Archive | Indexes

The Curious Case of the BMO Discount Bond ETF

When the BMO Discount Bond Index ETF (ZDB) was launched back in February 2014, it was unique: the first broad-market ETF in Canada made up primarily of bonds trading below their par value. By avoiding premium bonds, ZDB promised to deliver similar returns to traditional bond funds, but with greater tax efficiency, making it ideal for non-registered accounts. With a little more than two years of real-word performance, it’s time for a checkup. Has ZDB delivered on its promises?

Top of the heap

The first question we’ll examine is whether ZDB achieved pre-tax returns similar to other broad-market bond ETFs. The fund was designed to match the popular FTSE TMX Canada Universe Bond Index in credit quality, average term, duration and yield to maturity. But ZDB set out to achieve this profile using bonds with lower coupons to reduce the amount of taxable income.

As it turns out, ZDB outperformed all of its competitors in 2015. Here are the NAV returns for the calendar year:

BMO Discount Bond
ZDB
3.60%

Vanguard Canadian Aggregate Bond
VAB
3.48%

iShares Core High Quality Canadian Bond
XQB
3.38%

BMO Aggregate Bond
ZAG
3.24%

iShares Canadian Universe Bond
XBB
3.15%

Sources:  BMO ETFs,

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Decoding Vanguard’s New International Equity ETFs

This year has been another reminder of why international equities are such an important part of a diversified portfolio: in the first 11 months of 2015 the Canadian market was down almost 6%, while international developed markets were up close to 15%.

On December 9, Vanguard Canada launched two new ETFs tracking international equities: the Vanguard FTSE Developed All Cap ex North America (VIU) and a currency-hedged counterpart that uses the ticker VI. These new funds are a welcome addition to Vanguard’s ETF lineup, but they make the choices more confusing, because there are already similar funds on their menu. So let’s try to sort it all out.

First, the background. Vanguard Canada seems to have been put in an awkward position by recent changes to their benchmark indexes. Back in June, their US parent company announced that four international equity indexes provided by FTSE would expand to include mid-cap and small-cap stocks as well as China A-shares. Those were potentially useful changes that added more diversification. However, they also announced that the FTSE Developed ex North America Index would eventually become the FTSE Developed All Cap ex US Index.

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The Trouble With Bashing Bond Indexes

In my last post, I looked at a tired criticism of traditional equity index funds. Similar arguments have been made against fixed-income index funds, most recently in a blog post called The Trouble With Bond Indices produced by Mawer Investment Management. And once again, they don’t hold up to scrutiny.

First the background. Bond indexes, like their equity counterparts, are usually weighted by market capitalization. This means governments and companies that issue the most bonds (by dollar value) receive the largest weight in the index. Most index investors in Canada use funds that include only domestic bonds, and typically these are roughly one-third federal government bonds, one-third provincial and municipal bonds, and one-third corporate bonds. Global bond index funds are much less common in Canada (only Vanguard offers an ETF in this asset class), but the principle is the same: countries that issue the most debt receive the greatest weight in the index.

You may have already spotted the potential red flag: the more debt a country or company has on its books, the more of its bonds you’re likely to own if you use an index fund.

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Vanguard’s New World Order

If you follow my model ETF portfolios, you may have noticed that one of your holdings has a new name.

The Vanguard FTSE All-World ex Canada (VXC), launched in the summer of 2014, is a simple, low-cost way to get exposure to stocks in the US as well developed and emerging markets overseas. Now VXC has evolved to cover even more of the global equity market, and further expansion is planned for the coming months. To reflect these changes, the fund recently changed its name to the Vanguard FTSE Global All Cap ex Canada Index ETF. The ticker symbol remains unchanged.

VXC is an “ETF of ETFs” with four underlying holdings: the Vanguard Large-Cap (VV), the Vanguard FTSE Europe (VGK), the Vanguard FTSE Pacific (VPL), and the Vanguard FTSE Emerging Markets (VWO). The latter three ETFs recently adopted new benchmark indexes that include small-cap stocks as well as large- and mid-caps. As a result, the total number of stocks held by VXC has swelled from just over 3,000 at the end of August to more than 5,100 today.

The addition of all those stocks makes VXC more diversified than ever,

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China Grabs a Bigger Share of the Indexes

Traditional international index funds assign a weight to each country based on the size of its stock market. But in the case of China, that’s a bit misleading. Despite having the world’s second-largest economy, China has a relatively small number of publicly traded companies. Moreover, many of those publicly traded companies have been off-limits to foreign investors. As a result, the Vanguard Total World Stock ETF (VT) allocates just 2.5% to China—considerably less that than the share allotted to much smaller economies such as Canada, Switzerland and France.

