This is a core asset class for domestic investors, both for registered and non-registered portfolios. This year, all three of our core Canadian equity ETFs are back: Two broad-market picks from Vanguard and iShares have rock-bottom management fees of 0.05%, while a third, Horizons S&P/TSX 60 Index ETF (HXT), pushed even lower to 0.03%.
“It’s important simply to use low-cost, broadly diversified ETFs in each asset class, and in many cases the differences between specific products are so small they’re not worth debating,” says panelist and MoneySense columnist Dan Bortolotti. Both he and Justin Bender, his colleague at PWL Capital Inc., stand by last year’s picks: “We tend to use Vanguard FTSE Canada All Cap Index ETF (VCN) with our clients, but iShares Core S&P/TSX Capped Composite Index ETF (XIC) is extremely similar and we would not quibble with any of these choices.”
Tyler Mordy, president and chief investment officer at Vancouver-based Forstrong Global Asset Management (formerly Hahn Investment Stewards & Co.) prefers XIC because it tracks the broad S&P/TSX Composite Index. “VCN uses the FTSE Canada All Cap Index, a lesser-known index that covers Canadian large-, mid- and small-cap stocks,” he says. XIC has seven times the assets under management and 13 times the daily volume of VCN.
As for HXT, Mordy points out that it’s extremely efficient in taxable portfolios, deferring the tax liability of dividends by effectively commuting them to capital gains that won’t be realized until you sell your shares. It’s why Mordy sees HXT as the single best pick for Canadian large-cap stocks.
This year, our panel returned the two core U.S. picks from Vanguard but added a currency-hedged fund for those concerned about the Canadian dollar’s volatility.
Most investors will be satisfied with the Vanguard US Total Market Index ETF (VUN), which gives Canadians exposure to the entire U.S. market of 3,791 stocks, as well as a potential boost from the many more small-and mid-cap holdings in the broader fund. Vanguard S&P500 Index ETF (VFV) focuses on 505 large U.S. companies that make up the S&P500. Even though it doesn’t track a broad market index, Mordy prefers VFV over VUN because its management fee of 0.08% is half of the broader VUN.
A less unanimous pick was the Vanguard S&P500 Index ETF (VSP). “Given the substantial decline of the loonie to multi-year lows, investors concerned about a future appreciation of the Canadian dollar versus the U.S. dollar might consider replacing VFV with VSP,” says Alan Fustey. “Both ETFs have the same low MER of only 0.08%, so this represents a cost-effective way of gaining currency hedging.” A dissenting view came from Mordy, who says that “a currency-hedge is an active, tactical decision.” That’s inconsistent with the Couch Potato philosophy. Every portfolio is different; it’s best to talk to your advisor about the pros and cons of full or partial currency hedging.
This category had the most changes this year, with only one of our three All-Star picks returning from the 2015 list. The other two—covering global all-caps and Emerging Markets—saw a Vanguard ETF replaced by an iShares fund, and an iShares fund replaced by a Vanguard product.
Our experts added iShares Core MSCI All Country World ex Canada Index ETF (XAW), which gives Canadian investors one-stop access to global equities. Ultimately, the panel chose the iShares fund over Vanguard FTSE All-World ex-Canada Index ETF (VXC), because it offers a lower fee of 0.21% (versus 0.25% for VXC). It’s also more tax-efficient since it holds developed markets stocks directly rather than via an underlying ETF, which results in lower foreign withholding taxes. Says Mordy: “VXC holds China A-shares but we are suckers for the lower fees.”
For investors who already have plenty of North American exposure and need to invest outside this continent, the panel was unanimous in retaining iShares Core MSCI EAFE IMI Index ETF (XEF). Its management fee is just 0.2% and it also invests in small-cap equities. Two panelists preferred the alternative of Vanguard FTSE Developed ex North America Index ETF (VDU). However, VDU includes some exposure to Canada itself (up to 8%), which one might argue domestic investors already have plenty of. In December, Vanguard launched a replacement for VDU that excludes any Canadian exposure at all: the Vanguard FTSE Developed All Cap ex North America (VIU). But it’s too early to deem this new product an “All-Star.”
