

Why is this so? The main reason is found not on the iShares website but in the index provider Standard and Poors' Canadian Indices Index Methodology document which states this about the TSX 60 Index: "It has 60 constituents and represents Canadian large cap securities with a view to matching the sector balance of the S&P/TSX Composite Index." If S&P merely followed market cap for the top 60, there would be much heavier weight in the financial services sector stocks. The Composite Index is only 30% financial services so the 60 Index is artificially made to look like it.

That's why such small companies as Inmet Mining and Yellow Pages Income Fund, neither in even in the top 100 by market cap, show up in the 60 Index.

In contrast, another ETF which weights its stocks by size according to fundamental economic factors, the Claymore Canadian Fundamental Index ETF (symbol CRQ), has a substantially larger allocation to financial services - about 45% lately.

For an investor seeking to mirror the sector weighting of the overall Canadian economy, XIU comes closer than CRQ, since Financial services (including two other sectors - Real Estate and Management) make up only 20% of Canadian GDP (2008 figures - see Industry Canada data here).

The fact that CRQ's weighting scheme is based on actual historical accounting data, i.e. hard numbers, shows to what extent publicly-traded stocks in Canada are comprised of the financial industry. Private companies must thus make up a disproportionate share of other economic sectors. The Canadian public market is lop-sided.

For an investor seeking to go where the money is, or has been in the recent past, in terms of dividends, cash flow, sales and book equity, then CRQ comes closer than XIU since that is the basis on which CRQ picks stocks.

But to say that XIU is a totally passive fund, which therefore conforms best to an ideal, is not really true. XIU is not inherently superior to CRQ. Choosing XIU or CRQ comes down to which alternative investment strategy works best - XIU's strategy being based loosely on market cap (which in turn is based on the market's opinion of relative future value) and CRQ's based on past results being maintained in future. Which strategy works best is a matter of practical investigation.

Addendum
Just finished a chat with a very pleasant gentleman at S&P Canada who said that the financial companies in the above list were indeed excluded to keep the financial sector weight in line with the TSX Composite Index. Three others - Newmont, Boliden and Domtar - are not Canadian companies, a criteria which also forms part of the index composition. The last, Ivanhoe, has too small a float. iShares needs to improve its inaccurate summary description to include the fact that aligning to Composite sector weights is a criteria and that only Canadian registered companies, not merely TSX-listed companies, are included in the S&P TSX 60 / XIU.

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.

iShares Tax Info for 2008 Now Available

Those who use iShares Canada ETFs can get started on tax preparation in advance of receiving T3s from brokers as BGI published the 2008 tax distribution breakdown yesterday. The press release conveniently lists the data for all the iShares funds on one page. As of this morning, the distribution data doesn't show up yet in the individual fund information on the website.

To do all the tax book-keeping for 2008, one must adjust the Adjusted Cost Base by subtracting the Return of Capital (on the press release) and adding the Reinvested Distribution per Unit, which only appears under each ETF's Distribution History link, such as this one for XIU (it would have been helpful for BGI to stick that number on the press release too).

Great News from Claymore for ETF Investors

It is wonderful to read in an article by Rob Carrick in the Globe and Mail that Claymore Canada will be offering investors in its ETFs the possibility to do three things previously missing and which in my opinion add significant value:

1. Pre-Authorized Cash Contribution (PACC) plan to make regular monthly, quarterly or annual purchases of new shares
   
2. Dividend Reinvestment (DRIP) from existing holdings into new shares
3. Systematic Withdrawal Plan (SWP) to make regular withdrawals/sales of existing shares to generate cash

This considerably levels the playing field with mutual funds for small investors since all this will be done without charge - Free! The smaller the amount you have to invest the bigger the relative benefit since flat rate commissions at discount brokers would eat up more of small amounts to the point that it really did not make sense for trades of ETFs under $1000. The other big advantage is that one can put more of the mechanical part of investmenting on auto-pilot.

The article says Barclays, creator of the more popular market dominating iShares, is considering doing something similar. Yes, Please! That would really help force the mutual fund industry to lower its fees.

Questrade and Qtrade also lose a competitive differentiator. Their DRIP service would become un-necessary if iShares follows suit.

Comparison of Canadian Growth Portfolio ETFs from Claymore and iShares: XGR vs CBN, Which is Better?

A few days ago I posted about iShares new Portfolio ETF funds, stating my opinion that the XGR iShares Growth Core Builder Fund is reasonably good. There is existing competition for this fund in the one-stop shopping growth fund space in the form another ETF from Claymore, the CBN Balanced Growth CorePortfolio ETF.

I decided to have a look inside, do a comparison, see which is better and whether either is a great product that you and I should rush to buy now.

The Scorecard - my bottom line opinion summarized for those who want it all now

The winner by a narrow margin is XGR with 70 points out of 100, while CBN has 64. Call me a tough marker but that's a passing grade for both, not a fund-of-the-year score. Unlike most schools, in the right-most column, I dare to say exactly for what I would have given a perfect 10 (and I would be interested to hear other opinions too!).

