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%:

 WeightMERWeighted MER
TOTAL0.16%
Vanguard US Total Market Index ETF32.5%0.16%0.0520%
Vanguard FTSE Canada All Cap Index ETF24.0%0.06%0.0144%
Vanguard FTSE Developed All Cap ex North America Index ETF17.8%0.23%0.0409%
Vanguard Canadian Aggregate Bond Index ETF11.8%0.09%0.0106%
Vanguard FTSE Emerging Markets All Cap Index ETF5.6%0.24%0.0134%
Vanguard Global ex-US Aggregate Bond Index ETF4.7%0.38%0.0179%
Vanguard US Aggregate Bond Index ETF3.6%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.