ETFs 101 – Part I

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Since one of the focus areas of this site is going to be ETFs, I thought it would be a good idea to cover some basics of ETFs.

What is an ETF?

ETF stands for Exchange Traded Fund. An ETF is typically a collection of securities/assets (ie, stocks, bonds, commodities, currencies, or a combination) that are usually designed to passively track some market index.  An ETF, as the name implies, trades on the stock exchange similar to other stocks.

Types of ETFs

There are different types of ETFs available including

  • ETFs to track stocks, bonds, commodities, and currencies
  • ETFs to track countries and sectors/industries
  • Leveraged ETFs – which give you exposure of 2-3 times the market moves on a daily basis.
    • Eg: If the stock market moves 1% up or down, the leveraged ETF will change 2-3% in price
  • Inverse ETFs – go up in value if the asset it is designed to track goes down in value and vice versa
  • ETFs to track different strategies such as covered call writing

Other ETFs are coming on the market with more sophisticated strategies and may not be a purely passive index strategy.  For instance, Horizons ETFs has a line–up of actively managed ETFs available.  Although some of these go against the principle of passively tracking indices, they may be useful investment tools to achieve investment goals or needs.

ETFs versus Mutual Funds

—ETFs can be used instead of traditional mutual funds to achieve investment objectives.  —Studies show that it is difficult for actively managed mutual funds to consistently outperform the index it is tracking over the longer term.  According to the —Standard & Poor’s SPIVA Canada Year-End 2011 Report, the percent of active fund managers under-performing the index over 5 year period (ending Year-End 2011) are as follows:
  • —Canadian Equity (S&P Composite Total Return Index) – 97.26%
  • —US Equity (S&P 500 Index in Cdn dollars) – 89.01%
  • —International Equity (S&P EPAC LargeMidCap Total Return, Cdn dollars) – 93.88%
This means if you are investing in mututal funds, over the long run, your mutual fund will likely under-perform the index it is tracking!!  I would imagine on an after-tax basis, the under-performance would be even worse.


ETF Providers in Canada

For a list of Canadian ETF providers, visit the Links and Resources page.

In Part II we’ll dive into the advantages and disadvantages of ETFs versus mutual funds.

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BMO Wealth Institute Special Report: Enhancing Retirement Planning with ETFs

BMO Wealth Institute recently published a special report on using ETFs as part of retirement planning.  The report highlights the following 5 challenges with retirement planning and how ETFs help address these challenges.  The complete report can be found here.

• focusing on security selection and not asset allocation
• chasing past performance
• not rebalancing an investment plan
• implementing a portfolio with too much single-security risk
• not factoring in the impact of taxes when reviewing and/or updating
the financial plan

Monkey See, Monkey Do?

Most market indexes are constructed using market-capitalization weighting, and in turn, many ETFs aim to track the performance of these market-capitalization indexes.

However, there are alternative methods of creating an index other than using market capitalization.  Some examples include equal-weighted, value-weighted, price-weighted, and fundamentally weighted indices.

This article cites a study that stock indices created by ‘monkeys’ performed better than market-capitalization indexes on a risk-adjusted basis from a period of 1968-2011.  This study showed randomly picking and weighting stocks (the monkey approach) outperformed the market-capitalization indexes!  In addition and of more practical use, the study also found that 13 alternative indexing strategies all performed better than the market-capitalization indexes.

These alternative indexing strategies, also known as ‘smart beta’, start to blur the boundaries between passive and active investing in my opinion.  However, they overcome some of the weaknesses inherent in market-capitalization indexes and can be a good addition to an existing portfolio.  As evidence in the above cited article suggests, they may also deliver better performance.

The study was conducted by the Cass Business School and the original research papers can be found here.

Investing In Emerging Markets ETFs

According to FTSE’s research paper, emerging market economies are being driven into the forefront of global economic growth due to the emergence of new middle class, rapid urbanization, move from export-led to consumption-led growth, and emphasis on production of higher value products.

The Organisation for Economic Co-operation and Development (OECD) is projecting China’s share of the world GDP will rise from 11% in 2011 to 28% by 2030.  India’s share will go from 7% in 2011 to 11% by 2030.  USA’s share of the world GDP is projected to shrink from 23% to 18% over the same period.  Canada’s share will shrink from 2% to 1.6%.  As a result, it probably makes some sense for long term investors to allocate a portion of the portfolio to the emerging countries.

