If you’re investing outside of tax-sheltered accounts like RRSPs and TFSAs, you need to choose your investments carefully—otherwise you risk giving a big slice of your returns to the good people at the Canada Revenue Agency. Today we’ll look at ways to create a tax-efficient index portfolio using some innovative ETFs.

Swapping dividends for capital gains

In Monday’s post, I explained that Canadian dividends are not always as tax-advantaged as people believe. Capital gains are not only taxed at a lower rate in the highest tax brackets, but investors can also control when to take them—dividends, on the other hand, are taxable in the year they’re paid, even if you reinvest them.

Horizons’ swap-based ETFs—which I wrote about here—were designed to address this issue. They use a type of derivative that allows investors to earn the same return as the index, without collecting any distributions. Dividends paid by the companies in the index are reflected in the fund’s return, but all of the growth is characterized as capital gains and deferred until the fund is sold. There are currently just two funds in the family: the Horizons S&P/TSX 60 (HXT) for Canadian large-cap stocks, and the Horizons S&P 500 (HXS) for US large-caps.

The tax advantage is especially large for HXS, because dividends from US companies are fully taxable, while capital gains are taxed at half that rate. Consider this: if you held the iShares S&P 500 Index Fund (XSP) in 2011, you received $0.24 per share in cash dividends, a yield of about 1.6%. At the highest tax bracket, you would have lost almost half of that to taxes, reducing your return by about 80 basis points. If you held HXS instead, you would have received a similar 1.6% price appreciation instead, and you would have paid no tax. If you eventually sell the fund at a profit, you’ll pay tax on only half the gain.

Forward thinking

Claymore’s Advantaged ETFs—read a detailed description here—use forward contracts that “recharacterize” bond interest or foreign dividends as capital gains or return of capital (ROC). Unlike swap-based ETFs, which pay no distributions, the Advantaged ETFs are design for investors who want current income.

Return of capital is the most tax-efficient of all distributions, though it’s not a free lunch. ROC is not taxed in the year it’s received: instead, it lowers your adjusted cost base, and if you sell your shares at a profit in the future, you’ll incur a capital gain. So you’re not getting truly tax-free income—you’re really just getting your own money back—but you are generating tax-deferred cash flow. This document from Claymore explains the idea.

You can see why ROC is preferable to bond interest, which is fully taxable. In 2011, the Claymore Advantaged Canadian Bond (CAB) returned 6.8%. Roughly half of that came from price appreciation, while the other half came from distributions. However, unlike every other bond ETF, those distributions were return of capital, not interest. So you would have collected that entire 6.8% return without a tax bill.

Before you get too excited, there are downsides. All of the 2011 distributions from Claymore’s Advantaged ETFs were return of capital, but that won’t always be the case. In 2010, for example, CAB’s distributions were all capital gains. These would have been taxable—albeit at only half the rate of bond interest.

More important, the Advantaged ETFs have considerably higher costs than plain-vanilla index funds, which will lower their pre-tax returns. Those added costs offset some of the tax savings, and may even wipe out the advantage altogether. For example, both the iShares DEX Universe Bond (XBB) and BMO Aggregate Bond (ZAG) returned well over 9% last year—dramatically outperforming CAB. Even if you lost half your interest income to taxes, you might still have been better off with XBB or ZAG.

If you’re out of RRSP and TFSA room, you could use these ETFs to build a reasonably well diversified and tax-efficient portfolio of Canadian stocks (HXT), US stocks (HXS) and bonds (CAB). In some years—including 2011—you’ll have no tax payable at all. Just spend some time researching these complex products first, and don’t invest in anything you don’t understand simply because you think you’ll save some tax.

H&R Block software giveaway

Speaking of tax, the folks at H&R Block have offered to give away copies of their DIY tax software to five lucky Canadian Couch Potato readers. To enter the draw, leave a comment below or tweet this post to your followers before midnight EST on Sunday, January 29. I’ll announce the winner next Monday.

Here’s another excerpt from my recent interview with Atul Tiwari, Dennis Duffy and Joel Dickson of Vanguard. These questions focus on the types of products we might see from Vanguard in the future. You can read also read Part 1 of the interview here.

Your first family of ETFs have all been plain vanilla funds that track major third-party indexes. What new products are on the horizon?

