When iShares launched its Core ETF series back in March it made some waves in the industry. The company cut the fees on nine ETFs it considers building blocks of a long-term portfolio. Its boldest move was to slash the cost of one of its flagship products, the iShares S&P/TSX Capped Composite (XIC). At the time XIC was weighed down by a management fee of 0.25%, much higher than its competitors from Vanguard and BMO. After that fee was reduced to a stingy 0.05%—making it the cheapest ETF in the country—it prompted BMO to follow suit less than a month later.
Now more moves are afoot. On July 21, iShares rebranded these nine ETFs to include “Core” in their names. They also launched a new addition to the family: the iShares Core Short Term High Quality Canadian Bond (XSQ).
The new ETF is extremely similar to the iShares Canadian Short Term Bond (XSB) in most respects: both are about 60% government bonds and 40% corporates, and the holdings are all investment-grade (rated A or higher). Their fundamentals are almost identical:
| XSB | XSQ | |
| Yield to maturity | 1.58% | 1.55% |
| Average coupon | 2.98% | 2.81% |
| Duration | 2.83 | 2.77 |
| Average term | 2.83 | 2.92 |
Source: BlackRock Canada
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The big difference between the two ETFs is the management fee. While XSB charges 0.25%, the new Core product comes in at less than half that: just 0.12%.
BlackRock has also changed the name and ticker symbol of the former iShares High Quality Canadian Bond (CAB), which is now the iShares Core High Quality Canadian Bond (XQB). This fund has a similar makeup to the much older iShares Canadian Universe Bond (XBB), but again, the key difference is cost. XBB has a management fee of 0.30%, while the new XQB costs just 0.12%.
Harnessing the power of inertia
These moves have prompted some critics to wonder why iShares didn’t simply make XSB and XBB part of the Core family. Instead of creating what are essentially clones of existing ETFs, why not just cut the fees on the incumbents?
The business reasons seem obvious. XSB is the second-largest ETF in Canada with a whopping $2.35 billion in assets, while XBB has about $1.54 billion. Cutting the fees on those funds to 0.12% would cost BlackRock about $5.8 million a year. By launching parallel ETFs instead, they can offer a lower-fee option without losing the revenue from investors who are already holding XBB and XSB. Sure, investors could simply switch from one to the other, but most will follow Newton’s First Law of Motion and simply accept the status quo out of ignorance or laziness.
So if you hold one of the older bond funds, should you switch to XQB or XSQ? Certainly it’s worth considering, though I’d like to see a year of data to make sure the funds do indeed perform similarly. XBB and XQB are not identical: the latter is about 60% government bonds, while the former is closer to 70%. The differences between the short-term bond ETFs seem smaller, but I’d still watch them for a while before committing.
It’s also worth keeping an eye on their bid-ask spreads. In theory, the size and trading volume of an ETF isn’t supposed to affect its liquidity, but in practice it often does. XQB has gathered about $68 million in assets but still has low volume and an occasionally wide bid-ask spread, and the brand-new XSQ will take a while to acquire any volume at all. As always, place your trades thoughtfully and always use limit orders.
Although VAB is my core bond holding, I had been using CAB over the past few months as an intermediate to hold dividends and maintain bond exposure between rebalancing, as it traded comission free at Scotia iTrade. However, now that the ticker symbol has changed to XQB it looks like a comission is being charged. I’m checking with iTrade to see if this is just a temporary glitch, but buyer beware.
Would it make sense to purchase XQB over VAB? I understand that VAB holds 80% government bonds while XQB only holds 60% government bonds but how big of a difference would this make in the long run?
Thank you so much for the post Dan. I can always count on you for the latest news and analysis related to ETFs. You’re easily one of my top sources for this kind information. Thanks again!
Kornel
I’m currently holding XSB, but I have a re-allocation task coming up (basically shifting certain asset classes into certain TFSA/RRSP accounts) which will force me to sell all my XSB positions.
So I am planning to switch from XSB to VSB (0.17%), but now XSQ looks like a better option.
However, one of my motivations is that Vanguard is actually owned by its fund-holders, so the MER “profits” would eventually flow back to me (well a small proportion), while iShares profits go to BlackRock. I’m also a big proponent of Bogle, so not sure if the 0.05% savings is worth it. (Currently $17,000 in XSB, but expecting to eventually manage upwards of $100,000 in short-term bonds.)
The yield to maturity for XSQ is 1.55%. Whereas, there are several banks and credit unions are offering 1.80% to 1.95% for savings account and there is no MER. What is the benefit of choosing short term bond fund instead of high interest savings account?