Source: OECD

Share of Global GDP – 2011 (Source: OECD)

Source: OECD

Share of Global GDP – 2030. (Source: OECD)

There are several ETFs available that can be used to invest in the emerging markets.  Below are 2 equity ETFs and 2 bond ETFs that can be used to invest in the emerging markets.

Equity ETFs

Vanguard’s Emerging Market Index ETF (VEE)

This ETF tracks the performance of the FTSE Emerging Markets index which is a market capitalization-weighted index, which basically means larger companies in the index (and consequently, the ETF) will carry more weight in terms of representation and returns.

One main reason to consider this ETF is that it is the cheapest emerging market ETF available in Canada with a management fee of 0.49%.  Of note, this ETF will slowly reduce exposure to South Korea as it is now classified as a ‘developed market’ by FTSE.

iShares Broad Emerging Markets Index (CWO)

This ETF tracks the FTSE RAFI Emerging Markets index.  This index uses 4 fundamental factors to determine a company’s weight in the index according to specific rules.  These factors are dividends, cash flow, sales, and book value of a company.

This ETF is more expensive with a management fee of 0.65%, but since it uses a different indexing methodology, I prefer to use this ETF to get style diversification.

Bond ETFs

There are several options to access emerging market debt investments including forward-currency contracts, local currency sovereign bonds, USD-denominated sovereign bonds and USD-denominated bonds of EM corporations.

The 2 ETFs discussed below are both sovereign (government) bonds.

BMO Emerging Markets Bond Hedged to CAD Index ETF (ZEF)

This ETF tracks the Barclays Capital Emerging Markets Tradable USD Sovereign Bond Index CAD Hedged benchmark (now that’s a mouthful).  The bonds held are U.S. dollar denominated sovereign debt from emerging market issuers, and the currency is hedged back to Canadian dollars.

According to the Exploring Emerging Markets Debt article in the Journal of Indexes, most of the emerging market USD sovereign bond yields are influenced by the changes in the U.S. Treasury curve more than the local emerging market factors.

SPDR® Barclays Emerging Markets Local Bond ETF (EBND)

This ETF tracks the Barclays EM Local Currency Government Diversified Index which is a fixed-rate local currency sovereign debt of emerging market countries.  Investors benefit from diversification through gaining exposure to local economic and interest rate factors.  This ETF trades in the U.S. so Canadian investors will be exposed to an additional USD-CAD currency risk.

About Emerging Markets Index Benchmarks

Not all emerging market indices are created equal, and since ETFs track various benchmarks, it is a good practice to check what the underlying index of an ETF holds.

For instance, according to Standard and Poor’s article Looking Beyond Traditional Benchmarks To Add Value In Emerging Markets, traditional market capitalization weighted emerging market indices like the MSCI Emerging Market Index have a heavier concentration to the more mature economies like South Korea.  In addition, the index is also lacks exposure to smaller companies which can often show higher growth.

The U.S. has more ETFs to choose from to invest in the emerging markets if you want to be more tactical and diversify away from the traditional market capitalization index.  Some of these ETFs are shown in Exhibit 11 of the article mentioned above.

 

REFERENCES

1. Emerging Markets: Crossing the Rubicon

2. FTSE RAFI Emerging Index Fact Sheet

3. OECD – Looking to 2060: Long-term growth prospects for the world

4. S&P Dow Jones Indices- Looking Beyond Traditional Benchmarks To Add Value In Emerging Markets

5. Journal Of Indexes: Jan/Feb 2013 – Exploring Emerging Market Debt

New ETFs Provider To Enter The Canadian Market

Looks like the Canadian market will soon have an eighth ETF entrant.  FT Portfolios Canada Co has filed a preliminary prospectus with the Canadian securities regulatory authorities to launch it’s Canadian domiciled ETFs as reported in their press release.

The list of the new ETFs are as follows:

  • First Trust AlphaDEX Canadian Dividend Plus ETF
  • First Trust AlphaDEX U.S. Dividend Plus ETF (CAD‐Hedged)
  • First Trust AlphaDEX Emerging Market Dividend ETF (CAD‐Hedged).
  • First Trust AlphaDEX Global Energy Income Plus ETF (CAD‐Hedged)
  • First Trust Senior Loan ETF (CAD‐Hedged)

Although competition is nice, not so sure if more choices similar to what is already available is really necessary.