5 ETFs That Should Be More Popular

September 26, 2012

In high school, the popular kids aren’t always the one’s with the best qualities. More often they’re the ones with the good looks, charm, and nice cars. Meanwhile, the kids with the brains and the bad haircuts—and the best long-term prospects—eat lunch alone.

The world of ETFs is often the same way. According to the Canadian ETF Association’s latest stats, the most popular funds include those tracking gold mining stocks, preferred shares, high-yield bonds and covered calls, each with assets between $800 million and $1.3 billion. There’s nothing necessarily wrong with any of these ETFs, but none would be near the top of my list of recommendations for the average investor. Meanwhile, there are many excellent funds that can’t find anyone to ask them to dance.

Here are five unjustly small Canadian ETFs that are worth a closer look: none has more than $70 million in assets, and several have much less.

1. Vanguard MSCI U.S. Broad Market (VUS)

Regular readers know I don’t like currency hedging because of its relentless drag on long-term returns, so it’s good to know that Vanguard Canada is planning a non-hedged S&P 500 ETF later this year. Until then, if you want US equities with currency hedging, VUS tracks a much broader index, with over 3,300 stocks covering 99.5% of the market. The added exposure to small and mid-cap stocks and a lower fee (0.15%) makes the upstart VUS preferable to the iShares S&P 500 (XSP), which has $1.56 billion in assets.

2. First Asset Morningstar US Dividend Target 50 (UXM)

If you’re looking for US dividend stocks, this First Asset fund has an advantage over its oldest competitor, the iShares S&P U.S. Dividend Growers (CUD), which has 10 times the assets. It dispenses with CUD’s requirement that a company have a 25-year record of dividend growth, which is an arbitrary rule that excludes many stocks for the wrong reasons. And unlike the newly launched iShares U.S. High Dividend Equity (XHD), it’s equal-weighted, which means it’s not dominated by a small number of large companies. Lose the currency hedging and it would be even better.

3 and 4. iShares 1-10 Year Laddered Government Bond (CLG) and iShares 1-10 Year Laddered Corporate Bond (CBH)

The 10-year bond ladder has long been a popular strategy with fixed-income investors: it provides a steady, predictable income stream, and by avoiding concentration in any one maturity, the portfolio is barley affected by either rising or falling interest rates. These two ETFs offer a lot of convenience, since maintaining a ladder of individual bonds can be impractical for small investors. But although the iShares ETFs using five-year bond ladders (CLF and CBO) have well over $1 billion in assets each, the 10-year versions haven’t caught on at all. If the yield curve gets steeper (that is, if longer-term bonds start offering more attractive rates), expect that to change.

5. iShares Dow Jones Canada Select Value (XCV)

Value stocks have a long record of outperforming the broad market, but Canadian ETF investors seem little interested in the strategy: XCV has gathered just $50 million in its six years of existence. XCV’s index screens for stocks with low price-to-earnings and price-to-book ratios, high dividend yields, and solid earnings growth. And even though the last five years have not been particularly kind to value investors, the fund has outperformed both the iShares S&P/TSX 60 (XIU) and the iShares S&P/TSX Capped Composite (XIC) as of August 30, despite its higher fee (0.55%).

{ 18 comments… read them below or add one }

Smithson September 26, 2012 at 10:17 pm

I’m surprised that you like XCV. It has a high MER and its portfolio is quite concentrated (nearly 60% in financials).

I do like CBH. I’m thinking about switching the XCB which I own to CBH. Do you have any comment on which one would fare better in a rising interest environment?

Nathan September 26, 2012 at 10:31 pm

Hmm.. I’d honestly have to say there are good reasons why 1, 2, and 5 aren’t popular.

For #1, most investors would be better off with a US ETF like VTI. Slightly lower MER, better tax treatment in an RRSP, and you lose the significant, persistent drag of currency hedging. All for a one-time (or two-time considering withdrawal) currency exchange fee (which can be reduced further with Norbert’s Gambit).

For #2, my main question would be why someone would want a US dividend fund at all. Canadian dividends make some sense due to their tax treatment, although for most they aren’t much better than capital gains. US dividends though are taxed as foreign income, so this fund would only really be appropriate in an RRSP. Even then, if it’s the historical out-performance of small and high-dividend stocks you’re after, the real drivers behind that effect are the small and value factors. Given that, you’d be better off looking at a low-cost, diversified, small- and/or mid-cap value fund (like VBR and/or VOE) rather than an equal-weight dividend fund.

#5, XCV, on the surface looks very intriguing. Along with CRQ, it is one the only two real value index funds we have in Canada. Unfortunately, like CRQ, it is concentrated in large companies and is considerably more expensive than broader funds like VCE and XIC. A deeper look suggests that its value tilt is unlikely to outweigh these disadvantages in the long term: http://www.financialwebring.org/forum/viewtopic.php?f=29&t=115299 In my opinion a better opportunity if one were looking for a value tilt would be to get it on the US and international portions of one’s portfolio. There are many good options on the US side, including VBR and VIOV for small value, and CIE is a decent Canada-domiciled fund for international value exposure.

None of these are bad funds, but any means; in my opinion there are simply better alternatives in each case. (Surprised to see CCP recommending such niche products too! I guess there’s only so much you can write about, “Buy the market. Avoid high fees.” ;) But really, if we’re going to deviate from that simple, logical approach, we need to have a very good reason!)

Canadian Couch Potato September 26, 2012 at 10:33 pm

@Smithson: I agree XCV too heavily concentrated in financials: it would certainly have to be balanced with another Canadian equity holding in diversified portfolio. But you can make the same argument about XDV, which is 20 times bigger! The value premium and dividend yield are very closely related, though this idea is not generally recognized. See this article for more.