AT: We’re in the development and design stage for the next suite of ETF products that we’ll launch next year. Before we make any decisions about what those will be, we want to be in the market, talking to clients, talking to advisors, and then we will try to reach a conclusion about the next tranche.

The interesting thing that we have come across in terms of how to bring passive investing to Canada is that the index mutual fund market in Canada is pretty small. It’s concentrated in a few issuers and products that really don’t get much prominence. So we have seen indexing growing in Canada, but clearly the vehicle of choice is ETFs. The growth in the ETF market has been 30% or 35% per year, and predictions are $105 billion by 2016.

The main reason index mutual funds are not popular in Canada is that they’re way too expensive. So it seems to me there is a huge opportunity for someone to come in and grab that space.

AT: We have to start somewhere. You alluded to this idea when you asked about what we are bringing other than passive ETFs that already exist elsewhere, and we obviously think that it is not just low-cost. Our ETFs are the low-cost leaders in the market now, and we all know that low costs are important. But we also are bringing the thought leadership and the education.

The other big difference is our ownership structure: we are a client-owned organization, and we really do put clients first. We are all about continuously finding ways to lower our own costs so we can lower the costs of our investments for clients, and that’s unique. It’s not just unique in Canada, it is unique globally.

Can you explain how Vanguard’s ownership structure works, because there is a lot of confusion around that. I have heard Vanguard described as a nonprofit company, for example, which is clearly not accurate.

AT: The way it works is that in the US, the clients of Vanguard own the funds and ETFs,  and in turn the funds and ETFs own the management company. So we are not a public company, but we’re not a private company either in the classic sense of being owned by a family of shareholders. It’s more like a mutual. We are a for-profit company, but we give all the earnings back to clients in the form of lower expenses.

JD: The management company derives profits from its activities, and those profits are paid to the owners, who happen to be the investors in the US funds. Instead of being paid as a dividend, it is paid in the form of lower expense ratios.

Many investors have asked whether Vanguard will offer US and international equity ETFs without currency hedging.

DD: We have thought about it and I can tell you it is definitely something we are considering when we look at what we will be rolling out in the second tranche. We have done that in other jurisdictions, where we have offered both hedged and unhedged versions. So that’s definitely something we have looked at and will give it some consideration.

Vanguard offers a family of target retirement funds in the US. There seems to be few of these available in Canada, and I have a theory about why. If an advisor says to a client, “I’m going to put you in this target date and we won’t need to switch for 25 years,” the first thing the client is going to say is, “Then why the heck am I hiring you?”

JD: Even among advisors who buy into our philosophy, target date funds are not a huge seller, because advisors do view their job as asset allocation. Even if it is long-term strategic allocation, they want to build that for you rather than having it pre-packaged like a candy bar you buy in the store. So that is a hurdle. We get a lot of questions about how we might create target date funds out of our ETFs, but it’s just not clear what the distribution would be for a product like that.

DD: Much of the appeal of our target date funds has been in the retirement segment, for defined contribution investors. We just launched a series of target date funds in the UK, and that is also something we are looking at as we consider future opportunities in the Canadian market, where there is a huge number group RRSPs and defined contribution plans.

One of the alarming trends in Europe is the move towards synthetic ETFs. Is there any plan to move away from the physically backed ETF model that Vanguard has made its bread and butter?

DD: If we look at what we have launched in the US, the UK, Australia and Canada, having full-replication, asset-backed securities, as opposed to swaps, makes a lot more sense. I would never say never, but it is definitely not the direction that we are planning to go in.

JD: We have 35 years of experience managing physical, full-replication index funds, and that works great in large, liquid, diversified markets. There could be a role for synthetics in hard-to-access markets, where there might be some liquidity issues—where there might be restrictions on your ability to access those markets. Synthetic by itself is not the issue: it is how you negotiate the swap contracts.

When Vanguard announced its arrival in Canada this summer, investors welcomed the company with open arms: perhaps no country would benefit more from Vanguard’s devotion to low-cost investing. The company’s first Canadian ETFs started trading on the TSX on December 6.

On the day of the launch, I had the pleasure of sitting down with Atul Tiwari, managing director at Vanguard Investments Canada; Dennis Duffy, Vanguard’s director of business development for non-US markets; and Joel Dickson, a principal in Vanguard’s Investment Strategy Group.

Here are some highlights from the interview dealing with Vanguard’s overall strategy in Canada. Later this week I’ll run another excerpt that focuses specifically on the new ETFs and Vanguard Canada’s plans for the future.