” This fund has a similar makeup to the much older iShares Canadian Universe Bond (XBB), but again, the key difference is cost. XBB has a management fee of 0.30%, while the new XQB costs just 0.12%.” – As per TD Waterhouse, the MER for XBB and XQB are same (0.33%) even though there is significant different between management fee.
I’ll be sticking with XBB for now. I only hold bonds as a guard against volatility, so it’s still the winner for me: longer time to maturation, more AUM, and tighter bid/ask spreads.
@WS: I would not trust TD Waterhouse’s information about MERs. The info on the fund provider’s website is more reliable. In any case, no one knows what the full MER will be for CAB/XQB until the fund has a full year under its belt since the fee reduction. It’s safe to say it will not be anywhere near 0.33%.
@Ray: Yes, I would say the difference between 80% and 60% government bonds is significant. I would not choose to take the additional risk just to save a bit of MER. The risk decision should come first.
Given that XSB/XSQ are premium bond ETFs, they likely ought to go into a tax sheltered account.
I’m with WS on this one. Why should I choose XSB/XSQ over a savings account? On the one hand, XSQ offers a YTM of 1.55%, less ~0.12% management fee and with interest rate risk (duration 2.77). On the other hand, you can get 1.95% in a HISA with neither interest rate risk nor maintenance cost.
I prefer to stay invested in Vanguard ETFs. I’m worried that BlackRock could raise back the management fees, eventually. Had BlackRock really wanted to lower fees, they would have lowered the fees of XBB and XIU. That tells me something.
@ccpfan:
Vanguard has increased the management fees (and thus MER) of its ETFs in the past.
For example, in the aftermath of the 2008 crash, the MER of VTI, VEA, and VWO all increased by a fair bit. They were lowered again some 3 years later as AUMs rebounded.
Also remember that the mutualized owners of Vanguard are ONLY the holders of US domiciled funds – the Canadian ETF operation is run as a for-profit subsidiary to benefit the US parent group, so Vanguard Canada operates under similar commercial pressures to BlackRock Canada and BMO.
If you still prefer Vanguard that is of course your choice, but there are no guarantees at all.
@Steve:
I didn’t know that Vanguard Canada is a for-profit subsidiary of Vanguard US. I guess that could skew me to XSQ if I’m looking for only low cost.
But the other considerations is the effect of net-inflows to distributions of XSQ. This might not be a big deal since XSQ will distribute monthly, but net inflows could dilute distributions for a while.
I could go either way since I have other Vanguard and iShares (BMO, too) holdings. I’m not sure if having different fund companies (for different asset classes, but not within asset classes) is really diversification since the underlying asset class is basically identical.
Very timely material. Thanks for keeping us on top of things!
@WS and @Holger,
Where can I find these HISA’s returning 1.8%?
@Scott
My credit union currently has a premium savings account rate of 1.9% for any dollar amount. I’ve been with them for about 6 years and they’re always on top as far as rates go.
http://www.crosstowncivic.mb.ca/index.php?option=com_content&view=article&id=83&Itemid=19
It’s even more if you plan to park it in a GIC for 12 months or more…
http://www.crosstowncivic.mb.ca/index.php?option=com_content&view=article&id=84&Itemid=83
Most credit unions and caisse populaires have very competitive rates.
@Scott – I am getting 1.9% from Canadian Direct Financial. You can find more banks and credit unions from following link.
http://www.highinterestsavings.ca/chart/
@Scott – Another high-interest term deposit account is happysavings.ca (the online business unit of Sunova Credit Union). 1 year term. Interest rate bumps from 2.2% to 2.5% each quarter, so average for year is ~2.35%. This is substantially the same yield as XBB (YTM 2.4%) and notably higher than XSB and VSB. If someone were holding short-term bonds (lower duration) versus longer-dated bonds on the basis of fears of increasing interest rates then term-deposit is perhaps an option to consider.
CCP says above: “The risk decision should come first.”
Credit unions are provincial, not federal, government regulated financial institutions. Deposits in credit unions are not CDIC insured. Each province has its own credit union deposit insurer, none of which have anywhere near the heft of CDIC. In many jurisdictions, the provincial deposit insurers are not provincial government backed.
I say this not to cause alarm, but only to point out that the higher rates offered at some credit unions come, as one should expect, with higher risk.
@KISS
You’re absolutely right. No question.
That said, I’d personally struggle to envision a province letting depositors in a provincial credit union lose their savings. The systematic, reputation and political implications to the credit union industry of that province’s (and perhaps other provinces) would likely be substantial.
To my knowledge, and I could certainly be wrong, then the credit union oversight entities (e.g. Credit 1) have encouraged / mandated any historically credit-challenged credit unions to merge with a better-funded peer … perhaps partly to avoid depositor losses. I am not aware, though certainly curious to be enlightened, of any case where a Canadian credit union depositor has lost capital through organizational bankruptcy.
