In the latest episode of the podcast, we take a detailed (and technical) look at the inner workings of ETFs. I’m joined in the studio by Erika Toth, a director at BMO ETFs whose role is to help both investors and advisors understand how these funds are structured, how they trade, and how they should be used in a portfolio.
Erika makes reference to a couple of useful resources in the interview:
What to Expect During Tax Season, produced by BMO ETFs, answers frequently asked questions about how ETF distributions are taxed. It includes explanations of return of capital, reinvested capital gains (also known as phantom distributions), foreign withholding taxes and other important concepts.
Are Bond ETFs Dangerous? is a white paper by my PWL Capital colleague Raymond Kerzérho. It’s a response to one of the common criticisms of fixed income ETFs: namely, that their structure can lead to a lack of liquidity or even large losses for investors during a financial crisis. Ray finds no evidence for these claims.
The weighting is the hardest part
In the Bad Investment Advice segment, I look at the idea (argued in a marketing blog from Invesco) that traditional ETFs are inferior to alternative strategies, such as equal weighting.
Traditional indexes—like the S&P 500, or the S&P/TSX Composite Index—are built using a methodology called capitalization weighting (“cap-weighting” for short). A company’s market cap is calculated by multiplying its current share price by the number of shares outstanding in the market. So larger companies have a proportionally greater influence in a traditional index fund.
This characteristic of cap-weighted indexes is often made out to be a structural flaw, because it supposedly means investors get too much exposure to very big—and potentially overvalued—companies. The Invesco article goes so far as to call this “buying high and selling low.”
One alternative is equal weighting, which allocates the same amount to each stock in the index. In the case of the S&P 500, each of the 500 companies is assigned a weight of 0.2%, so giants like Microsoft and Apple have the same influence as much smaller companies like Nordstrom and Harley-Davidson.
The problem comes when the author states that “historical performance data for the S&P 500 Equal Weight Index shows that it has consistently outperformed the market-capitalization-weighted S&P 500 over the long term.” Only when you read the fine print to you learn that “the long term” actually goes back only to April 2003.
If you’re going to be an index investor, you’ll need to get used to people disparaging cap-weighted indexes. They’re routinely presented as fatally flawed investment strategies that underperform virtually every theoretical alternative in historical backtests. Yet here in the real world, the reality is quite different. Over every meaningful period, traditional index funds are routinely in the top quartile for performance.
For all of their faults, traditional index ETFs are the cheapest, simplest and most tax-efficient way to build a diversified portfolio. If they don’t offer enough to enable you to achieve your financial goals, then something other than your investment strategy is to blame.
What’s the true cost of your ETF portfolio?
In the Ask the Spud segment, I answer a question from a reader whose advisor is deeply confused about how ETF fees are calculated. If you’re a new investor you might have the same misunderstandings, so let’s break this down.
The investor, Jim, is considering buying the Vanguard Growth ETF Portfolio (VGRO), which includes seven underlying ETFs covering the global stock and bond markets. The published management expense ratio for VGRO is 0.25%. The advisor, however, told Jim that he would also be paying the MERs of each of the underlying ETFs, which average 0.20%. Seven ETFs at 0.20% equals 1.40%, the advisor says, plus another 0.25% for the wrapper and Jim’s actual cost will be 1.65%!
Of course, this is nonsense. The advisor has made two fundamental errors here.
First, the asset allocation ETFs from Vanguard, iShares and BMO all waive the management fees on the underlying funds, so you pay only the stated MER. This is explicit in the prospectus of each of these funds.
What’s more disturbing is the advisor’s math skills. He’s assumed that if you hold seven funds in your portfolio and each one charges 0.20%, then your overall fee is 1.40%. In fact, it’s 0.20%. To calculate the overall fee of a portfolio with multiple funds, you don’t simply add the MERs. First you need to multiply each fund’s fee by its weight in the portfolio, and only then do you add these “weighted MERs” together.
For example, if you purchased all of the funds in VGRO separately, and in the same proportion as they’re held in VGRO, your portfolio’s overall MER would be 0.16%:
|Vanguard US Total Market Index ETF||32.5%||0.16%||0.0520%|
|Vanguard FTSE Canada All Cap Index ETF||24.0%||0.06%||0.0144%|
|Vanguard FTSE Developed All Cap ex North America Index ETF||17.8%||0.23%||0.0409%|
|Vanguard Canadian Aggregate Bond Index ETF||11.8%||0.09%||0.0106%|
|Vanguard FTSE Emerging Markets All Cap Index ETF||5.6%||0.24%||0.0134%|
|Vanguard Global ex-US Aggregate Bond Index ETF||4.7%||0.38%||0.0179%|
|Vanguard US Aggregate Bond Index ETF||3.6%||0.22%||0.0079%|
VGRO actually has an MER of 0.25%, which means you pay an additional nine basis points for the convenience of managing one ETF instead of seven. I think that’s an excellent trade-off for most DIY investors, as you get all of your rebalancing done for you, and you can make a single trade any time you add money to your accounts.