Why did you decide to enter the Canadian market with ETFs rather than mutual funds? And why did you target advisors rather than retail investors?

AT: Having looked at the Canadian market for at least 14 or 15 years, Vanguard considered a number of different entry strategies. The reason we executed now is that the Canadian marketplace is changing. We are seeing a lot more advisors moving from a commission-based approach to a fee-based approach, and that fits in squarely with the Vanguard model. We don’t pay for distribution anywhere in the world, so to enter the Canadian market with mutual funds would be kind of tough, because it is a very commission-oriented business.

About 20% of advisors’ overall business in Canada uses a fee-based model, whereas in the US it is about 65%. Canada is probably where the US was about eight years ago. The other thing is, there are a lot of regulatory changes going on globally. By the end of next year, commissions will essentially be banned in the UK. Same thing in Australia. In the US, they are discussing the fiduciary standard for brokers, and even the OSC [Ontario Securities Commission] has said recently that they are going to consider a fiduciary standard. So with a little help from the regulatory changes, we think we will be well-positioned.

What were some of the uniquely Canadian challenges that you faced? For example, low-cost, direct-sold mutual funds are extremely popular in the US, but investors in Canada haven’t really embraced them.

AT: You’re absolutely right: a number of companies have tried, but direct-sold funds just haven’t caught on in Canada. And a lot of that is because mutual funds are sold and not bought. We haven’t got any plans to launch mutual funds at this stage, but that is not to say that in the future we won’t. We entered the market with the product that we thought would be the best entry point for Canada, and that is ETFs.

One of our other challenges—and certainly one of the key components of our Canadian strategy—is investor education. We will be doing a lot of thought leadership, a lot of seminars—we will do whatever we can to get the message across to investors and advisors about the effects that costs have on your returns over the long run.                                  

Index investors are well aware of the benefits of low costs. But how do you make that case to advisors?

DD: This has been a challenge for us in every market. Even before ETFs, we had a pretty significant advisor business in the US, but the fee-based business was a relatively small percentage of the overall market back in the early 2000s. We went into the UK prior to the legislation banning commissions: we felt there was enough fee-based business there, and we were willing to make the commitment. We are very patient company: look at how long it took us to get into Canada! But there is a lot of education that is going to be needed.

JD: It’s important to recognize that the advisor’s compensation doesn’t need to change at all [if they start using Vanguard ETFs]. Even if they are getting 1% or 1.5% or whatever for their services, we would hope that there is an opportunity to lower fund costs: if you can show 24 basis points with your ETF holdings as opposed to another 1.5% on underlying mutual funds, that’s a huge benefit.

Yet many advisors—and their clients, for that matter—continue to insist that active management is part of their value-added, despite overwhelming evidence to the contrary.

JD: That is a key issue: the value-added model has been disrupted. We talk about a concept we call advisor’s alpha, which is to say, how do you as an advisor position your value to clients in a world where it is not about picking the best funds, or the best managers? It’s about focusing on things you can control, like costs, and risk, and taxes and behaviour.

The problem is, these things are sometimes hard to measure. Some of the best “performance” an advisor could have provided came when the client called them up in the depths of the market in 2009 saying, “Get me out now!” and the advisor said, “Remember our overall asset allocation for the long run?” That doesn’t show up on your statement as the performance of your portfolio versus some benchmark. But if the investor would have sold out on their own, there is huge value added.

No new models yet

Many readers have emailed to ask me whether I will be updating my model portfolios with the new Vanguard ETFs. I’m not planning to do that just yet—for a couple of reasons.

First, the funds have been trading for only a couple of weeks, and while I have little doubt that Vanguard will do a good job keeping tracking errors and bid-ask spreads low, I would like to wait and see.

Second, Vanguard Canada’s US and international equity ETFs use currency hedging, which I have avoided in my model portfolios. It is possible that Vanguard will eventually launch unhedged versions of these ETFs, at which point I would be more likely to incorporate them.

I am resisting the urge to tinker with the model portfolios every time new ETFs are launched. However, this time next year I will re-evaluate the marketplace, and it’s likely that I’ll make some changes to the portfolios to reduce their cost.

Quicken winner

Thanks to everyone who entered the draw for the copy of Quicken Home & Business 2012 money management software. The lucky winner is Chris, who contributes some of the wisest comments on this blog. Congratulations!