But I do rather like data, so here’s a few doodles.
Not a single non-CDIC protected institution, such as a Canadian credit union, has failed in at least 47 years. Per wikipedia (http://en.wikipedia.org/wiki/Canada_Deposit_Insurance_Corporation):
“Since 1967, 43 financial institutions have failed in Canada and all 43 were members of CDIC”
Credit Union Central publishes quarterly data tables of the top 100 Canadian credit unions … assets, members, locations, etc. … http://www.cucentral.ca/SitePages/Publications/FactsAndFigures.aspx
Given my earlier doodle then I note that Sunova Credit Union has ~$1.1bn of assets. Per its financial statements then it has ~$70m of member equity (CU equivalent of shareholder equity) and ~$6m of net income in 2013 … https://www.sunovacu.ca/WhyWereAwesome#whoweare-reports. So does not appear, at face value, to be distress. I have no connection whatsoever in regards Sunova CU, other than having some capital in a term deposit.
There is incremental risk in credit union deposits through no CDIC protection. How much is subjective. The interest differential between be quite significant. Choices.
@Ross:
“If someone were holding short-term bonds (lower duration) versus longer-dated bonds on the basis of fears of increasing interest rates then term-deposit is perhaps an option to consider.”
GICs would not be a better option than short-term bonds in that scenario. The YTM of locked-in GICs relative to marketable bonds/ ETFs partly reflects a liquidity premium – if interest rates do go up, you are locked into your lower-rate GICs and facing a loss in the form of opportunity cost. No free lunch there.
@Steve
Noted. But careful not to ignore the impact of interest rates on investment principal (i.e. capital gains/losses).
YTM is computed based on discounted cash flows relative to the current valuation of the security/ETF. If increased interest rates cause bond ETFs to rise then this, in arithmetic terms, is due to a reduced denominator (a lower security valuation) and an unchanged numerator (amount of coupon and principal payments are not unchanged). This is captured in the term of duration. In the above article then XSB and XSQ have portfolio duration of approximately 2.8. So a 1% increase in interest rates will result in a 2.8% decrease in the price of the bond ETF. Duration: http://www.investorwords.com/1602/duration.html
With GICs then interest and principal are not impacted by interest rates during the related term.
So impact of +1% interest rates:
– short-dated bond / ETF bond = 2.8% capital loss + same series of cashflows (so higher coupon yield and YTM from lower security price)
– GIC = no capital gain/loss and same string of cashflows
– typical bond ETF = approx 8% capital loss (XBB has duration of 7.9 years)
Yes, the GIC creates interest-rate risk in regards opportunity cost. But I’d challenge an assumption that short-dated bonds create a lesser amount of interest rate risk than GICs.
Yes, the GIC creates liquidity risk. But I’d suggest that this should be irrelevant unless the investor’s time horizon is short … which I’d suggest is rather against the CPP philosophy so would have much broader impact than bonds-vs-GICs.
In a taxable account then there may be incremental advantages due to Bond ETFs typically containing above-par bonds. https://canadiancouchpotato.com/2013/03/06/why-gics-beat-bond-etfs-in-taxable-accounts/
But both short-term bonds and GICs do create a risk of underperformance, versus traditional bonds, over the long term. http://www.rickferri.com/blog/investments/the-risk-of-short-term-bond-funds/
@Ross:
“But I’d challenge an assumption that short-dated bonds create a lesser amount of interest rate risk than GICs.”
Where a GIC has annual interest reinvested (as is usual), the duration of that GIC is exactly equal to its remaining term to maturity (in effect like a zero-coupon bond).
If a short-term bond ETF has a weighted average portfolio duration of 2.8 years, then a GIC with a remaining term to maturity of 3+ years (or a GIC ladder with a weighted average term to maturity of 3+ years) will have a greater interest rate sensitivity (and thus “risk”) than the ETF.
GICs that pay out interest annually will have a shorter duration relative to those that don’t, and thus a lesser interest rate sensitivity, but the principle is the same – if their duration is longer than that of a bond ETF, then the GIC will have a greater interest rate sensitivity than the ETF.
The loss suffered as the result of the opportunity cost of having capital locked into fixed interest GICs when interest rates are rising is a real loss, as is the loss suffered from a fall in the price of the ETF – just because the first loss is less visible does not make it any less real.
However, unlike a bond ETF, which can be sold in order to crystallize a taxable capital loss (a valuable asset), the opportunity cost loss of the GIC is a complete write off due to lack of liquidity.
As I said, there is no free lunch at all with GICs relative to short-term bond ETFs.
What if I don’t hold any bonds and have some fund allocated for bonds just didn’t make my mind yet. Please advise whether I should XSQ, XQB or both. Thanks.