Archive | Indexes

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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What Causes an ETF’s Tracking Error?

Last week I explained the importance of monitoring an ETF’s tracking error, which is the difference between a fund’s actual performance and the returns of its index.

The most significant reason index funds lag their benchmarks is the impact of management fees and GST/HST. If your index fund has an MER of 0.25%, you should expect its tracking error to be within a basis point or two of that figure. But it’s often more than that—and sometimes it’s much less. In a series of two posts this week, I’ll look at some real examples from 2012 to illustrate the other factors that can cause an ETF’s returns to vary.

Currency hedging. US and international equity ETFs hedge currency risk using futures contracts. These are renewed every month, and if there’s a dramatic currency movement between contracts—or if the fund experiences a large cash inflow or outflow—that can show up as tracking error. The iShares S&P 500 (XSP) and Vanguard MSCI U.S. Broad Market (VUS) both had tracking errors over 70 basis points in 2012, despite MERs of just 0.24% and 0.17%, respectively.

Currency hedging can also work in the fund’s favour,

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How Well Does Your ETF Track Its Index?

The ideal index fund would deliver the precise return of its benchmark, but we all know that’s not realistic. ETFs and index funds may be cheap but they’re not free, and fees almost always cause them to lag slightly. Index investors accept this because they know the alternatives are usually much worse, but they can’t be too complacent. It’s important to periodically check your ETF’s tracking error: that is, the difference between the index return and the fund’s actual performance.

Where do you find this information? Over at iShares, you simply visit the ETF’s web page and click the “Performance” tab. You’ll see the returns of both the fund and its index over various periods from one month to 10 years, as well as calendar-year returns. iShares currently lists fund returns according to net asset value (NAV) only: the market price field is blank. For example, over the 12 months ending March 31 the iShares S&P/TSX Capped Composite (XIC) lagged its index by 29 basis points:

The process is almost identical at Vanguard: again, simply visit the ETF’s web page and click the “Performance” tab.

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New iShares ETFs Give Canadians the World

In an era when ETFs are becoming increasingly narrow and specialized, the new iShares funds launched this week were a pleasant surprise.

Granted, they were late to the game with the iShares S&P 500 (XUS), which is now the fourth ETF that tracks the S&P 500 with no currency hedging. (Vanguard, BMO and Horizons all beat them to market.) But the two international equity ETFs are a lot more interesting. In fact, the iShares MSCI EAFE IMI (XEF) and the iShares MSCI Emerging Markets IMI (XEC) are the most significant index funds to be launched in Canada in at least six months.

We are the 99%

The “IMI” in the name of the international funds stands for Investable Market Index. These MSCI benchmarks are designed to capture 99% of the equity market in a given region, including large, mid, and small cap companies. This is the same strategy used by the Vanguard Total International Stock (VXUS), a core holding in my Complete Couch Potato portfolio.

All three of the new funds simply hold an existing US-listed ETF in the iShares Core Series,

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Ask the Spud: Adding a New REIT to the Index

Loblaw recently announced it will be creating a new real estate investment trust (REIT). Once it goes public, how would it be added to existing real estate ETFs? And considering how large the proposed REIT will be, what effect might it have on ETF shareholders? – Joel H.

On December 6, Loblaw Companies announced it would be turning its vast property holdings into a REIT in the new year. Units in this new trust will be listed on the Toronto Stock Exchange and sold during an initial public offering (IPO) in mid-2013.

Any time a new company is listed on the TSX, it may be considered for inclusion in any number of indexes. For example, stocks in the S&P/TSX Composite Index must meet certain criteria (mainly size and liquidity). The index is reviewed every quarter, and if a company no longer meets these criteria it can be removed. By the same token, any newly listed company that does fit the criteria can be added to the index.

The new Loblaw REIT will be one of the largest in Canada, so it will likely qualify for inclusion in the Composite index.

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Inside the iShares Minimum Volatility ETFs

Last week we looked at two low-volatility ETF strategies based on beta and the standard deviation of daily price movements. Now let’s complete our roundup by looking at a third methodology used by MSCI, the index provider behind the new iShares family of low-volatility ETFs. This is one is completely different from the other two.

MSCI’s strategy is based on creating what’s called a minimum variance portfolio, an idea that goes back to Harry Markowitz’s Modern Portfolio Theory in the 1950s. What makes this strategy unique is that the individual companies don’t matter much in isolation, or even relative to the market as a whole. What’s important is their correlation with each other: the goal is to combine stocks in a way that results in a portfolio with the lowest possible volatility. Think of it like a cake recipe where you add baking powder and salt—which can be unpleasant on their own—because they taste delicious when combined with the other ingredients.

The methodology starts with a parent index that represents the broad market—such as the MSCI Canada Index—and then applies a number of rules to optimize that portfolio.

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Inside the BMO and PowerShares Low-Vol ETFs

In the last 14 months or so, Canada’s ETF providers have launched several funds based on low-volatility strategies. As we saw in my last post, the research suggests it may be possible to build a portfolio of stocks with lower volatility than the broad market without sacrificing expected returns. But exactly how do you select those stocks?

There are several ways to implement a low-volatility strategy, so before you consider any of the new ETFs, make sure you understand how they differ. Today we’ll take a look at the methodologies used by BMO and PowerShares. Next week we’ll look at the iShares strategy.

BMO looks at beta

Rather than tracking an index, the BMO Low Volatility Canadian Equity (ZLB) simply uses a transparent set of rules. You start with the 100 largest stocks in Canada and rank them according to their beta over the previous 12 months. You then select the 40 with the lowest beta: the lower the beta, the greater the company’s weight in the fund. No stock can make up more than 10%, sectors are capped at 35%, and the fund is rebalanced just once a year.

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Barry Gordon on Building an Index: Part 2

In Monday’s post I shared part one of my interview with Barry Gordon, CEO of First Asset, who explained how his firm worked with Morningstar to create new ETF indexes. In part two the interview, Gordon discusses his partnership with PC Bond Analytics, the firm that manages the DEX bond indexes, the most widely followed fixed-income benchmarks in Canada.

Let’s talk about how things worked with your barbell bond ETFs. With the Morningstar equity ETFs there was already an existing methodology. But although the barbell bond strategy is not new, as far as I know there has never been an index.

They know the concept well at DEX, so I went to them and said we want to create these ETFs that replicate a barbell index, do you think you can do that? The process was iterative in the sense that they would come to us with what they thought worked, and I would make suggestions and ask questions based on what we thought was better suited to an ETF. They had to make sure the index was really reflecting what I was trying to do.

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