The BMO Canadian Dividend ETF (ZDV), launched last month, is unusual among dividend ETFs in that it does not track an index. Instead, it follows a “rules-based methodology” to screen stocks according to yield, dividend growth and payout ratio.

Last week, I asked whether ETFs really need an index in order to play a role in a passively managed, low-cost and low-turnover portfolio. Instead of tracking a traditional third-party index, can an ETF’s fund manager simply draw up its own set of quantitative rules and accomplish the same thing? If I had to make that argument in court, I’d build my case this way:

Many indexes are not transparent. Let’s all agree that transparency is paramount in a passively managed fund. But we should acknowledge that many well-known indexes are not particularly transparent.

Few people question whether funds tracking the S&P 500 or the Dow Jones Industrial Average are passive. And yet, although the major criteria are public knowledge, the companies in the S&P 500 are selected by a committee. The DJIA is even more of a black box—there’s nothing at all transparent about how this granddaddy of indexes is built. Just because your ETF tracks a third-party index doesn’t mean that you can understand exactly how the holdings are determined.

The fund provider may be determining the strategy. In the olden days, index funds all tracked well-known third-party benchmarks, many of which had been around for decades. But many new ETFs track indexes that were commissioned by ETF providers themselves.

Claymore’s bond ETFs are a good example, as are several of BMO’s equity funds, including the BMO Dow Jones Canada Titans 60 (ZCN). Dow Jones has long managed a family of Titans indexes that track the large-cap market in various countries, but I don’t think it’s a coincidence that the index for Canada has 60 stocks (the same number as the S&P/TSX 60), nor that it was launched in May 2009, three weeks before ZCN started trading.

The point is that even if a third party creates the index, the ETF provider may still be the one making the decisions about the overall strategy.

Index licensing is expensive. Any time an ETF or index fund uses a third-party benchmark, it pays a licensing fee. Fund companies are tight-lipped about how large this fee is, but according to a recent Reuters article, it is typically one-tenth to one-third of the overall management fee. In most cases, that would be somewhere between three and 18 basis points.

When the ETF’s investing strategy is straightforward, you have to wonder whether it really makes sense to pay an index licensing fee. The BMO S&P/TSX Equal Weight Banks (ZEB) is the most glaring example: it holds equal amounts of the big Canadian banks, and that’s it. Does one really need to hire Standard & Poor’s to divide by six? Couldn’t the fund save its investors several basis points by getting rid of the index?

For what it’s worth, the index-free BMO Canadian Dividend ETF (ZDV) is currently the cheapest dividend fund in Canada, with an MER of 0.40%, including HST.

Indexes still have value

I’ve laid out these arguments because I want investors to make sure they understand the subtleties. I do think it’s possible for a fund to be transparent, passively managed and maybe even cheaper without a third-party index. But I also believe that an investor considering an ETF with no index needs to ask some pointed questions:

Is the methodology fully explained? Indexes don’t guarantee full transparency, but they certainly help: many providers do publish thorough explanations of how their indexes are built. The description of the stock-picking criteria used by the BMO Canadian Dividend ETF (ZDV), by contrast, is extremely vague. All we’re told is that stocks are chosen based on “the three-year dividend growth rate, yield, and payout ratio” and that “securities will also be subject to a liquidity screen process.”

By comparison, the index-tracking Claymore and iShares dividend ETFs use methodologies that are explained in much greater detail by S&P and Dow Jones, respectively. If BMO were to provide a more meaningful description of its strategy, and they could ensure that the manager is not at liberty to stray from these rules, then I would consider ZDV a passive fund. But we’re not there yet.

Who’s benchmarking the fund’s performance? The most useful measure of an index fund’s performance is its tracking error, or the difference between the returns of the index and the actual return achieved by the fund. The iShares Dow Jones Canada Select Dividend (XDV) returned 12.82% in 2010, compared with the index’s return of 13.32%. As an investor, I know that the tracking error of –0.50% is identical to the ETF’s fee, which means the fund was managed almost perfectly.

How will investors measure the performance of ZDV? Even if the fund is transparent about its methodology, it will be impossible to know how well the managers executed that strategy. An index provider does more than just draw up a methodology: companies such as S&P and Dow Jones also compute and publish the returns of their indexes monthly and annually, which holds ETFs accountable. There’s a lot of value there—certainly it’s worth paying a few basis points for that benchmarking.

