Archive | June, 2011

Understanding Swap-Based ETFs

Last fall, Horizons Exchange Traded Funds launched two innovative new ETFs. Rather than simply holding the stocks in the indexes they track, these funds use a derivative called a “swap” to get exposure to the market.

While swap-based ETFs are new to Canada, they’ve been popular in Europe for years. In fact, providers such as Lyxor and db x-trackers, which together offer a couple of hundred funds, use the structure for almost all of their products. Even iShares now uses swap-based ETFs in Europe, though not in North America.

I’ve always appreciated the simplicity and transparency of traditional index funds, and swap-based ETFs don’t fit that description. But they do have the potential to offer significant advantages, especially to investors who have maxed out their RRSPs and other tax-sheltered accounts. Let’s pop the hood on these pioneering ETFs and see how they work.

I’ll show you mine if you show me yours

The first swap-based ETF to hit the Canadian market was the Horizons S&P/TSX 60 Index ETF (HXT). Like the iShares S&P/TSX 60 Index Fund (XIU),

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Letting You In On a Big Secret

Joel Greenblatt has a sense of humour—I’ll grant him that. In The Big Secret for the Small Investor (Wiley, 2011), he pokes fun at the crass title of his previous book, You Can Be a Stock Market Genius, and goes so far as to renounce it: “It was meant to help the individual investor, too. It didn’t.” Now the author has new strategy to share with his readers.

Greenblatt spends the first few chapters building his case by explaining why identifying undervalued stocks is far more difficult than it sounds. Then he describes the challenges faced by active managers: if they are index huggers they almost never beat their benchmarks, and if they are more adventurous they risk periods of dramatic underperformance, which usually gets them fired. As a result, managers become so obsessed with short-term results that they can’t follow through with legitimate strategies—such as value investing—that might actually do well over the long term.

If you think you’re about to hear an argument for indexing, you’re right—sort of. Greenblatt doesn’t take the position of orthodox passive investors: that you should be content to achieve market returns at the lowest possible cost.

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The Tuber Gets Tested

Monday’s post comparing one of my model ETF portfolios to one created by Dimensional Fund Advisors attracted a lot of interest from readers—and from some DFA advisors, too.

Shortly after that post went live, I was contacted by a DFA advisor whom I’ll call John (his compliance department keeps him on a short leash). John ran some numbers to compare how the original Über-Tuber might have performed alongside a DFA portfolio over the last 15 years.

Of course, none of the ETFs in my suggested portfolio were around in 1996. So John used index data to estimate the returns of the Über-Tuber, subtracting the MERs of the funds to account for costs. For the DFA portfolio, he subtracted a 1% advisory fee from the fund returns. Here’s the breakdown he used:

Index
Über-Tuber
DFA

Canadian One-Month T-Bills
20%
20%

DEX Universe Bond
20%
20%

S&P/TSX Composite
4.8%

Barra Canadian Value
7.2%

DFA Canadian Core

20%

Barra Canadian Small
8%

DFA U.S. Vector

18%

Russell 2000 Value
8%

Russell 1000 Value
10%

DFA International Vector

14%

MSCI World (ex. U.S.)
4%

MSCI EAFE Value
10%

S&P Global REIT
4%
4%

MSCI Emerging Markets
4%
4%

100%
100%

Here are the results from July 1996 through April 2011:

Annualized
Total
Growth
Standard

Return
Return
of $1
Deviation

Über-Tuber
6.36%
149.53%
$2.50
7.82%

DFA Portfolio
6.42%
151.57%
$2.52
8.14%

And here’s how the path of those returns would have looked during the period:

As you’ll see,

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