Some Details
CBN's expense ratio is the sum of its own 0.25% plus that of the funds inside, which I calculated as 0.55% using the proportions of the component holdings. It is interesting that Claymore actually uses four funds of its competitor iShares (IGT, XRE, XRB and XCB) to make up 15% of the portfolio fund. The MER statement is the one critical thing I noticed (is there more?) that is NOT up to date in the Prospectus page 65 and for which I penalized CBN. Unlike the web site summary page on CBN, the Prospectus still says the MER is 0.7% for everything including the Claymore subsidiary funds; this is what was changed on Nov.18.

Diversification is broader and better in the XGR contents when one looks at the constituent funds. For instance, XIC is the total TSX 300 fund within XGR while the CBN equivalent content is CRQ which only contains 69 companies (more or less parallel to XIU, which I consider to be a large cap fund, not the broad total market). The same situation exists with XGR's holding of EEM a broad emerging markets ETF while CBN contains CBQ, which is confined to BRIC countries (Brazil, Russia, India, China).

In addition, the equity market funds used by CBN follow the fundamental indexing approach for their weighting, as opposed to market-cap weighting of iShares' funds. Fundamental indexing used various accounting measures to select and overweight companies considered to be better value and it is an investment strategy that I slot (though it doesn't apply the limited price to book definition proven by the research) into a Value asset class and not a whole of market holding that the true passive investor seeks.

The too-large Bid/Ask spread and Premium/Discount to NAV are surely mostly the result of these two ETFs both being quite small (both are less than $10 million in assets) and thinly traded. If the funds got a lot bigger that disadvantage of both would decline but in the meantime it's not good for the investor.

XGR's vague investment policy statement, which as I said in my previous post, implies an active management approach that is likely not the way they will actually manage the fund. Still one must take note of what is written, caveat emptor.

With about half its holdings in fixed income XGR is more like a balanced fund than a growth fund. With 80% equity, CBN is just a little above the usual maximum of 75%- it is in the aggressive growth zone.

Thoughts on How to Start a Portfolio from Scratch

A reader has asked:
"This question is about what to do with your money if you have a lot of it to invest every month. Lets say I had $5k per month to invest, how much would you recommend I save up before I purchase more ETFs and as such, re balance my portfolio? You see, if you read what I have been reading, many people promote the passive strategy (i.e: minimal trades per year, spending less time watching each individual holding etc)...now, I have been reading blog posts, and people have been saying that they wait until they have about 2-3k saved up, and then they "buy more ETF's". But if I did that, I would be buying ETF's every month or 12 times/year, and if I have 6-7 holdings (even at e*trades low cost of 9.99) I'm still spending over $700+ in the year just on trades. So that seems bad right? On the one hand I hear I should wait and just "do the couch potato" and re balance once per year - but I also feel like sitting on $60,000 (saving $5k/month for a year) and just plopping in such a large sum every December would be ridiculous. So the answer must
lie between purchases every month (too often) and purchases once per year (not often enough). What is recommended and why? How often should I purchase more?"

My comments:

• first, all what follows supposes that the intent is to establish a diversified portfolio with specific proportions of the total portfolio value to be invested in various asset classes; my own portfolio structure is shown at the bottom of my blog - you can see the percentages for each asset class on the Asset Allocation tab and the ETFs I have chosen, as well as alternatives. You can adjust the percentage allocations as you wish, the point is to set a target allocation.
  
• for someone who will quickly accumulate a portfolio in excess of $100k, using only ETFs and a broad range of them - I have 16 of them in mine - makes it possible to invest in minor asset classes which can provide greater diversification and higher returns.
  
• in practical terms there is a trade-off between trading costs and portfolio balance; since any cost is a certain negative return, I believe that's the most important consideration, especially in the short term (a couple of years) while the portfolio is building. At $10 per trade, the commission on a $5,000 purchase is 0.2% but for $1,000 it is 1.0%, which starts to hurt. Do that twice in a year to re-balance and it takes away an appreciable chunk of returns. For that reason, until two or three years had passed (at your rate, you would have $120k invested after two years) I would be very surprised if any asset class had changed so much that it was necessary to do a trade only for re-balancing, so I would only use new funds to progressively establish the portfolio, asset class by asset class and not bother doing trades specifically for re-balancing
  
• I would therefore do one monthly trade - a purchase of one ETF with all of the $5k - to get the funds invested immediately. There is no reason to sit on the cash and wait; the method I outline below is simple enough I believe.
  
• I would also start with core asset class ETFs to get the basics in place (sooner rather than later since one never knows when it might be necessary to interrupt the build-up; it will be better to leave an in-progress portfolio that is at all times reasonably balanced ).
  For example to build my portfolio:
  

month 1 - buy $5k of XIU,
month 2 - buy $5k of VGK,
month 3 - buy $5k of XBB,
month 4 - $5k of VV,
month 5 - $5k of VPL,
month 6 - $5k of VWO,
month 7 - $5k of VGK again,
month 8 - $5k of XBB again,
month 9 - $5k of XIU again,
month 10 - $5k of XSP,
month 11 - $5k of DJP,
month 12 - $5k of VGK again.

Total trading costs $10 x 12 = $120. The first table shows the investments at end of year 1 in terms of dollars, actual percentage of portfolio and the eventual target portfolio percentages for reference. The smaller asset classes are over-invested but that quickly begins to change in year 2. The row and column totals for the assets are already taking shape.