I’m not ready to jettison the idea of passively managed funds that don’t track an index. But it’s too early to accept them uncritically. For now, at least, I believe there’s just too much potential for things to go wrong when no one is looking.

Given the popularity of investing for yield these days, it’s not surprising that BMO’s most recent product launch included the brand new BMO Canadian Dividend ETF (ZDV). But this fund does have at least one surprising trait—one that suggests the direction the ETF industry may be heading. What makes ZDV different from its competitors at iShares and Claymore is that it does not track an index.

In a previous post, I discussed the future of ETFs with Oliver McMahon, iShares Canada’s director of product management. “A lot of the products you’re going to see in the future will not track an index,” he predicted. “The holdings are still going to be fully transparent, and they’re going to be passive investments: the portfolio manager is not trying to derive alpha. But rather than paying a provider to produce an index, the methodology may just be determined in-house.”

That seems to be the case with the new BMO dividend ETF. According to the prospectus, ZDV and three others launched at the same time “are not index mutual funds and are managed in the discretion of the Manager in accordance with their investment strategies and, as such, are generally more active in nature than index mutual funds.”

Does “no index” mean “actively managed”?

Despite that declaration, I would stop well short of calling this an actively managed ETF. The prospectus goes on to state that “eligible securities will be selected using a rules-based methodology that considers dividend growth, yield and payout ratio and eligibility will be reviewed annually. Securities will also be subject to a screening process to ensure sufficient liquidity.”

Compare that with this description of the actively managed Horizons Dividend ETF (HAL): “HAL’s investment process is primarily based on fundamental research as well as quantitative and technical factors. Investment decisions are ultimately based on an understanding of the company, its business and its outlook.”

There’s a huge difference here. HAL’s managers have free rein to choose stocks for the fund, and to weight them in whatever manner they deem appropriate, so long as they fit the fund’s overall objective. The stocks in ZDV, by contrast, are selected according to a list of predetermined rules, and they are assigned weight in the fund based on yield. Assuming the manager adheres to these rules, it would be fair to call ZDV a passive fund, even if it doesn’t track an index.

Remember, a “rules-based methodology” is exactly what is used to construct an index. In the case of ZDV, however, BMO appears to have come up with the methodology themselves, rather than farming out that job to S&P or Dow Jones, like Claymore and iShares have done with their dividend ETFs.

The big question for investors is, does this make a difference? Does it really matter whether the ETF provider or a third party makes the rules? I’ll consider these questions in my next post.

It’s not easy to make a splash in the crowded ETF space these days. Many of the new products we’ve seen in the last year or so have been clones of existing ETFs or exotic specialty funds. Any Canadian investor who wants to build a diversified portfolio with ETFs has more than enough choice already.

That was the challenge for Vanguard Canada when they announced they’d by launching a family of ETFs this year. Given the company’s reputation for rock-bottom fees, there was a lot of speculation about whether they would try to compete on price. Even if none of their ETFs are radically different from their competition, they could grab some market share from their competitors by offering similar products with much lower fees.

Well, Vanguard has just released the costs of its new ETFs, which will start trading in the coming weeks. It looks like they’ve lived up to that promise:

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Note that the above figures are the management fees, not the entire management expense ratios (MERs). According to the press release, “Vanguard expects the MERs of its ETFs to be substantially similar to their management fees, as the Vanguard ETFs should incur only nominal other costs that would be included in the MER calculation.” They will have to add the 13% Ontario HST, which would bring a 0.20% fee up to 0.23%.

Even if you add a few basis points for HST, these are very competitive fees: in fact, all of them are lower than comparable products from iShares, Claymore and BMO. The Vanguard  MSCI Canada (VCE) will be the second-cheapest ETF in Canada, behind only the Horizons S&P/TSX 60.

I would suggest that Vanguard has now changed the game in the Canadian ETF market. Any bank or other financial institution that is planning to launch a family of broad-based ETFs will likely find there is no way to compete: it was hard enough to go against iShares, and now the pricing pressure is all but insurmountable. Any new players will probably stick to specialized products, wrap programs, or some other strategy to package and sell ETFs through advisors.

