Not long ago I was striding through Toronto’s Union Station when I came face to face with Canada’s changing investment landscape. All around me—not only on the windows and walls, but even on the floors—were advertisements for a newly launched family of exchange-traded funds (ETFs). Here at MoneySense we’ve been writing about these investment products for a long time, but we’ve never assumed ETFs were widely familiar the way mutual funds are (see An ETF primer), Yet here they were featured prominently in ads aimed at busy commuters in a downtown train station. ETFs, it seems, have gone mainstream.
In the last six or seven years, ETFs have snowballed in popularity. There are now seven providers in Canada managing more than $56 billion, and ETFs are gathering assets at more than triple the rate of mutual funds, according to the Canadian ETF Association, an industry group. But unlike most well-hyped innovations—which are usually just new ways for financial institutions to siphon your savings—ETFs have truly changed the game for Joe and Jane Investor. It’s easier than ever to build diversified portfolios at rock-bottom costs.
However, with more variety comes more confusion. When MoneySense created the Global Couch Potato portfolio in 2004, there were only two ETF providers in Canada and maybe a dozen funds from which to choose. Today there are more than 250 ETFs on the Toronto Stock Exchange and well over 1,000 on U.S. exchanges. How can investors make sense of these dizzying options?
That’s why we created the MoneySense ETF All-Stars. In this inaugural edition, we asked five investment professionals to help us compile a list of the best funds in the major asset classes. By choosing a handful of ETFs from our list, you can build an extremely well-diversified, low-cost portfolio no matter what your financial goal. We’ll even show you how the parts can fit together with three model portfolios on page 53.
An important note before we go further: the method we used to choose our ETF All-Stars is quite different from the one we applied to mutual funds (Best mutual funds 2013). The reason is simple: most mutual funds aim to outperform the market—or deliver similar returns with lower risk. But ETFs have a different goal: they’re designed to deliver the same returns (with the same risk) as an index, minus only a small cost. That requires a change in thinking. If the Canadian stock market declines by 10%, an active mutual fund manager who gets defensive at the right time may reduce that loss and score points for risk-adjusted performance. By contrast, an ETF tracking Canadian stocks can be expected to lose 10%, plus a little more due to fees. That doesn’t make it a bad fund: on the contrary, it’s doing precisely what it’s supposed to do.
So what factors did we look at to choose our All-Star lineup? Here’s a rundown:
Fees. Not surprisingly, ETFs with the lowest fees typically do the best job of tracking their indexes. That’s why low cost was paramount when making our choices. We didn’t automatically choose the cheapest fund in each category, but all other factors being equal, the ETF with the lower fee got the nod.
Note some ETF providers publish their funds’ management expense ratio, or MER, while others list only the management fee, which is not quite the same thing. The MER is always higher, since it includes the management fee, taxes and a few incidental costs. To make fairer comparisons, we’ve added the 13% Ontario HST if a fund lists only its management fee.
Strategy. Almost all the earliest ETFs were tied to traditional indexes that weighted each company according to its size (or more technically, to its market capitalization: the current share price multiplied by the number of outstanding shares). Today there are numerous variations on this theme, as ETF providers try to improve on traditional index strategies. Our expert panel usually gave preference to ETFs with straightforward, easy-to-understand indexes, since these usually result in the lowest turnover and fewest transactions.
Diversification. If you’re a typical long-term investor, your portfolio should provide you with the broadest possible exposure to the major asset classes. That’s why our experts gave preference to ETFs tracking broad indexes rather than narrow slices of the market, such as the energy, financial or technology sectors.
Liquidity. If you’re used to buying individual stocks, you know small, thinly traded companies have wide bid-ask spreads: in other words, there’s a big difference between the price you pay when you buy and the amount you receive when you sell. In theory, ETFs don’t work like this: you should always be able to buy or sell an ETF at a price that closely reflects the value of its underlying holdings, regardless of how many units of the fund change hands each day. But our expert panel generally preferred well-established ETFs that manage a lot of assets and trade frequently. Size and scale not only offer added liquidity, they also offer some assurance an ETF will still be around in a few years.
Tracking error. The true cost of an ETF is its tracking error, or the degree to which it lags its benchmark index. If an index returns 10% and an ETF tied to that benchmark returns 9.5%, its tracking error is 0.5%. While management fees are the biggest culprit, a low-fee ETF may still lag its index significantly because of other costs, such as currency hedging (more on this later). We’ve made sure our All-Stars have a good record of keeping tracking errors low.
Tax efficiency. ETFs are generally more tax-friendly than mutual funds. However, some do a better job than others: funds with a lot of turnover can stick their investors with an unwelcome bill for capital gains, for example, though this is still likely to be less than the average actively managed equity mutual fund. Others give up a greater share of foreign withholding taxes. So we’ve selected the funds that do the best job of keeping the tax collector’s hands off your investment returns.
To see the starting lineup in the Canadian, U.S. and Global Equities categories as well as the leading bond and speciality ETFs, pick up a copy of the February/March issue of MoneySense on newsstands now through March 31st or buy the digital download today.