Here’s a handy calculator you (or Jim’s advisor) can use to understand the weighted MER of your own portfolio.
Sorry to hear you’re hanging up the proverbial towel on the podcast! It was always an excellent listen and a valued component to my investing information pool of knowledge. It’ll be sadly missed!
Many thanks for these 26 podcasts that I have looked forward to each month. While I will miss future episodes being produced you’ve created a remarkable body of information for the couch potato investor to review.
Thanks for all the advice, the podcast helped dip my toes into investing.
Noooooooooooooooooooooo. I’m so sad to hear this, you give great, sensible advice. Now what do I listen to??
Oof, hit me with the gut punch at the end of that podcast. Sorry to hear that the podcast will be no more!
@Lise might be worth checking out the Rational Reminder podcast by Ben Felix.
Yeah… too bad about the podcasts. Really enjoyed them and used then to convince my friends towards passive investing
Thank you for all your help with my investments. I do not think I could have done it without your articles, blog and podcasts. They have served as an invaluable resource as I DIY my portfolio.
To say that I am appreciative does not convey my deep thanks.
Thanks for the podcast. I discovered this series when you were at episode 8, and since then have listened to the whole thing many times over. It’s an invaluable resource for new and seasoned investors.
Many thanks Dan, I really enjoyed your podcast and writings. You are the main reason I changed how I was investing my money. Good luck going forward!
I often wondered how you managed to juggle all the articles for MoneySanse, your couch potato blog and PWL white papers along with these podcasts. Your in depth commentary and timely advice has helped me to avoid many of the pitfalls that befall DIY investors.
Your contribution to the investor education cause will be missed. Thanks for your efforts.
Many thanks to everyone for the supportive words, and I’m very pleased to hear that so many people enjoyed the podcast!
To clarify, I do still plan to publish new articles here on the blog as time permits. It’s only the podcast that has been mothballed.
Dan, my question is not related to this particular podcast. Are you aware of the proposed changes to the TD e-series funds? It appears that they are changing the indexes they are tracking (to Solactive), they will reduce management fees and there may be some tax implications depending on capital gains. Anything you believe couch potato investors should be aware of as it relates to their portfolios? Or are we good to stay on the couch? :)
Link: https://www.tdassetmanagement.com/document/PDF/news-insight/MANAGEMENT_INFORMATION_CIRCULAR_IN_RESPECT_OF_SPECIAL_MEETINGS_OF_UNITHOLDERS_EN.pdf (see pages 33 to 44).
As with the others, I was very disappointed to hear that you are discontinuing one of the best podcasts I have come across that helps with personal investing. It was smart, direct and easy to understand. You helped me realize a goal of mine that I had in the 1980’s:
Just “make” the market … “beating” the market is a game for those who like to buy lottery tickets.
I will continue to follow your contributions, regardless of the form they take.
Wow thanks so much for the series.
This was a great help every 6 weeks to keep me on the straight and narrow for simple evidence based investing!
You’re work has been a service to the country. Sounds facetious but I’m only 0.1% joking.
Thank you for your work helping us navigate the financial world.
Take time to sip a coffee and consider the better financial world you’ve helped create.
Sorry to hear you are taking a break, but I am sure you are very busy, you are well trusted and i am sure you have a lot of Clients to take of. If I were to use an Advisor it would be you. Your are also the reason, I feel I can currently get by without one.
Hope you continue the website and post the valuable information you have provided in the past.
@Bobby V: Stay tuned, I will be writing about this soon. The short answer is that it’s not a major concern.
Dan, I wanted to join the others and express my gratitude for your work on the podcast over the last few years (and all of your contributions more broadly). I’ve learned a lot from you, and my portfolio is healthier for it. When I started my financial journey I was woefully ignorant, and that ignorance manifested a life of mindless consumption and debt. Thanks to you, I now have so many more possibilities. I will miss our monthly check ins.
– Your devoted disciple, G
That’s not to say that there can’t be a problem with a capital weighted index. At one point Nortel (RIP) accounted for over 40% of the S&P/TSX 60. I don’t think you’ll find anyone that would say that that kind of situation doesn’t present a serious problem w.r.t. diversification.
Personally, I like the S&P/TSX Capped Composite index which imposes capped weights of 10% on all of the constituents. That way, you can’t get a Nortel-like situation. XIC and ZCN, to name 2, track it.
On the side topic of changes in ETFs, Horizons swapped based ETFs are converting to corporate-class funds due to the tax changes announced in the last budget. Supposedly, “all of the same benefits” of the swapped based ETFs will be retained. Can you possibly comment on this? It seems odd that Horizons should be able to totally side-step the tax changes that easily – surely there’s a catch.
