Archive | Indexes

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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Why Your Problem Is Not Your Funds

In Monday’s post I looked at “smart beta,” which promises to outperform cap-weighted indexing strategies. I’m frequently asked if I think Couch Potato investors should dump their traditional index funds in favour of these tempting alternatives. Here’s why my answer is no.

I could rhyme off technical reasons for being skeptical about the outperformance of alternative indexes: the research ignores costs and taxes, the strategies may not work in the future, and so on. But I won’t go down that road, because the most important reason is not technical, but behavioral.

Everything beats the market—except investors

To recap, two recent papers from Cass Business School in London looked at US stocks from 1968 through 2011, a period when a cap-weighted portfolio would have returned 9.4% annually. (Canadian stocks had an almost identical return over those 43 years.) The researchers examined 13 alternative strategies—which favoured value stocks, small-cap stocks or low-volatility stocks—and found all of them outperformed, with returns between 9.8% and 11.5%.

For many people, the takeaway from these findings is, “I should use alternative indexes, because I can beat the market by a point or two.” My reaction is different: I want to know how many investors earned even 9.4%.

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Does “Smart Beta” Really Beat Cap-Weighting?

“Smart beta” has become a buzzword in investing circles, especially among pension funds and other institutional investors. The term may be new, but the idea isn’t: it’s about looking for ways to capture the returns of an asset class with a strategy other than traditional cap-weighting. These alternatives include fundamental indexing, equal-weighted indexes, low-volatility strategies and a few more exotic techniques.

A growing body of evidence has highlighted the inherent flaws in cap-weighted indexes, which are undeniable. By their nature, cap-weighted indexes give the most influence to the largest companies, as well as any that happen to be overvalued. That’s a potential problem because these are companies that are most likely to underperform the broad market over long periods.

A second potential problem with cap-weighted indexes is concentration. This isn’t an issue in huge markets like the US, or in a multi-country index like the MSCI EAFE. But it’s a concern in small countries like Canada (where Nortel once represented about a third of our entire stock market) and in individual sector funds. That’s why I favour the BMO Equal Weight REITs (ZRE) in the Complete Couch Potato portfolio: unlike its competitors,

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The Wait is Over: New ETFs From Vanguard

“Ask and ye shall receive.” That should be the refrain of Couch Potato investors during the last 10 months or so as the industry has filled just about all the gaps in the ETF marketplace.

First it was the flurry of S&P 500 ETFs without currency hedging: Vanguard, BMO, iShares and Horizons have all launched one since October. Then iShares brought out a pair of broadly diversified international equity ETFs, also without the hedging. Now Vanguard Canada has announced a new suite of ETFs that includes a few we’ve been eagerly awaiting.

Vanguard filed the preliminary prospectus for these new ETFs on June 19, and since new products typically appear about 90 days later, at least some should start trading by the end of summer.

First there’s the long-awaited Vanguard U.S. Total Market, an unhedged version of VUS. Its underlying holding will be the US-listed version of this fund, the Vanguard Total Stock Market (VTI), a core piece of my Complete Couch Potato.

While the fees for the new ETFs haven’t been announced,

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Is One Index Really Better Than Another?

Couch Potato investors try to capture the returns of entire asset classes rather selecting individual securities. And we do that with passively managed funds designed to track indexes that represent each of those asset classes. But which index, exactly?

Since Vanguard announced last fall that it would be ending its relationship with the index provider MSCI, the question is worth considering. Vanguard’s Canadian equity ETF, for example, was originally benchmarked to the MSCI Canada Index but now tracks the FTSE Canada Index. Can investors expect the fund to behave differently now?

The short answer is yes, but the full story is more subtle: if the past decade is any guide, the performance of the two indexes will vary from year to year. But the differences are likely to be the result of random noise, and neither of these benchmarks can be said to have any meaningful advantage over the other.

There’s more than one way to measure the market

Investors often refer to “the index” the same way they refer to “the dictionary.” But in both cases, the definite article isn’t really appropriate: there isn’t a single authority.

