iShares ETFs: Looking Back, Looking Forward

This past spring, a number of Canadian iShares ETFs celebrated their 10th birthday. The country’s largest ETF provider now has 10 funds with a history that goes back to at least 2001, and according to the research firm Fundata, six of them were first quartile performers for the decade ending June 30, 2011. (This means they outperformed at least 75% of their peers.) A pair of others were second quartile, with only two lagging the category average:

iShares ETF 10-year quartile
DEX Short Term Bond Index Fund 1
DEX Universe Bond Index Fund 1
S&P 500 Index Fund 1
S&P/TSX 60 Index Fund 1
S&P/TSX Capped Composite Index Fund 1
S&P/TSX Capped Financials Index Fund 1
S&P/TSX Capped Energy Index Fund 2
S&P/TSX Capped Information Tech Index Fund 2
S&P/TSX Completion Index Fund 3
S&P/TSX Global Gold Index Fund 4

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Fundata also reports that 11 of the 16 iShares ETFs with a five-year track record were first quartile performers, too. That’s an impressive result for a family of funds that simply try to capture the returns of an asset class with no attempt to beat the market.

An ETF history lesson

Even before iShares, Canada was a pioneer in the ETF space: in 1990, the first successful exchange-traded index trackers appeared in Toronto. They were called Toronto Index Participation Shares (TIPS), and they tracked what was then called the TSE 35. In 1999, this product was purchased by Barclay’s Global Investors and later rebranded as the iUnits S&P/TSE 60. Today it’s called the iShares S&P/TSX 60 Index Fund (XIU), and it’s far and away the largest ETF in Canada, with about $10 billion in assets.

The ETF that is now the iShares DEX Universe Bond Index Fund (XBB) was also a trailblazer: it was one of the first fixed-income ETFs in the world when it was launched in November 2000. But it wasn’t an index fund: it simply held a single 10-year Government of Canada bond. (It used the ticker symbol XGX, with the G indicating “government” and the X a nod to the Roman numeral 10.) The predecessor of the iShares DEX Short Term Bond Index Fund (XSB), launched the same day, held one five-year bond. By December 2004, these ETFs had evolved into the index-tracking products they are today. They now hold hundreds of bonds each, and boast more than $3.5 billion in assets.

Another change in the iShares lineup came in 2005, when the federal government eliminated the foreign-content rules for RRSPs. Before that time, investors could hold only 10% to 30% of their RRSPs in non-Canadian assets. However, because XSP and XIN are domiciled in Canada, they offered a way to get U.S. and international exposure without qualifying as foreign content. After those restrictions were lifted, and investors could buy cheaper US-listed ETFs that tracked the same indexes, iShares added currency hedging to XSP and XIN to differentiate them.

The middle of the last decade was an interesting period for ETFs in Canada. iShares’ only competitor was TD Asset Management, whose four Canadian equity ETFs couldn’t compete on price. With incredibly bad timing, TD got out of the ETF business in late 2005. Just a couple of months later, Claymore launched its flagship Canadian Fundamental Index ETF (CRQ) and the popularity of ETFs began to snowball.

The future for ETFs

I recently spoke with Oliver McMahon, director of product management at iShares Canada, about the evolution of ETFs in this country, and where the industry may be heading.

“My prediction is, because most of the large and recognizable indexes are already covered by ETFs, a lot of the products you’re going to see in the future will not track an index,” McMahon says. “The holdings are still going to be fully transparent, and they’re going to be passive investments: the portfolio manager is not trying to derive alpha. But rather than paying a provider to produce an index, the methodology may just be determined in-house.”

One example already in the iShares lineup is its Diversified Monthly Income Fund (XTR), which used to be the iShares S&P/TSX Income Trust Index Fund. When income trusts all but disappeared last year after the government changed the tax rules, this fund had to evolve. It now holds nine income-oriented ETFs with a breakdown of 50% equities and 50% fixed income, rebalanced quarterly. With such a simple mandate, it doesn’t make a lot of sense to pay an index provider.

Along the same lines, one has to ask why a fund like the BMO S&P/TSX Equal Weight Banks Index ETF (ZEB) needs to license an index. The ETF simply holds equal amounts the Big Six Canadian banks—presumably any fund manager with the ability to divide by six would be able to figure out the holdings. Yet part of the fund’s MER goes to S&P for performing this mathematical feat.

It will be interesting to watch the marketplace evolve in the coming years. I think there’s plenty of room for ETFs that don’t track a third-party index, though I hope it isn’t a slippery slope. Will the portfolio managers of these index-free funds be bound by strict rules, or given the leeway to use their own judgment? If it’s the latter, at what point does a supposedly passive fund become actively managed?

There is a lesson in iShares’ 10-year track record. All of those first quartile performers are plain-vanilla index funds, which means the old model works. It remains to be seen whether innovations can improve on it.

10 Responses to iShares ETFs: Looking Back, Looking Forward

  1. Sean August 12, 2011 at 2:13 pm #

    I love plain vanilla. I think the more complicated a fund’s mandate, the more likely it will perform poorly (probably because of the increased costs).