• Continuing this pattern in year 2 buying $5k per month, month 13 - buy $5k of XBB, month 14 - XMD, month 15 - AGG, month 16 - XRE, month 17 - XSU, month 18 - RWX, month 19 - XBB, month 20 - EFV, month 21 - XBB, month 22 - VGK, month 23 - XIU, month 24 - XBB. Only one non-core asset class remains to enter the portfolio - VNQ, US Real Estate. The row and column totals are getting close to the target allocations.
  

• The principle is simply to put each new month's purchase into the asset class that is furthest away from its target percentage. Since the evolution of the markets will move the actual percentages away from their initial purchase value, putting each new purchase into the asset class that is furthest away in actual terms as of the day of purchase will perform re-balancing. As long as you continue to put new money in, I would not see a need to do any annual re-balancing at all. For my model $100k portfolio, in the six months since I set it up in May the furthest any asset class has moved away from the target as of today is VGK, down $930; multiply that by 5 to get a hefty $500k portfolio and that could be re-balanced with one purchase. As time goes on, each $5k purchase represents a smaller and smaller percentage of the total portfolio, and each previous purchase goes down in percentage terms, bringing ever greater accuracy to the portfolio balance, especially among the minor asset classes.
  
• With fewer ETFs in the portfolio, it would be even easier to attain the target percentages - instead of VGK, VPL and VWO, you could simply buy VEU, the Vanguard Rest-0f-World (non-US), for XIU and XMD, take XIC, the S&P TSX Composite, for XSP, VV, XSU, buy VTI, Vanguard's US total market fund (though that would mean all your US holdings would be subject to the effects of the US$ fluctuations, something I think is too extreme, preferring to have half of my US large cap equity in the hedged XSP). The only minor one I would always wish to own is real estate due to its proven negative correlation with other asset classes, which thus provides very valuable volatility reductions for the portfolio.
  

That's it.

Selecting the Bond ETF(s) and Why Bonds instead of Cash

A reader sent in a couple of excellent questions on the practical aspects of setting up the bond portion of a portfolio:

1. which Canadian bond ETF to buy for a portfolio - the iShares Short-Term Fund (Ticker: XSB), or the iShares Canadian Universe Fund (all issuers and maturities; under ticker: XBB), or possibly other funds
   
2. why buy any bond fund if cash in ETrade is paying a healthy 4.15%?

To start a portfolio, I would favour XBB since it covers the whole Canadian bond market. Buying and holding the market is one of the fundamental principles of passive index investing. If one were to buy only XSB, that cuts out a substantial portion of the bond market.

The attached chart, using data from the iShares Canada website on December 6, illustrates more key differences between XBB and XSB:

• long term, the performance of XBB will be superior - note the five year return of 5.89% vs 4.37% (these figures are for the reference index that the fund attempts to track; the tracking error shows how much the ETF deviates from the index); Since XBB holds some long term bonds, it has a longer duration (see here for an explanation of bond duration as opposed to the term to maturity), which means more sensitivity to interest rate changes and more volatility, but which also provides greater yields in the long term.
• XBB's tracking error is a little more than XSB's, partly a reflection of the 0.05% higher MER on XBB
• currently, the yield difference is much slimmer than the long term averages for different maturity funds
• XBB has some of its distributions in the form of capital gains (cf 2005 and 2004), which benefits from a lower tax rate if held outside an RRSP or other registered account
• XLB has a much higher longer term performance, as shown by the results of the index it tracks
  

Note also that TD CanadaTrust also offers a mutual fund - the TD e-Series Cdn Bond Index - that tracks the same whole of market Scotia Capital Universe Bond Index as XBB. The TD fund has a higher MER of 0.48%, which almost certainly results in lower net returns than XBB. However, being a mutual fund, it charges no commissions, so if regular purchases of small amounts in a building up phase of a portfolio are taking place, it may be a better choice (e.g. the 0.15% extra MER is about the same as a $10 trading commission on a $6666 purchase of an ETF) . The other caveat is that one must have an account with TD to buy that fund.

I would note in passing that other commentators like Efficient Markets Canada and Investor Solutions, seem to be saying that short bonds / XSB are a permanently better choice because of the return to risk/volatility relationship - i.e. that long term bonds are too volatile for the small extra return. Perhaps at a moment in time, or for a specific time period, the relationship may be out of whack, but finance theory and research say that they will get realigned. There are bubbles and anomalies in the markets but they get eliminated.

Another point to consider is that just as the equity portion of a portfolio is better off with holdings beyond the Canadian market, so too is it for bonds. The next stop is likely the addition of a US fund. Major ETFs available to Canadians through US markets include BND, the Vanguard whole of US market bond fund and AGG, the iShares Lehman Aggregate Fund. There don't yet appear to be any international bond index ETFs, which would be good for even wider diversification. The Google spreadsheet at the bottom of my blog shows how I have structured my portfolio - instead of my bond ladder, just substitute XBB.

As of today, the minimal difference between the yields on cash and short, medium or long term bonds suggests that it may be just as well temporarily to hold the cash. Sooner or later larger rising differences for longer maturities will re-establish itself. ETrade's fine print does state that the interest rate can change anytime, which means having to monitor it and the funds to decide when to make the shift into the bonds. Incidentally, the ETrade folks said to me in a phone call that cash balances are protected for up to $1 million by the Canadian Investor Protection Fund.