@Jim R: I will be writing about the Horizons ETFs shortly.
I’ll share my devastation on the podcast ending a bit later, but first…this Ask the Spud just about killed me. While it’s been clear to me that staff at banks have peddled MFs using extremely questionable tactics like chasing returns of their best performing funds, or advertising the “batting average” from a previous podcast, the idea of adding all the %s of each MER is insane – I’m going to give the FA the benefit of the doubt on math rather than morals – meaning they MUST know this is wrong, and are trying to inflate the perceived cost to make their MF recos more attractive. I recognize investing is a complex topic and so you’ll have some bad apples that take advantage of clients by being selective in what is shared, IMO this just goes too far. So my question to you: do you think there is enough regulation and over site in terms of advice advisers provide clients? Do we need something to shine a light on what’s happening behind the scenes (now that your podcast is done…and no offense, but a wider net to cast)?
Your podcast has been a great source of information! I’ve learned so much! Thank you for all your hard work and hope that the hiatus doesn’t last too long!
I will echo Darren’s comment, Dan – in fact I will cut and paste it! You are the main reason I changed how I was investing my money.
About 5 years ago, I was searching the internet (what a wonderful tool) for a better way to achieve our financial goals, after wasting 15 years in mutual funds hell, when I stumbled on to the CCP site.
Thank you for your invaluable contributions to informed investing.
Thanks for all the work you put on to educating investors all these years! Your podcast had always been one of the best ones and I always looked forward to the next episode. Hopefully sometime in the future you’ll be able to bring them back!
Thank you so much for these podcasts, Dan. I’ll miss them and keep checking the CCP site for your commentary.
I particularly enjoyed the dive into ETF internals with Erika Toth. ETFs are a very clever wrapper structure with how market makers are incentivized by simple market forces to keep the current unit market price and current NAV always close throughout the trading day at no cost to the ETF provider.
One interesting thing is I believe market makers and the ETF provider can exchange units of the fund with the basket of underlying holdings in either direction (when units are created or destroyed) without this legally being considered a sale or purchase (it’s a 1:1 swap). This makes it a lower cost activity in terms of transaction costs and taxation to correctly match ETF units to market demand.
In the discussion of how ETFs pay out underlying dividends, Ms. Toth almost addressed something I’ve wondered for a while. What’s the customary lag between an ETF getting dividends and paying them out?
If an ETF pays out quarterly dividends (say a Q1 dividend), is the dividend the payout of what the provider received the previous quarter (Q4) because they will know the exact amount at that point and it’s nice bonus for them to keep the cash for three months for free? Or do they try to match their paid out Q1 dividends to what they expect to receive in Q1? Or just pay out whatever dividends they’ve received since their last dividend payment? It would be interesting to know the underlying mechanism.
While on the subject of minutiae, it has long been a mystery to me know how brokerages determine the unit price for DRIP reinvestment purchases. This price never seems to match up to any particular closing unit price around either the dividend record date or payment date.
Thank you Dan sharing your knowledge about investing and index fund. I found your web site / podcast 2 year ago when looking ways to reduce my management fees and it completely changed my vision of investing ! Among the podcasts I listen to …. CCP was BY FAR my preferred one (great subjects, detailed explanations, trustful source)….. so what am I to listen now ?!? :))
Could you share with us some of your favorites resources about investing and index funds ?!? podcast ? blogs ? website ? ….. so that I can continue to educate myself about the subject.
Thanks again Dan.
@Tim: Like you I have never been able to learn exactly how ETFs determine the amount of their distributions. But they definitely do not pay out dividends before they receive them, so the Q1 dividend payment represents dividends received in the first quarter of the year. Some ETFs seem to pay rather inconsistent distributions, which suggests that they are simply sweeping out whatever they have received. Others make some effort to smooth these out, either by holding back some dividends (remember, these don not have to be paid to investors: they can be reinvested), or by topping them up with some return of capital.
Re: DRIP prices, Vanguard’s website says “the price of your new units will be the average price of all units purchased under the plan excluding commissions, fees and transaction costs incurred by the plan agent.” My understanding is that the brokerage purchases units for all of its clients with DRIPs on that ETF, potentially at slightly different prices, and then distributes them to each client with the same average price so as not to favour one or the other.
@Philippe: Thanks for the kind words. The blog isn’t going anywhere, just the podcast, so I hope you will continue to visit.
A Big Thank You Dan, for the 26 podcasts that you provided. I listen over and over and have learned so very much from your explanations. I look forward to your future Blog posts. THANK YOU!
“Of course, this is nonsense. The advisor has made two fundamental errors here.”
Unlikely the advisor made an error an likely new exactly what he was saying and doing to keep Jim as a client.