    I think I was one of the first to buy into XGX (the former XBB)!

    I do have trouble dividing by 6. I need a calculator. My mom can do it in her head.

  2. Canadian Couch Potato August 12, 2011 at 2:19 pm #

    @Sean: Love the old-school approach. Maybe your mom should apply to S&P and become a provider of equal weight indexes. 🙂

  3. Raman August 12, 2011 at 2:46 pm #

    I suspect ZEB pays S&P for more than a simple division by 6 calculation — more likely, it has to do with the optimal time to rebalance the holdings in the 6 banks. I.e., as the value of the respective banks’ shares in the ETF change with price changes in the respective stocks, it becomes a non-trivial problem to determine when one should sell some of the one that has increased the most, and buy some of the one that has increased the least (or decreased the most).

    You wouldn’t want to rebalance when one holding has increased 0.1% more than it’s desired allocation, but you also wouldn’t want to wait for it to have increased so much that it was now too large a proportion of the ETF.

    This calculation would necessarily make use of the volatility of the specific holdings, and perhaps that of the market as a whole (maybe using an analogue of the VIX). I’m sure there are some wizards at S&P who do this sort of thing and sell the methodology (or its results) to BMO for a small fee.

    Then again, I may be way off, and BMO really does pay them huge amounts to divide by 6. Excuse me as I go tell my 4 year old niece to work at S&P and rake in the profits 🙂

  4. Canadian Couch Potato August 12, 2011 at 3:05 pm #

    @Raman: The equal-weight methodology is publicly available here. The rebalancing is simply done quarterly. I was being a bit flippant, I admit, and there’s more involved than dividing by six. But the rules are quite straightforward, ans surely the fund manager could easily come up with a similar set of rules very easily.

    I suspect that ETF investors, in general, like the idea of third party setting the index guidelines, which appears more objective. It also serves as a benchmark for the fund’s actual performance. (How does one gauge the performance of XTR, for example?) That was especially true for the first generation of ETFs that tracked the S&P 500 and other well-known indexes. However, it’s now common for an ETF provider to commission an index specifically for an new product, which is putting the cart before the horse. I don’t think this offers any value to investors.

  5. Be'en August 12, 2011 at 10:07 pm #

    Would it be too extreme if one owned only XTR in his portfolio and nothing else?! It would keep things very simple.

    My wife and I are about 55 years old and wishing to retire at 60. XTRs 50/50 holding of fixed income and equities is almost “perfect” for us. As we age we could add a bond ETF to tilt in favour of fixed income with appropriate rebalancing. (Is XTR a first-quartile performer?)

    Any thoughts?

  6. Superior John August 13, 2011 at 5:35 am #

    As always Dan, a great informative article! From history to the present how easy would it be for an argument against the couch potato approach? It would be fun to listen to that.

  7. My Own Advisor August 13, 2011 at 7:00 am #

    Great information Dan!

    I’m a big fan of XIU and XBB; no frills, cheap, high-transparency and those are the just the appetizers with these guys.

    What will the future hold for ETFs? Probably a great deal of niche and customized products to come, in a market that is already getting flooded by that. Personally I’ll stay with the broad-market products like the ones above.

    I’ve always liked vanilla flavour 😉

    Cheers,
    Mark

  8. Canadian Couch Potato August 13, 2011 at 9:58 am #

    @Be’en: There’s no meaningful performance history for XTR, because it completely changed its mandate less than a year ago (it used to hold income trusts). Could it be your only holding? Well, I think it depends on your tax situation—if I had both RRSPs and taxable accounts, I would probably want to put the bonds in the RRSP and the equities in the taxable account, which you clearly can’t do if you hold one fund. I would also be concerned that there is zero foreign exposure and quite a high allocation to high-yield bonds. But you could do a lot worse, for sure.

    @Superior John: IF you want to hear arguments against the Couch Potato strategy, there are a lot of blogs where that takes centre stage. 🙂

    @Mark: Yes, I think you’re right that ETF growth going forward will be largely niche products, which I really don’t think will benefit investors much at all. It may just confuse them more. I look forward to Vanguard’s entry in the ETF space here, but otherwise, I think we have more products than we need.

  9. DrSAR August 18, 2011 at 5:17 pm #

    I always wonder why there appears to be no ETF trying to emulate a couch potato-type portfolio. Maybe come up with 5 different ones to offer different levels of equity/bond allocation. They could pay you a licensing fee. The rebalancing would potentially be more cost efficient and maybe they can make the whole thing more tax efficient. Why is this not done? Are Couch-Potatoers such a minority?

  10. Canadian Couch Potato August 18, 2011 at 5:30 pm #

    @DrSAR: Well, I would be happy to accept the licensing fee. 🙂 Actually, there are a number of “target date” funds, which do pretty much what you describe. They’re popular in employer-sponsored retirement plans, and they’re almost always index mutual funds rather than ETFs. Remember that it is not in the financial industry’s best interest to sell you one fund that you never trade.

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