In other news…

We’ve just updated the Model Portfolio performance results for the period ending October 31. The year-to-date performance of the Complete Couch Potato is 1.28%—hardly cause for dancing in the streets, but given the state of the global economy and the extreme daily volatility, that’s a surprising result. Have a look at the five-year performance numbers of the major asset classes: with a couple of exceptions, these are not nearly as bad as you might think considering this period includes the 2008–09 financial crisis and this summer’s huge declines.

Many thanks to everyone who attended or tuned in to the ING DIRECT panel discussion on Wednesday evening. I enjoyed meeting the readers who came by to say hello in person, including Mike from MoneySmarts, and hearing from those who Tweeted their comments. It was an honour to share the stage with Rubina Ahmed-Haq and Ellen Roseman. Preet Banerjee was also present.

Q: I just read about the launch of RBC’s family of target-maturity corporate bond ETFs. They seem like they would be an attractive option for the fixed-income portion of my RRSP. How do these products compare with more conventional bond ETFs? How do I compare their yields? And can I use them in a laddered fashion? — Karl T.

RBC became Canada’s sixth ETF provider when it launched a family of eight corporate bond funds last week. Unlike traditional fixed-income ETFs, which continually buy new bonds to replace those that mature, these new products have a “target maturity.” That means all the bonds in the fund will come due in the same year, and once they’re redeemed, the fund will be liquidated and all the money returned to investors.

ETFs like these are not exactly new in Canada: BMO launched four similar funds in January, with target dates of 2013, 2015, 2020 and 2025. However, RBC’s offerings fill in the gaps, covering every year from 2013 through 2020. Each ETF will mature on or about November 30 of the target year.

Extreme couponing

Whenever you buy an individual bond or a bond ETF, you’ll be quoted both its coupon and its yield to maturity (YTM). It’s crucial that you understand the difference between these two figures, or you’ll fall victim to the yield illusion that plagues so many investors.

The coupon tells you how much you’ll receive in interest payments each year, but that’s not the whole story. The YTM is a much more important number. When the coupon is higher than the YTM, it means the bonds were purchased at a premium, and they will suffer small capital losses when they mature. These losses will cause the fund’s price to fall, offsetting some of the interest payments and lowering your total return.

That’s where the YTM comes in: it factors in both the coupon payments and the expected capital loss and tells you what your total return will be if you hold the bond (or the ETF) until its maturity date. Have a look at the dramatic differences between the coupon and the yield to maturity in the new RBC funds:

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The RBC Target 2018 fund’s distributions will be a whopping 6.39% a year, but these will be offset by capital losses, so your total annual return will be less than half that: just 3.21%. Don’t be misled by those tempting coupons. You’re not going to earn 5% or 6% annually with any of these ETFs.

Target maturity v. traditional

How do these yields stack up against those of traditional bond funds? Actually, there’s no meaningful difference in risk or return if you make a fair comparison. To do that, you need to look at corporate bond funds with a similar duration, which is a measure of sensitivity to interest rate risk. (The longer the duration, the more the fund’s price will drop if interest rates rise.) I’ve included the duration of the RBC funds in the table above.

Now let’s compare these with other corporate bond ETFs. You can visit the website for Claymore’s 1–5 Year Laddered Corporate Bond ETF (CBO) and learn that it has a duration of 3.07, which makes it comparable to the RBC Target 2014 ETF. You’ll also see that he yield to maturity of CBO is almost identical at 2.29%. Meanwhile, the iShares DEX All Corporate Bond Index Fund (XCB) has a duration of 5.78, which is very close to that of the RBC Target 2018 ETF. Again, the yield to maturity of XCB is virtually the same as the comparable RBC fund: in this case, 3.25% versus 3.21%.

The only difference here is that CBO and XCB will always have approximately the same duration. The durations of the RBC funds, however, will get shorter every year as the fund approaches the target maturity date.

How to put these ETFs to work

So how might a target maturity bond ETF fit into your portfolio? You might use them to fund a future obligation on a specific date: if you know that you will need your money in 2015 for a down payment, you could buy the RBC Target 2015 ETF instead of putting it in a savings account or buying a four-year bond or GIC. You’ll receive interest payments for the next four years, and then have your money returned to you at the end of that period.

Target maturity ETFs do have some advantages over individual bonds. The first is diversification: each RBC fund holds 20 to 50 issues. Another advantage is that you can invest small amounts, which is difficult to do with individual corporate bonds. You can also add new money to your investment whenever you want—although you’ll incur a trading commission each time.

