General information

Updated: Sep 2011

ETFs typically are composed of securities that mimic the composition of some index and as a result, closely track the returns of that index. As such, there is very little investment management involved in security selection and, thus, the term “passive” is commonly attributed to ETFs. The index that a particular ETF follows can be one for stocks, bonds, commodities, currencies, investment trusts, etc and the list continues to expand. An investor receives the return of that particular index less the ETF’s management fee and plus/minus any tracking errors (which are minor deviations from the actual index itself). Mutual fund companies also offer mutual funds that track indices as well, but their higher management fee has made them less popular. To determine if a particular ETF is suitable as an addition to one’s overall investment holdings, it is important to understand what asset class it represents, how it attempts to mimic that index and how it is weighted in the various sub-categories of that index (eg industrial and geographic sectors for equities and maturities and debt rating for bonds).

Scope of Global ETFs

ETFs have become a popular, and growing, form of investing over the last five years, with close to $1 trillion invested in approximately 1,000 funds. BlackRock iShares is the largest player in the ETF market, followed by State Street SPYDRs, Vanguard, and Invesco Power Shares. (iShares were launched in early 2000 by Barclays Global Investors and later sold to BlackRock in 2009).

Composition of an Index

Financial companies create ETFs that they consider have enough investment demand to warrant a market presence. Standard and Poors (S&P) is one of the world’s largest index creators and it uses specific criteria to design its indices. For instance, for a country to be included in an index, it’s currency must be freely traded and its ‘GDP per capita’ must be greater than $15,000. Some S&P indices are broad and others are very focused. The widely-encompassing S&P Global 1200 Index, for example, includes the 1,200 largest companies on the planet and captures around 70% of the world’s market capitalization across 29 geographic markets. On the other hand, a newer, more focused index is the S&P Global Alternative Energy Index, which includes companies from the S&P Global Clean Energy and S&P Global Nuclear Energy Indices, and provides exposure to leading alternative energy firms in the developed and emerging markets.

The SPYDR 500 (SPY) is the most actively traded, the biggest ($85 billion) and the oldest ETF (launched in 1993) that tracks the S&P 500 Index. This index is widely regarded as the best single gauge of the US equity market. It covers approximately 75% of the US equity market capitalization and is a collection of the largest 500 market-capitalized companies in the United States. The ‘information technology’ sector presently is the S&P 500’s largest industrial sector weighting (at 19%), reflective of how important the tech industry now is to the US economy.

Scope of Canadian ETFs

Canada has 174 ETFs, with a value of approximately $41 billion. The biggest Canadian ETF is the iShares S&P TSX 60 Index Fund ($13 billion). BlackRock Asset Management is the largest player with $30 billion under management (74% of the Canadian ETF market), followed by Claymore (14%), Horizons (7%) and Bank of Montreal (5%). Competition from large US financial companies is upon us, as Vanguard, a US fund giant, and PowerShares, a large US ETF provider, are planning to enter the Canadian ETF market soon.

Below are some ETFs that we currently are adding to select portfolios, along with their investment directive and annual management fee:

S&P Global 100
“IOO”/US exchange
100 multi-nationals drawn from the S&P Global 1200 0.40%
Vanguard Dividend Appreciation
“VIG”/US exchange
Tracks the ‘Dividend Achievers Select Index’ holding stocks of companies with a record of growing dividends year over year 0.18%
Dow Jones Canada Select Dividend “XDV”/TSX exchange 30 of the highest yielding, dividend-paying companies in the ‘DJ Select Dividend Index’ 0.50%
S&P /TSX Capped Utilities
“XUT”/TSX exchange
11 large Canadian Utilities (Top are: 20% Fortis, 17% TransAlta, 14% Emera, 12% Canadian Utilities) 0.55%
Nasdaq Biotechnology
“IBB”/US exchange
126 large companies engaged in the biotechnology industry represented by the NASDAQ Biotech Index 0.48%
MSCI Emerging Markets
“XEM”/TSX exchange
852 companies in the Emerging Markets, replicating the MSCI Emerging Markets Index (24% weighting in the Financial sector) 0.82%

New kids arriving on the block—actively-managed ETF

Unlike most ETFs that are designed to passively track an index, ETFs that are actively-managed try to outperform an index, like most mutual funds attempt to do. They are managed by investment teams and can make individual security selections, or even liquidate to cash in an uncertain market if that is part of their investment strategy, whereas an index ETF is always fully invested.

A few years ago, Horizons AlphaPro introduced active ETFs in Canada that trade over the TSX. There are a relatively small number of active ETFs in the US, initiated by Invesco PowerShares. It was just announced that Pimco, a US firm that offers the world’s largest mutual fund (Pimco Total Return Fund at $243 billion), soon will introduce an ETF version to mimic its flagship bond mutual fund, setting the annual management fee at 0.55%. As non-American investors are ineligible to buy US mutual funds, they now will be able to buy this ETF version instead in US dollars over the NYSE. This may become a more common way for other large US mutual funds to become globally available, thus expanding the market-reach of these US-based financial companies. Canadian mutual fund companies soon may face strong competition if these actively-managed foreign ETFs become a popular choice.

Keeping costs at a minimum

As an investment advisor with your best interest in mind, it is our fiduciary duty to seek suitable investments that not only provide appropriate diversification and fit your asset allocation plan, but also minimize your overall management costs. Mutual funds and ETFs both have ‘embedded’ management fees, yet ETF costs are normally significantly lower than mutual funds offered in Canada (around 2% lower!). For several years, we have used ETFs as key core components of the equity portion of your portfolios, keeping in line with a target ‘sector’ strategy for your equities.

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ETFs have proliferated over the last few years and many more specific investment choices are now available. One US-traded candidate that may suit your portfolio is the Agribusiness ETF “MOO” that represents an agricultural Index that provides exposure to global companies that derive at least 50% of their revenues from agriculture, such as Deere & Co, Potash Corp. and Monsanto. Its annual management expense fee is 0.59%. Another is the new Vanguard Dividend Appreciation ETF “VIG”, with a low 0.23% fee that invests in US companies with a record of growing their dividends year over year.

ETFs trade over stock exchanges and many track major stock market indices. A key feature is that ETFs have relatively low annual management fees (ranging from 0.09% to 0.85%) versus a mutual fund (1% to 3%). Investing in ETFs is an efficient way to diversify equity portfolios, not only geographically but sector-wise as well.

For comparison, the sector breakdown of a sample of exchange-traded funds can be seen below:

You can see from the above table that Canada’s index has a heavy weighting in Resource and Financial stocks and reflects our primary industries. Technology is given heavier weight in the United States and Japanese indices. Health contributes more to the United States and Europe’s indices. If you hold any of these ETFs, we include their individual sector breakdowns in our overall sector analysis of your portfolio

Newer ‘global’ funds are now part of our international ETF investment options and include the following:

 

Updated: Sep 2011