Bonds and cash can provide a highly beneficial diversification effect in a portfolio with equities; through being un- or sometimes negatively-correlated with equities, they can increase returns and lower volatility at the same time. This surprising result has been documented and explained in such fine books as Roger Gibson's Asset Allocation and Richard Ferri's All About Asset Allocation, which I have reviewed previously.

ETFs, Fundamental Indexing and Oysters

Fellow blogger Preet Banerjee over at WhereDoesAllMyMoneyGo was kind enough to send me a link showing an impressive-looking long-term out-performance graph of the RAFI Canadian Index over the S&P TSX 60 Index. The return is about 3.1% higher in the back-testing period of 1987-2006 with a lower volatility, as measured by standard deviation. Very impressive! Is it time to dump XIU (the iShares S&P TSX60 tracker ETF) and move over to one of (there appear to be a number of choices for the investor on these mutual funds - deferred sales charge, front-end, no-load) the ProFTSE RAFI Canadian Index Funds?

A bit of googling turned up a brief but instructive analysis titled Fundamental Indexing and the Three Factor Model by noted financial author William Bernstein (of Four Pillars fame). The article deals with the US but the principles remain the same for Canada and would for anywhere else. In it he finds that the approach of the RAFI index can be mostly accounted for by the value-equity tilt and, to a lesser extent, by the size tilt that fundamental indexing imparts and about one-third due to its own unique characteristics. And furthermore about the unique third, Bernstein concludes: "Unfortunately, this latter effect is not statistically significant, raising the issue of data mining. ... Differences in the expenses, fees, and transactional costs incurred in the design and execution of real-world portfolios can easily overwhelm the relatively small marginal benefits of any one value-oriented approach."

When one looks at the annual expense ratio of the Canadian Pro Index Funds at 1.85%, that latter warning becomes especially relevant considering that XIU's expense ratio is only 0.17%. So, if one takes the 3% out-performance of the RAFI index, which is not the fund and is before expenses, subtracts 2/3 for the value tilt, (which can be obtained with by buying the relatively new XCV iShares Canadian Value Index ETF, with the admittedly higher MER of 0.50%), one is left with only 1% out-performance, a gain that is completely lost with the higher expense ratio.

Fundamental indexing, as opposed to market capitalization weighted indexing, is an intriguing idea and has stirred a lot of debate since Rob Arnott launched the concept upon the financial world a few years ago.

But, for now I will follow the lead of the old wise oyster in Lewis Carroll's poem the Walrus and the Carpenter in Alice in Wonderland. The walrus and the carpenter invite the oysters for a pleasant walk along the beach, and this is the dubious oyster's reply:

"The eldest Oyster looked at him,
But never a word he said:
The eldest Oyster winked his eye,
And shook his heavy head--
Meaning to say he did not choose
To leave the oyster-bed."

If you don't know already, you can find out here what terrible fate awaited the oysters who succumbed to the ruse.

Question on Bond ETFs Doing Poorly

A reader asks: ''Interested in any comments you might have on XBB & XSB bond ETF's. Performance has been poor this year even with dividends.''

You are right, the performance of both has not been very good, barely keeping pace with inflation over the past year at around two and a half percent total return (for details see the Fixed Income list at iShares.ca product page). That's the reflection of the usual pattern - when interest rates rise, as they have, bond prices go down and so the market value of XBB and XSB suffer. If interest rates remain stable, the yield of around 4 to 5 % will re-establish itself as the bond return. Though the returns haven't been good, I'd still consider them a good long term investment as part of a diversified portfolio with equities. I don't actually own any myself since I have been buying individual bonds, which have also gone down in market value.

If equities are having their day now, bonds will again have theirs sometime. Compared to bond mutual funds, the iShares XBB and XSB have lower MERs so from that perspective they give you more. And they are passive index trackers, rather than active managers, which most bond mutual funds are. That's another advantage of XBB and XSB.

Meantime, you can keep receiving the cash distributions (not technically dividends but interest income when it comes to tax reporting). If you treat them like I do as part of a portfolio, come rebalancing time if they are still down in value and less than their target percentage of your portfolio, I'd sell some equities and buy more XBB and XSB to get back up to the target. I call it the autopilot ''sell high, buy low'' strategy.

Thanks for the question Patrick. Best of success with your investing.

The Best US Large-Cap Index ETFs Compared

Back in May in my post on the complete overhaul of my portfolio, I showed a chart of my selected ETFs along with some credible contenders in several asset class categories. In one of these, US large-cap companies, my choice was Vanguard's offering, the Vanguard Large-Cap Index Fund (ticker VV), over some very good other choices, the iShares S&P 500 Index Fund (ticker IVV) and the grand-daddy of ETFs, the SPDR aka Spiders (SPY). Along with those, I've included the iShares Canada S&P 500 currency hedged version (XSP) and the TD e-Series S&P 500 currency hedged fund (fund symbol TDB904) for the benefit of Canadian investors like me who don't want to face the negative consequences of a Canadian dollar continuing to rise vs the US$.

The chart illustrates the factors that I believe justifies the conclusion that Vanguard is the best, though not by a great deal. I've coloured the cells light blue where the particular factor favours that ETF. The visual impression is a bit misleading since a number of cells at the bottom all have to do with tax efficiency.