The RBC funds carry a management fee of 0.30%, which you would not pay if you bought individual bonds. However, the retail spread on individual bonds can be very high (and hidden), especially if you’re buying from a discount brokerage. In many cases, the ETF will be a better deal in the end.

RBC’s new ETF website suggests that you can also use these products to build a bond ladder. Presumably they will launch a new ETF every year beginning in 2013, to replace the one that gets liquidated, allowing investors to maintain an eight-year bond ladder indefinitely.

However, for long-term investors who do not have a specific time horizon, a traditional bond ETF is almost surely a better choice. First, the fixed income side of a portfolio should include government bonds as well as corporates. And second, if you do hold corporate bonds, a single fund such as CBO or XCB will be more manageable and less expensive in the long run than building a ladder with these ETFs.

Got a question about index investing? Send it to mail@canadiancouchpotato.com and it may be answered in a future installment of “Ask the Spud.” Answers are provided as information only and do not constitute investment advice.

One problem with the two leading Canadian dividend ETFs is that they are not very well diversified across sectors. The iShares Dow Jones Canada Select Dividend (XDV) is half banks and financials. Claymore’s S&P/TSX Canadian Dividend (CDZ) has the opposite problem: it includes none of the banks, and although it has a broader overall mix it is 25% oil and gas stocks.

The newest Canadian dividend ETF hasn’t seemed to generate a lot of buzz, but in my opinion it tracks an index that is better than both of the incumbents. The iShares S&P/TSX Equity Income (XEI), which was launched back in April, simply selects the 75 companies in the S&P/TSX Composite Index with the highest yield, period. (If there happens to be fewer than 75 stocks with yields above the median, other rules kick in.) These companies are weighted by market cap, but no company can make up more than 5%, and no sector more than 30%.

This index avoids the problem inherent in CDZ (which had to kick out the banks because they haven’t raised their dividends for five years running) and XDV (which is hugely overweight in banks because there is no sector cap). However, it’s still very heavy in financials, energy and telecoms:

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Note: The CDZ website lumps together all consumer retailers in a single category. I split the 11.8% figure equally between discretionary and staples as an estimate.

Biases without borders

The fact is, no Canadian dividend ETF can get around the fact that our economy is highly concentrated in some sectors and all but absent from others. That’s why dividend-oriented investors—just like more conventional Couch Potatoes—would do well to look south of the border for some diversification. But again, the methodology that US dividend ETFs use can have a huge effect on their sector breakdown.

Take a look at these three dividend-focused ETFs. The first is the SPDR S&P Dividend ETF (SDY), which includes only companies that have grown their dividends for at least 25 years. (The brand new Claymore S&P US Dividend Growers ETF (CUD) tracks the same index.) Because of its focus on mature companies, it’s very heavy on utilities, financials and consumer retailers, and light on technology and telecoms.

Contrast that with the Vanguard Dividend Appreciation ETF (VIG), which also focuses on dividend growth, but without the strict 25-year rule. It’s dramatically lighter on financials and utilities, but much more tilted to energy and industrials.

Finally, the WisdomTree Total Dividend Fund (DTD), which is fundamentally weighted. It falls in the middle of the other two with respect to financials, utilities, and energy, and has the highest weightings in telecoms, health care and technology.

Complementing Canada

It should be clear that all dividend-focused indexes have built-in sector biases. But these sector biases are very different in Canada and the US. What this means is that any of the US funds listed above would go a long way toward diversifying a portfolio of Canadian divided payers.

Here’s what your sector breakdown would look like if you combined these ETFs with XEI in equal amounts. All three combinations offer a much broader mix of dividend stocks than you can get at home:

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Disclosure: I do not own any of the ETFs discussed in this post.

This week saw the launch of the Claymore S&P US Dividend Growers (CUD), an ETF that will have great appeal for income-oriented investors. The fund tracks the S&P High Yield Dividend Aristocrats Index, made up of the 60 highest-yielding US stocks that have increased their dividends every year for at least 25 years. (The stocks are then weighted by yield, not by market cap.)

These are companies with a very impressive record of paying their shareholders. By comparison, the S&P/TSX Canadian Dividend Aristocrats Index requires only five consecutive years of rising dividends. Of course, a fund of Canadian companies with a 25-year record of increasing payouts would have one holding: Fortis.