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Two Core ETFs Get New Indexes

Vanguard announced last October that it would be ending its relationship with MSCI, one of the largest index providers in the world, and using new benchmarks for many of its most popular ETFs. That transition is now complete. Between January and April of this year, Vanguard Canada’s emerging markets equity, Canadian equity, and international equity ETFs all got new indexes created by FTSE. And earlier this month Vanguard changed the benchmark for two US-listed ETFs that happen to be core holdings in my Complete Couch Potato portfolio.

The Vanguard Total Stock Market (VTI) is now benchmarked to the CRSP US Total Market Index rather than the MSCI US Broad Market Index. The Canadian-listed version of this fund, the Vanguard US Total Market Index (VUS), simply holds VTI and adds currency hedging, so it is affected by the index change as well.

Don’t expect any meaningful effect on the performance of VTI. The CRSP index is slightly broader than its MSCI counterpart: the latter “targets for inclusion 99.5% of the capitalization of the US equity market,” while the former “represents approximately 100% of the investable US stock market.” That means the CRSP index will include more micro-cap stocks,

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Why Use a Strip Bond ETF?

Barry Gordon admits he was surprised when he first read Justin Bender’s entry in First Asset’s Search for Canada’s Next Top ETF contest, which I introduced in my previous post. “It runs against the grain of everything we thought we knew about strip bonds,” he says. But Gordon’s firm turned the idea into the First Asset DEX 1-5 Year Laddered Government Strip Bond Index ETF (BXF), which begins trading next Tuesday. Here’s an overview of this innovative new index fund, as well as an explanation of how it might be used in a portfolio.

Inside the ETF

First Asset tasked PC-Bond with creating the index for their new strip bond ETF. Here’s the basic methodology:

the ladder will have “term buckets” with bonds of approximately one, two, three, four and five years to maturity
each bucket will include five individual strip bonds: four provincial (mostly issued by Ontario and Quebec) and one federal (or federal agency)
the bonds will be selected with liquidity in mind: the issues must be at least $50 million and will be screened for maximum trading volume
the index will rebalance annually in June: bonds with less than one year to maturity will be sold and the proceeds used to purchase new bonds for the five-year bucket

No surprises so far.

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More on Socially Responsible Index Investing

Here’s part two of my conversation with Timothy Nash, president of Strategic Sustainable Investments and the blogger behind The Sustainable Economist. (Part one is available here.) Next week I’ll go into more detail about specific investment products that combine passive investing with SRI principles.

Many socially responsible investors seem to think buying a company’s stock is somehow giving them capital they can use to do evil, and that’s why they’re wary about owning index funds. I’m not sure I buy that argument.

TN: I often get asked how much of a difference I’m making by owning socially responsible index funds or ETFs. And it’s tricky, because obviously when you own equities the money doesn’t go directly to the company—at least not once you’re beyond the IPO. But you can make the argument about cost of capital. When companies have a large market cap, the more demand there is for that stock, and the easier it is for them to raise capital.

There is another argument, too. With ethical consumerism—whether you’re buying fair trade, or local, or organic—you are impacting that invisible hand of the marketplace.

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When You Can Ignore Tracking Error

In Monday’s post, I reviewed the major factors that contribute to an index fund’s tracking error. Here are some other things to consider when you’re comparing your fund’s performance to that of its benchmark. These can cause tracking errors to seem unusually large or small, but they need to be understood in context.

Changes to the index. A number of ETFs changed their benchmark index during 2012, including some core equity funds from BMO and Vanguard. When there is an index change in the middle of the year, measuring tracking error becomes difficult and the numbers can be misleading. Until late September, the BMO S&P 500 Hedged to CAD (ZUE) held just 100 large-cap stocks selected using a different methodology. ZUE ended up lagging the S&P 500 by less than its management fee, which is normally an excellent result, but in this case it was a fluke.

A small number of ETFs in Canada are not tied to any third-party benchmark. The BMO Canadian Dividend (ZDV), for example, includes 30 stocks selected using an in-house methodology. In cases like this,

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