Vanguard's VV is better on:

• MER, or Management Expense Ratio, which is the overhead paid to Vanguard to manage the fund - the lower the number, the better it is for the investor
• on the premium/discount, in this case the discount, which is the average amount the market price of the ETF deviates from the Net Asset Value (NAV), the value of the under-lying stock holdings; the smaller this number the better, the investor neither gains nor loses as the fund is fairly priced; in this case VV is tied with SPY for the best
• 3-year performance, which is higher in VV's case; now some will note that VV uses a different index than all the others, which use the S&P 500 and thus the result should not therefore be comparable. I'm going to stick my neck out a bit by saying that the others suffer from using the S&P 500, a flawed index (as noted by Peter Bernstein in his book, which I reviewed a few days ago). Check out the text below on the S&P 500's flaws and see if you agree with me. The fact that everyone uses it, as they do the far worse Dow, doesn't make it good!
• all the various tax efficiency measures; especially note that the ratios at the bottom of the table, higher in VV's case, mean that the investor loses less to the government through taxes on VV than the other funds. Canadians should note that the source of this is US websites like Vanguard and the absolute numbers reflect US taxpayers but I believe the relative advantage of VV is still there. The size of the 2006 distribution by VV, which would be a highest-rate income item for a Canadian, compared the that of IVV, confirms this conclusion.
  

There are a bunch of blank cells in the table, where I could not find the numbers despite hours of searching. Canadians will note more blanks for XSP and TDB904, where the available data on comparative websites like Morningstar, GlobeFund and those of the providers iShares Canada and TD Asset Management don't seem to be very forthcoming with data. I had to email iShares Canada to learn why their 3-year performance figure on their website differed so markedly from the S&P's results - turns out they only started hedging XSP in November 2005. Therefore, all note, the numbers may not be 100% accurate!

One disappointment for me in all this is how much one loses in buying XSP or TDB904 for currency protection. There's a big performance loss. It's curious that XSP managed in 2006 to distribute some of its distribution as capital gains instead of income, better because of the lower tax paid on capital gains over income. The tracking error of TDB904 at 6+% is abysmal. I had to calculate that one myself so it may be wrong but the high cash holding of 4% of assets, which came from Morningstar Canada, is consistent with such poor tracking.

The suggested weaknesses of the S&P 500 as a market index include:

• it is really only a large cap index with about 75% of the total market value of US shares
• it weights the companies within the index based on the value of the public float in the judgement of the Standard and Poors selection committee, so this biases the index away from a true market cap weighting that follows from financial theory
• some non-US companies are still in the index, having been grand-fathered upon moving away from the US
• some US companies that are illiquid are excluded like Warren Buffett's Berkshire Hathaway, a gigantic omission as it is a huge company
• delays in adding new companies in new sectors distort the true market weighting – it took a while before Google entered the S&P 500

see http://en.wikipedia.org/wiki/S%26P_500 and a letter by Darren Bramen on this page http://www.aicpa.org/pubs/jofa/apr2000/letters.htm

A Starter Diversified Index Portfolio for Canadians

One of my relatives recently asked what an example "starter" portfolio would look like based on the same principles of diversified passive index investing that I tried to use for my own. Here's my answer. First, my definition of "starter" is:

• any investment amount up to $25k or thereabouts;
• investor with lesser knowledge of investing and taxes and perhaps less interest too.

Such a definition does not indicate any particular risk-aversion stance, i.e. how conservative or aggressive it should be. In other words, the degree of risk would and should be decided independently based on different factors. Just for the sake of comparison with my own decision on the amount of riskiness and volatility, I'll use the 30% fixed income, 70% equity ratio. The idea of once-yearly rebalancing the portfolio back to the target percentage amounts also applies the same to this as any much larger portfolio. For other levels of risk acceptance, simply use different percentages of the same funds.

Click on the image to see the portfolio. It has these characteristics for these reasons:
1) only five holdings in total - this is to have large enough amounts in each holding to make it likely there will be something worth rebalancing in a year and to make it simpler and easier to do the rebalancing.
2) the five holdings give the maximum amount of diversification / low- or non-correlation base on what I've seen and read. Especially significant is the XRE for real estate, the asset class that seems to offer the most extreme negative correlation with other equities and thus the most diversification effect, the highly desirable quality passive portfolio investors seek.
3) use of TD e-Series mutual funds instead of Exchange Traded Funds (ETFs) because the benefit of slightly higher MERs (e.g. the TD MER of 0.31 vs iShare Canada's XIU's 0.17%) will be more than offset by trading fees in a year when rebalancing takes place (I assume that at a discount broker it will cost $25 per trade so a two-trade rebalancing of one sell and one buy at $50 would compare to 0.14% of $7500=$10.50 in extra MER for the Canadian holding). On top of that, as I've noted before, tax tracking is easier with mutual funds. And adding new money to the portfolio is much cheaper with mutual funds as no trade is required. TD's funds take as little as $100 for additonal contributions. Hopefully a small portfolio will be on the growth path with new money being added.
4) the US holding is the currency-hedged version while the international holding is not, because it seems to me that the multi-decade currency shifts of the US$ vs Canada$ have been large and can drastically negatively affect portfolio returns despite what the US stock market may actually do ... who is ready to predict and stake their financial future on the Canadian dollar either staying the same or depreciating vs the US$ from now on? To me, that's a too-severe and too-concentrated risk. On the other hand, the international holding is not currency-hedged, despite the availability of a hedged version, because the large number of countries and currencies spreads the effect much more and therefore lessens the chance of negative consequences. In addition, I have read material that says Canadian equity investors can benefit from foreign currency exposure so it seems to have positive support for that position as well. If any can point to serious number crunching studies that address the issue of currency risk please tell me as it is an area of doubt for sure. Yet one cannot sit on the fence till the perfect answer is available, huh? So I'm giving it my best guess.