In my series of posts about dividend investing last January, I expressed some skepticism about the devotion to dividend growth strategies. It’s not that there’s anything wrong with the companies that have paid reliable dividends, of course. It’s just that some investors seem to take it for granted that these stocks will deliver above-market returns. They’re influenced by graphs like this:

The problem with this graph is that it’s entirely backward looking. If you knew in December 1986 which companies would be dividend growers over the next 24 years and which would cut their payouts, you would indeed have crushed the market. But of course, you couldn’t know that. You can only identify dividend growers after many years of increasing payouts. (This survivorship bias is brilliantly explained in this article on Seeking Alpha.)

Of course, by that time much of the advantage will be gone, because the company’s reputation will be priced into the stock. For what it’s worth, over the last five years, the Aristocrats index has performed almost identically to that of the broad US market (about 3.5% annualized), which should not be surprising if you believe that markets are at all efficient.

There’s value in low volatility

That said, mature businesses with a history of rising dividends are often less volatile. Indeed, have a look at the new PowerShares S&P 500 Low Volatility Portfolio (SPLV), which includes the 100 companies in the S&P 500 with the most moderate price swings over the previous 12 months. You’ll find many names that are also in CUD: stable, blue-chips like Exxon Mobil, Procter & Gamble, McDonald’s, Consolidated Edison, Johnson & Johnson, Kimberly-Clark, PepsiCo, Wal-Mart. It’s hard to go too far wrong with a lineup like that.

The new Claymore ETF isn’t wholly new in the marketplace: the SPDR S&P Dividend ETF (SDY) tracks the same index and has been around since 2005. The differences are that CUD trades in Canadian dollars and uses currency hedging. The Claymore ETF’s management fee is 0.60%, which should make its total MER about 0.68% when you include the taxes. That’s about double SDY’s expense ratio of 0.35%.

If you’d like to chew over the CUD, you can download the fact card here. Claymore has also produced a document outlining dividend growth strategies.

It seems like every week we hear high-profile announcements about new ETFs, very few of which promise anything genuinely new. Then along comes something unique in Canada and I haven’t seen so much as a press release about it. Yesterday I logged on to my Scotia iTrade account and discovered that the brokerage now offers dozens of commission-free ETFs.

This is a big deal. While ETFs in Canada are dramatically cheaper than index mutual funds (with a few exceptions), one hurdle remains: buying and selling ETFs incurs commissions. In small accounts with the big banks’ discount brokerages, you can pay as much as $29 per trade. Of course, $10 trades are now commonplace, but even that fee makes small monthly contributions and dollar-cost averaging prohibitively expensive.

Last year, several U.S. discount brokerages—including Fidelity, Schwab and Vanguard—began offering commission-free ETF trades. I wrote a post in February 2010 wondering aloud if any Canadian brokerage would follow suit, and suggested that BMO was the obvious candidate, since they are the only firm to have both a discount brokerage and a family of ETFs. Now it turns out they’ve been beaten to the punch.

iTrade teams up with Claymore

The Scotia iTrade deal is a partnership with Claymore, and most of the commission-free ETFs are from that provider: in fact, Claymore’s whole family is on the list of eligible ETFs. This isn’t surprising, as Claymore has been the leader in the effort to close the gap between mutual funds and ETFs: they were the first to launch a dividend reinvestment plan (DRIP), Pre-Authorized Cash Contributions (PACC) and Systematic Withdrawal Plans (SWP).

Eight iShares and seven Horizons ETFs also eligible for commission-free trades. The iShares products on the list are mostly sector ETFs, plus a couple of specialized Canadian and emerging markets funds. The flagship iShares products are all absent, probably because Claymore has core ETFs that compete with them.

The menu of Horizons ETFs includes non-leveraged commodity funds (copper, silver, oil and gas, though not gold) as well as  Horizons S&P/TSX 60 (HXT) and the Horizons S&P 500 (HXS). These are the swap-based ETFs I wrote about back in June. They provide exposure to the large-cap Canadian and U.S. equity markets using derivatives and may be a good choice for taxable accounts. HXT is the cheapest ETF in Canada at just 0.08%—combine that tiny fee with zero trading commissions and it becomes a very tempting alternative to the granddaddy of ETFs, the iShares S&P/TSX 60 (XIU).

Kudos to Scotia iTrade and Claymore for introducing something genuinely new and useful into the chaotic ETF landscape. Here’s hoping they’ll spur other brokerages and ETF providers to offer something similar.