This is about to change: during the coming months and years, index investors will be able to access more of China’s vast economy. Vanguard recently announced that its flagship emerging markets ETF, the Vanguard FTSE Emerging Markets (VWO), will soon be adding China A-shares to its benchmark index. This development will also affect Canadian-listed ETFs that include this fund as an underlying holding.

Taking the A-train

Let’s look at what this means for indexers. Right now, most foreign investors can buy public companies in mainland China only through share classes denominated in foreign currency and traded on exchanges outside the country,

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Vanguard’s VXC Gets a Facelift

The Vanguard FTSE All-World ex Canada (VXC) allows Canadians to get access to US, international and emerging markets equities with a single ETF, and it’s one of the ingredients in my model portfolios. Vanguard recently announced some planned changes to VXC’s benchmark index, so let’s take a closer look.

Right now, VXC holds only large and mid-cap stocks, but it will soon be adding small-caps to the mix—at least for overseas markets. This will come about indirectly as a result of changes to the benchmark indexes of three of the fund’s underlying holdings.

VXC gets exposure to international developed and emerging markets through three US-listed ETFs: Vanguard FTSE Europe (VGK), Vanguard FTSE Pacific (VPL) and Vanguard FTSE Emerging Markets (VWO). These will soon begin tracking new “all cap” indexes that include small companies as well as large and mid-caps. Vanguard estimates that small-caps will eventually make up about 10% of each ETF. To reflect these changes, VXC will receive a new name: the Vanguard FTSE Global All Cap ex Canada Index ETF.

But it’s not clear whether VXC will add small-caps to its US equity exposure.

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Are Preferred Share Indexers Dumb Money?

It’s hard to keep a straight face while arguing for active strategies in asset classes like large-cap stocks or government bonds. Those markets are so liquid and so well covered by analysts that it’s almost impossible to find and exploit inefficiencies. But many would argue that active managers at least have a fighting chance in asset classes that like, say, emerging markets or small-cap stocks.

On the heels of my previous posts on Canadian preferred shares, let’s consider whether this is another asset class where active managers can be expected to add value compared with a simple indexed approach using ETFs. I recently explored this idea in a conversation with Nicolas Normandeau of Fiera Capital, who manages the Horizons Active Preferred Share ETF (HPR). I think it’s important to have these debates occasionally, because if you believe in indexing, it’s important to be able to defend the strategy with rational arguments and not ideology.

Here are the main arguments in favour of using an active strategy with preferred shares:

The market is complex and inefficient. The entire preferred share market in Canada is about $60 to $65 billion—about the same as the market cap of Canadian National Railway.

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When Discount Bonds Are Hard to Find

Everyone loves a discount, but if you’re buying bonds these days you may be out of luck.

Just over a year ago, the BMO Discount Bond (ZDB) was launched as a tax-efficient alternative to traditional bond ETFs. ZDB tracks the broad Canadian market, but it selects bonds trading at a discount, or at a very small premium. Discount bonds have a lower coupon than comparable new bonds, and they will mature with a small capital gain. That combination is more tax-efficient than premium bonds, which have higher coupons and mature at a loss.

A discount bond ETF is a great idea for non-registered accounts, but it faced challenges from the beginning. After many years of interest rates trending downward, there simply aren’t many discount bonds in the marketplace. Traditional broad-market bond ETFs hold between 500 and 900 issues, but ZDB holds just 55.

This constraint has become more urgent after the Bank of Canada unexpectedly cut short-term rates in January. Yields on intermediate and longer-term bonds also fell, driving bond prices up sharply. Suddenly bonds that were trading at a discount were priced at or above par.

In my blog post introducing ZDB,

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Inside the New Vanguard ETFs

Vanguard Canada launched some new ETFs this week, and I spoke with managing director Atul Tiwari about the funds. Let’s take a closer look.

Cross-Canada coverage

The Vanguard FTSE Canada All Cap (VCN) expands on the older Vanguard FTSE Canada (VCE). While VCE holds 78 large-cap stocks, the new index includes 255 holdings and covers 96% of the Canadian equity market. That makes it roughly equivalent to the S&P/TSX Composite Index, which holds 234 companies and claims 95% coverage.

This is about as close as you can get to a total-market index in Canada: dig further and you run into serious liquidity problems with small, thinly traded stocks. “We started out with a very large universe and pared it back to a number we thought would be terrific,” Tiwari explains. “But once you get to the practical aspects it gets pretty tough. Our partners on the capital markets side, who are creating units and doing the market making, have to be comfortable they can find these securities. Obviously there’s a cost associated with that, and at some point it gets too unwieldy and it doesn’t make sense.”

With a management fee of just 0.12% (the MER will be a few basis points higher),

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