What would come next as an addition to the portfolio? Probably a small cap equity holding, as a diversification and higher expected return asset, which would involve something like US small cap ETFs iShares Canada's currency hedged XSU or Vanguard's VBR, a small cap value ETF, or perhaps the new iShares Canadian small cap ETF XCS.

One negative of the TD e-Series funds is that they are a tied product and can only be purchased through TD Asset Management or TD Waterhouse and only on-line. That may not be convenient for everyone.

Other simple portfolios I have come across include those of Efficient Market Canada and Shakespeare, so take your pick.

That's it. What do folks out there think?

Detective Work Uncovers Excess Fund Fees in Canada

Today I came across another example of the ridiculous excess of fees charged to Canadian investors by fund companies, this time by Barclays Global Investors and its ETF arm, iShares Canada.

If you look up iShares Canada in the Morningstar.ca website, you will find therein a mutual fund called iShares CDN S&P 500 Index C$, which tracks the S&P 500 US stock index and is hedged in Canadian dollars. It's code is BGII500R. This is the self-same thing as the Exchange Traded Fund (ETF) called iShares CDN S&P 500 Index under the ticker XSP trading on the TSX. You will note in Morningstar that the Objective text for BGII500R says "XSP is ..." and the MER is only 0.15%. Morningstar also says that BGII500R is offered by Barclays Global Investors Canada. Funny, I thought, I've never heard of a mutual fund version by Barclays, maybe they are getting smart and beginning to offer ETF and mutual fund versions of the same thing as Vanguard has started to do in the US. It looked even better when I remembered that the MER for XSP is 0.24%.

Just to be sure I tried calling iShares Canada to confirm BGII500R's existence but the rep there said he didn't know anything about it since it isn't an ETF and they don't deal with mutual funds, then he gave me a number for BGI USA that turned out to be a wrong number (great customer service iShares!). I tried looking up BGII500R on my BMO Investorline mutual fund lookup and sure enough it is there. There's got to be a catch I thought, this "looks too good to be true". We've all heard the warnings about that expression, right? Well, so it is. Here is the explanation I got from BMO Investorline (kudos to the rep who took the trouble to make an enquiry). BGII500R is indeed available but it is only offered to US investors! (Just for fun, I tried to put in an order on the BMOIL system but it told me the mutual fund code BGII500R is invalid). That's right, a US stock index hedged in Canadian dollars sold only to US folks. Is that 'cause they're planning to retire here? Do they know something we don't about the US$?

And why should we Canadians pay more MER for the identical thing? And it's our hedged dollar too!

ETF Screeners, Tools and Primers

Since I have been spending huge amounts of time researching Exchange Traded Funds (ETFs) in preparation for a complete re-structuring of my investments based almost completely on ETFs, it might be of interest for me to relate what I have found of use on the Internet.

ETF Primers, FAQs and Portfolio Principles:

• Wikipedia's ETF Entry - summary explanation of ETFs; lists of providers and exchanges around the world where ETFs are available; lots of links
• Efficient Market Canada's Example ETF Portfolio - Martin Gale explains how a Canadian can build a simple global portfolio using ETFs
• ETFs vs Index Mutual Funds and ETF vs Open-End Fund Shootout (Wm Bernstein) - pros and cons of each
• IFA Canada - lots of high-quality educational material as well as sample portfolios for this company that sells low cost funds, but the principles are the same.
• Altruist Financial Advisors - links to more complicated and technical references on ETFs (and many other investing topics) under the Reading Room tab
• Bogleheads Forum - fans of John Bogle, Vanguard Fund founder; lots of links to ETF and other investing material in the Reference Library, plus opportunity to ask questions of investing junkies who generally believe in low cost passive investing
• Seeking Alpha - extensive information on all aspects of ETFs, from basics, investment strategy, asset allocation resources and tools, indexes with many links, all of it annotated
  
• Financial Webring - Canadian investors, including those who write the most and have published some excellent resources; permanent section on funds and ETFs; good place for discussion and to ask questions

ETF Screeners and Comparison Data:

• Stock-Encyclopedia.com - Canadian, US and UK-traded ETFs in one place; useful categories / asset classes for portfolio building; ETF names are written out, not abbreviated; ticker symbols always visible to avoid confusion; ETF investment objective and reference index but little else - links to provider / sponsor websites for details; links to multiple quote websites like Yahoo, Bloomberg, Google, MSN Money; doesn't include all ETFs e.g. missing REITs like ICF, IYR; no side-by-side comparisons, portfolios or other fancy stuff but I found it to be very useful for preliminary identification of candidate ETFs because the site is so simple and quick and includes US and Canadian ETFs together
  
