Archive | Indexes

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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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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