@Nathan: I should clarify that I’m not specifically recommending these ETFs: none of them are in my model portfolios. What I meant to highlight is that in all of these cases there are similar but inferior ETFs that are much more popular. For example, I obviously prefer VTI to VUS, but I wasn’t comparing these to US-listed ETFs. What’s surprising is that XSP has $1.56 billion in assets and VUS (which is superior in all aspects) has $60 million. Obviously this is because VUS is still very new, but it’s a reminder that inertia is very powerful among investors.

Al September 26, 2012 at 11:08 pm

I found out Vanguard does not have a DRIP option on their ETFs after I made purchases. My bad of course but it did not even cross my mind that this may be the case.

Canadian Couch Potato September 26, 2012 at 11:15 pm

@Al: Do you mean on a US-listed Vanguard ETF or a Canadian one? My understanding is that most brokerages don’t DRIP any US-listed ETFs.

Smithson September 26, 2012 at 11:16 pm

@CCP – Thanks for the link. I’ve always suspected that dividend investing was a specialised version of value investing. Indeed, XDV is too concentrated in financials. When it comes to dividend ETFs, I like ZDV (it should be on your list of ETFs that should be more popular as it is <$70M). It has a lower management fee (0.35%) than either XDV or CDZ and it is certainly more diversified than XDV. I know that there was some discussion awhile ago regarding the lack of clarity regarding the methodology of its stock selection, but BMO has posted it at:

http://www.etfs.bmo.com/ETFConsumer/controller/image?image=portfolio_methodology_pdf&lang=en

Canadian Couch Potato September 26, 2012 at 11:33 pm

@Smithson: I guess I just find it hard to imagine a Canadian dividend ETF being underused these days. :) But you’re right, ZDV does have a better sector balance, and I’m much more comfortable with it now that they’ve published the index methodology. Vanguard’s planned dividend ETF will be even cheaper (0.30%) and will be worth a look also.

Joe K September 27, 2012 at 1:06 am

Being the incumbent has its advantages! Hopefully Vanguard is able to penetrate the Canadian market in the next few years.

I also vote for ZDV that should be more popular vs. CDZ and CPD.

Canadian Capitalist September 27, 2012 at 10:41 am

I think the popularity of XSP is easily explained. ETFs in general have tremendous first-mover advantage (as others have pointed out) and to be honest, the price differential with VUS isn’t enough to entice investors to switch.

gsp September 27, 2012 at 11:58 am

TDW DRIPs US listed ETFs as long as enough of their customers own them and they have decent volume. I can confirm the following can be DRIPed at TDW:

VTI
VB
VBR
VEA
VWO
VXUS
SCZ

Not eligible for DRIPs last I checked were VSS and SCHB but they add more all the time so just ask. Several in the eligible list above were previously not eligible but were added over time.

B September 27, 2012 at 2:09 pm

If I DRIP a US listed ETF through TDW, will I get dinged for foreign exchange fees on dividend payouts that are re-invested?

Canadian Couch Potato September 27, 2012 at 2:17 pm

@B: There’s a thread about this in the previous post… The short answer is, “Yes, probably.”

gsp September 27, 2012 at 3:41 pm

@B, sounds like you’re asking about a registered account even if you didn’t specify. With most VG ETF’s payable date being tomorrow I’ll be able to answer that question then.

Their intl ETFs are now on quarterly distributions instead of annual, starting with tomorrow’s payment which will include the first 9 months of 2012.

Smithson September 27, 2012 at 3:57 pm

@Canadian Capitalist: I agree that the price differential isn’t enough to make me switch from XSP to VUS. Also, it would trigger significant capital gains. My solution is to direct any new money entering my portfolio into the lower cost option (VUS in this case). The only way to get lower MERs is to vote with your money. This is happening in the US and I hope it happens here:

http://business.financialpost.com/2012/09/10/blackrock-to-cut-etf-fees/

Al September 27, 2012 at 6:28 pm

Hi Dan. It was Vanguard Canada etfs that did not have DRIPs. I knew about the US ones

Nathan September 27, 2012 at 6:37 pm

Keep in mind that DRIPs are handy, but aside from the issue of avoiding currency exchange on dividends they’re not a huge deal for those making regular contributions, since you can just roll the dividend into your next contribution.

Jason September 30, 2012 at 1:43 pm

CCP, Could you expand on your comment that the iShares 10 year laddered ETFs should outperform the 5 year laddered ones when interest rates start to rise. I thought you would want to keep the fund duration shorter in a rising interest rate environment. The average duration is shorter for the 5 year laddered ETFs. Also how does one compare the index-to-maturity metric between the 5 and 10 year laddered products? A bit confused here.

Canadian Couch Potato September 30, 2012 at 2:12 pm

@Jason: Sorry if my comment was unclear: I didn’t suggest the 10-year ladder would outperform, only that it would become more popular.

Right now the yield curve is unusually flat, which means that 10-year bonds are paying only slightly better yields than 5-year bonds, so you are really not rewarded for taking on greater risk. The yield to maturity on CLF is 1.52%, while on CLG it is 1.78%. In a more “normal” environment, the yield difference between five-year and 10-year maturities is 100 basis points or more, making it worth it for the investor to go out past five years. If we return to a situation like that, I’d expect CLG to attract more attention from investors.

You are correct that if rates rise all along the yield curve, then CLF will lose less than CLG. But rates don’t necessarily move in tandem. You could have a situation where short-term rates rise and intermediate- and long-term rates fall. In that situation, CLG would indeed outperform. If the reverse occurred (rates rose faster at the longer end of the curve) then CLF would outperform. Unfortunately, no one forecast these movements in advance.

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