• MarketWatch.com (engine for Wall Street Journal and XTF.com - US ETFs only; Quickscreener tool has useful asset classes; includes Management Expense Ratio (MER), Net Assets, Performance, Turnover, Top Ten holdings, Sector breakdown in one compact, easy-to-read page but is missing Geographical breakdown for international funds and Number of Holdings; no links to Providers; fund names are abbreviated making some difficult to understand; no portfolio tool
• Morningstar.com engine for Investors Business Daily) Morningstar.co.uk and Morningstar.ca - US, UK and Canadian sites for each of those countries' ETFs and mutual funds; very sophisticated and complete but consequently complex and slow to use; important things are buried several clicks down, like ticker symbols, holdings, sector and geographical details; enables creation of a portfolio, which can then be characterized using the X-Ray tool to show sector and geographical dispersion, expected returns and other very useful stats to judge whether a proposed portfolio will be well diversified. Very cool! But it only works for the funds within that country so Canadian investors like me who want/need to use US funds to diversify properly cannot see the whole portfolio analyzed. It's still very handy and unique.
• IndexUniverse.com - US ETFs only; you need to register (it's free) to get access to the database and screener; same complete coverage of 498 US ETFs plus articles and commentary, discussion forum; the screener has a lot of variables one can choose but there are a lot of pre-set ones ticked having to do with performance so it is necessary to do a lot of un-clicking then re-clicking to select the factors one needs; the MER is one screen and it has a good increment of 0.25%; US investors have it easy since mutual funds and ETFs can be screened at the same time or separately; names of funds are somewhat abbreviated but not too badly and the ticker can always be made to appear; there are no market quotes, no links to provider websites and no sectoral of geographical breakdown of fund holdings, no total number of holdings within a fund, no portfolio capability.
• GlobeFund.com - Canadian ETFs along with mutual funds and it is hard to tell them apart from the way the data is presented and certainly the entry link doesn't mention ETFs. Nowhere, for instance, is the ticker symbol XSP shown for the ETF iShares S&P 500 C$ on this data page; it is possible to filter using MER, though the increment is only 0.50%; it is difficult to tell apart actively managed from passive funds, a matter of interest to me; the website is generally slow to respond; there are performance figures, sector and geographic weighting charts, though the latter doesn't work properly for the iShares EAFE ETF that is based on the US-traded ticker: EFA and so is marked as 100% US though it is everywhere but there underneath.
• Financial Post / National Post - Canadian mutual funds with the few domestic ETFs, though the website label doesn't say anything about ETFs ... oops, the Claymore Investments range isn't included; a lot less data than the other sites; with so little ETF choice in Canada it would be imperative to include them.
  
• iShares.ca - the most popular Canadian-traded ETFs with lots of useful data and explanations
  
• Vanguard and iShares.com - US websites of low cost US-traded ETFs that will likely attract most Canadian and UK (those who can trade on US exchanges) investors with a bent for passive index investing; good places to get the details on funds to round out the diversification objectives with other asset classes; Vanguard has a neat tool that lets you compare side-by-side any of its ETFs with another of any other company, e.g. for a European holding should it be VGK or IEV or EZU - Vanguard's tool provides more data than some of the big specialized websites above.

Happy research everyone. If anyone has other suggestions for sources, let me know.

Is Currency Hedging on Foreign Equity Too Expensive?

Someone named George$ wrote a very pertinent post on the Financial Webring asking what people think of the Globe and Mail article by Allan Robinson in which several major fund managers like Franklin Templeton and Fidelity Investments say they do not do currency hedging on their international equity funds to eliminate the effects of foreign exchange shifts because it is not worth it. I've replied to George$ on the site, where hopefully others will comment too, but here is my reply. This is an important question for anyone who wants to use international investments, whether equities or fixed income, to diversify and reduce risk.

I'd sure like to see those studies done by Templeton because there can be very long term trends between currencies, for example the Canadian vs the US dollar. In the ten years from January 1997 to April 2007, the CDN$ went from 0.73 to 0.87 a 20% increase and from 0.62 to 0.88 in the five years between November 2001 and November 2006, a 42% increase. That would be enough to wipe out a substantial chunk of the US market gains for a Canadian investor. How long does the investor have to wait for currency fluctuations to even out and what is to be done in the meantime if the investor needs to cash in? Is Templeton referring to the situation of a large number of currencies with a very broad portfolio such as the MSCI EAFE index? But then, iShares Canada sells the XIN fund that mirrors the MSCI EAFE index and is 100% hedged to CDN$. Its MER is 0.15% - quite reasonable. The similarly hedged XSP mirroring the S&P 500 also has a 0.15% MER. In the end I ask myself, why do I want to bet on the currency as well as the foreign stock/index if I can avoid doing so at a reasonable cost.

One possibility I cannot admit to having modeled or seen done by someone else is the effect of re-balancing under an asset allocation policy. That would have one pushing more funds into markets when the exchange rate changes, a kind of dollar cost averaging. Not sure if that would reduce or completely eliminate the currency effect over time. Anyone have a view?

I've previously posted other comments on this question on my blog.