@Brian: Perhaps, but I doubt it. In situations like this, it’s usually genuine ignorance. I always like to remember that an advisor who tries to mislead a client about something like this is taking a huge risk. If Jim had recognized the error (and many clients would), the advisor would have looked very bad: he’d either be called out as a liar or as an idiot.
Dan, I get a little confused when I hear/read the advice to ETF DIY-ers to place “limit” orders when buying/selling ETFs. I understand the clarity this gives the investor as they understand how many units and the total dollars of their order(s) (as unlike mutual funds, you can’t buy partial ETF units), but I just can’t shake the fact that this seems to me like “timing the market”, which of course is a no-no for DIY CCP investors. Wouldn’t it be best to just divide the number of dollars you have to invest by the current trading price and round down to the nearest whole number, then place a “market” order for that amount of ETF shares? For example: I have $1,000, the ETF I want to buy is trading at $23.30, so I can buy 42 (1,000 / 23.30 = 42.92) whole shares (assume commission free), with some cash left over. I would just worry about the scenario where you place a “limit” order for – in the same scenario – $23.25 so you can buy 43 whole shares, and the price never comes down that low in the day, or maybe even for a few days. You’ve now missed out on time where you could have been invested in the ETF, rather, you’ve tried to get it at your price.
@Chris: I think you have misunderstood what the limit order is supposed to do. If your order every sits unfilled for any length of time, then you have placed it incorrectly. This should help:
One interesting thing regarding capital gains distributions is that sometimes they’re just distributed as cash and not reinvested. I was a bit surprised with XAW last tax season, I had less tax than expected because some of the cash distribution were capital gains which is taxed at a lower rate.
Also before this I had the impression that capital gains were always reinvested, that’s why you have to take note of the reinvested number on the ETF website, not use the capital gains distribution on your tax form when calculating ACB.
Your podcast has given us the opportunity to get to know you better and has only served to reaffirm what we already had gleaned from your blogs: you are a guiding light in the Canadian investment industry, a lone soldier with a logical, facts and data driven, unbiased approach to providing investment advice. While we empathize regarding the demands of your schedule, your country needs you. Perhaps one of your team members or colleagues or an advisor in your network would consider taking on the podcast production under your tutelage? Pass the torch? Or is there another source of investment podcasts you support and recommend?
Your work has been the basis of my investing activity! Though this was mostly before the podcast, I looked forward to the podcasts and I’m sad they’re not continuing.
Thanks for all you’ve done. I will miss the podcasts!
@B Nole: Many thanks for the kind words. Justin Bender is planning to launch a new podcast shortly. Stay tuned!
Your blog, podcast and reading material have created my investments. I started with Questrade, created TFSA, RRSP, and a Margin account, and adopted your ETF model portfolio, learned to trade and re-balance, adjusted cost base at tax time, and I’ve seen a wonderful growth of my three accounts since I started this in 2016. I’ve never had any investment strategy or advice before reading your website.
Thank you very much Dan, your advice has been worth literally thousands to me.
I’m 25 now and I have you to thank for giving my hard earned money a strategy, and a focus on total return over a lifetime. (no matter how horribly flawed market cap weighting is harr harr)
I’m a 3rd class power engineer (boiler operator in the oil industry) and I’ve been so privileged to gain some of you knowledge and how-to on becoming a DIY investor. I’ve also enjoyed many of the PWL publications, and money sense articles you’ve created.
With that, I’ve continuously saved since I started working in 2016, and you’ve given me some savings habits which will last a lifetime! I’ll survive along with Justin Bender’s “rational Reminder” and I hope you return to the Podcasting space one day, although I realize your departure is indefinite.
Thanks so much!
@Daniel S: Many thanks for the kind words, and glad to hear that my work has been helpful in your journey. Keep up the great work!
Miss the podcast was a great show
This site is super and I am grateful for all of the advice which I have implemented. One question I can’t figure out. I have 25k USD in US stock in an open account (from previous corporate job). I have plenty of room in my RRSP and TFSA. Should I sell this stock, pay the capital gains taxes and reinvest the remaining amount in one of my registered accounts so it can grow tax sheltered or leave it be? Big than you!
@Angele: Thanks for the comment. There are really a few questions here.
The first is whether an RRSP or TFSA contribution is more appropriate: that will depend on a number of factors, including your marginal tax rate and whether you’re saving for retirement or a shorter-term goal.
The second is whether you want to continue holding than stock: would it be more appropriate to sell it and invest the proceeds in a diversified ETF (it probably is).
Finally, if you sell the stock and receive the proceeds in USD, then it may well be appropriate to contribute that USD to an RRSP, where it could be used to purchase a US-listed ETF. If you are contributing the cash to a TFSA, however, it would be better to convert it to CAD, since US-listed ETFs are a poor choice in a TFSA.