I wish Allan Robinson had gone to see the iShares folks but it was good to read anyway.

iShares Distribution Reinvestment vs DRIP

A follow-on to yesterday's post about Exchange Traded Funds (ETFs) is another perhaps confusing characteristic regarding distributions and reinvestments. As the blue highlighted area of this table shows for the Canadian iShares ETFs, in 2006 there were both cash distributions and reinvested distributions paid on a number of the ETFs. The cash distributions are actually paid out to the owners of each ETF at the end of each quarter just like dividends of any other company stock (with shareholders of record date for eligibility etc). An iShares press release gives the amounts for the 2007 March end quarter. For buy and hold investors like me, I don't need the cash/dividend to pay everyday expenses and I would rather that all the money be reinvested with the least cost and effort. Unlike many companies which have Dividend Reinvestment Programs (DRIP) that allow any dividends paid out to be automatically used to buy extra shares without brokerage fees, iShares cannot do so itself with its cash distributions as it explains on this FAQ page, though it says that brokers might provide the service (and it seems that Canadian ShareOwner Investment Inc is one that will but mine - BMO Investorline - will not ... hint, hint).

Stingy Investor has a very handy page listing all the Canadian companies with DRIPs (and related things like Stock Purchase Plans) for those who are interested.

Adjusted Cost Base for ETFs and Mutual Funds

I'm doing my taxes these days and part of that is to report the gain on some iShares Exchange Traded Funds (ETFs) that I sold in 2006. There's a tricky bit involved in that process which I figure is worth noting in case anyone might end up paying tax twice on their gains. Though mutual funds and ETFs are substantially similar in that they pass through capital gains and income to unit owners, there is a particular and important difference when it comes to the reinvestment of distributions. In mutual funds, the reinvestments show up as additional units and a higher adjusted cost base (ACB) for those units but with ETFs they do not. You must keep track yourself of the reinvestments and the higher ACB for ETFs. Otherwise, if you just take your original purchase cost for the ETF as the ACB, you will end paying tax again on the reinvested distribution that you already pay each year when taking figures from the T slips. I know my discount broker BMO Investorline does not keep track of the higher ACB when it shows my cost in account listings or statements. Probably none of the discount brokers do and I'm not sure all full service brokers do. It's worth checking. The iShares website has a good FAQ on the subject with more detail and a side-by-side example of the ETF vs mutual fund method. Here is another good explanation how this works for mutual funds from McColl Turner Chartered Accountants. Update January 14, 2008: Note that a return of capital distribution reduces the cost of an ETF and it is necessary for an individual investor to subtract it to properly track ACB. The proper formula for ACB, as explained by Howard Atkinson on page 160 of his excellent book on ETFs, The New Investment Frontier III, is: ACB = (total purchases + acquisition costs + reinvested distributions - return of capital) / units purchased. The main iShares page has a link labeled iShares CDN Funds - 2006 Tax Characteristics which shows all the iShares Canadian ETFs and their reinvested distributions; for earlier year breakdowns, go into the individual fund info and look for the Distribution History link on the left hand side e.g. this page for the Energy sector XEG fund.

I have to admit that despite my general preference for ETFs, this is an advantage of mutual funds over ETFs in the calculation convenience and the avoidance of costly oversights. Over a long holding period this can be significant. Even in the short space of two years from 2004 to 2006, the iShares TSX 60 XIU that I sold increased by almost $3 per unit in ACB. I'd be paying our friends at CRA quite a bit more if I simply used the original purchase cost.

Duplication of Stock Holdings in Canadian iShares ETFs

It has been noted often in the past that actively managed Canadian equity mutual funds suffer a great deal from portfolio overlap due to the small number of companies on the TSX. It is hardly useful to buy several different mutual funds since they end holding more or less the same stocks. That has led me to wonder to what degree the same problem confronts the iShares Exchange Traded Funds. The various funds bear names that suggest different specializations and thus different holdings.

The image shows the summary of the spreadsheet analysis I compiled from the fund holdings on the iShares website as of February 20th. My conclusions are graphically summarized as red = bad, green = good and yellow = mediocre choices of fund combinations. Another way of saying this is that when the overlap of the fund holdings is too great (the red combos), it isn't worth holding both funds since one ends up with more or less the same holdings.

Based on that principle, XIU (iShares TSX 60 Large Cap) and XMD (Mid-Cap) have zero overlap (green cells) and make sense as a combination). So too are XIU and XRE (Real Estate Trusts). On the other hand, XIU with XEG (Energy stocks), XFN (Financial companies) or XDV (Dividend stocks) have too much overlap and do not make sense. XDV and XFN are more or less the same thing, being dominated by the banks. One might even wonder if the XFN and XMD are worth the 0.55% and 0.5% MERs respectively, instead of simply buying the stocks directly. Several funds are so concentrated on a few holdings that they are virtually a play on a couple of stocks. XIT (Information Technology) has only nine holdings and Nortel, RIM and Cognos make up 67% of its total value. ... highly risky if the past is any guide. XMD is a good Canadian compromise - it is middle of the road and has a bit of everything. The last combination that are more less the same thing is XGD (Gold) and XMA (Materials). XMA is more diversified with 61 holdings vs only 30 in XGD.

The number of holdings across all these nine specialty funds is still less than the TSX as a whole, with only 241 separate equities, against 273 in XIC, which is iShares' TSX market fund.

Now that I know, guess I'll have to simplify my portfolio some to eliminate the useless duplications.