For Emerging Markets, the panel was split. In the end, Vanguard FTSE Emerging Index ETF (VEE) was selected over last year’s pick, iSharesCore MSCI Emerging Markets IMI Index ETF (XEC). It’s worth noting that VEE tracks the FTSE Emerging Index, which has included China A shares since 2015. “Given its transition toward China A, VEE now arguably provides superior access to Emerging Markets,” Rebetez said. The iShares fund uses MSCI indexes, while Vanguard uses FTSE indexes, which treat South Korea differently. The first considers Korea an emerging market, while the latter considers it developed. Whichever you prefer, PWL recommends opting for the same provider for both asset classes. Otherwise, you end up with either a double-market weighting to Korea or none at all.
The last seven years have been rough for retirees and those looking toward risk-free sources of investment income. The phenomenon of “financial repression” has conspired to keep real (after inflation) interest rates close to zero, unless you’re prepared to take on extra credit risk or lock in to longer terms.
The bottom in rates may have occurred in December, when the U.S. Federal Reserve moved off zero with a 0.25% rise in rates. Whether they are “one and done” or this proves the first in a long series of rate rises over the next few years is unclear. But investors have learned that guessing future directions of interest rates can be as futile as predicting the timing of the next correction in stocks.
Our panel saw no reason to abandon any of last year’s four All-Star Fixed-Income ETF picks. We also added an innovative new one.
We were unanimous in retaining Vanguard Canadian Aggregate Bond Index ETF (VAB) and Vanguard Canadian Short-Term Bond Index ETF (VSB). Both are appropriate for registered accounts and, in this still-low-interest rate environment, it’s important that investment costs stay low. Vanguard remains a cost leader here. Mordy notes that VSB is the cheapest in its category, with over $2.1 billion in assets, and is the most liquid in the secondary market. Long-term investors with no view on rates may find VAB appealing, with 80% in government and 20% in corporate issues and an average term of 10 years.
As well, BMO Discount Bond Index ETF (ZDB) is back, with all but one panelist on board. Bortolotti and Bender say ZDB remains a good choice for taxable investors needing exposure to the broad bond market (average duration is seven years, similar to VAB). Mordy adds the caveat that ZDB may expose investors to more corporate issuer risk than a broad market bond ETF like BMO Aggregate Bond Index (ZAG).
For taxable portfolios, BMO S&P/TSX Laddered Preferred Share ETF (ZPR) is also back. Canadian preferreds provide conservative investors with a bond-like investment taxed favourably like Canadian dividends and ZPR minimizes interest-rate risk by focusing on “rate reset” preferreds that can be reissued at higher rates once rates rise. It divides preferreds into five equally weighted “buckets,” laddered so they mature in one to five years, further lowering interest-rate risk. One dissenting panelist is Rebetez, who says ZPR had a better year gathering assets than generating performance. Bortolotti says PWL doesn’t use preferreds, but “if you want to access this asset class ZPR is probably the best way to do it.”
A new addition for those who want to keep their bonds short is the First Asset 1-5 Year Laddered Government Strip Bond Index ETF (BXF). It invests in Canadian federal and provincial government strip bonds with maturities ranging from one to five years. It was created with PWL’s input to solve the problem of tax-inefficiency in traditional bond ETFs. Most bonds trade at a premium: If they were issued when rates were higher, they’re now priced above face value. That means taxable investors will pay tax on a high coupon, then get stuck with a capital loss when the bond matures. However, strip bonds always trade at discounts, so tax is paid only on an amount equal to the yield to maturity. You won’t suffer a capital loss unless interest rates spike and the bonds are sold before maturity.
However, this pick was not unanimous. “Holding strips is tax-efficient but the ETF equally weights only about 25 holdings—versus more than 300 for VSB—and investors must also assume extra duration risk,” Mordy cautioned.
These are the best broad-market ETFs in each major category as chosen by our panel of experts:
The ever-changing ETF landscape
Our All-Star picks are mostly passive “plain-vanilla” ETFs trading on the TSX. But there is an increasing number of alternatives out there for every niche and craving. If bleeding-edge biotech is your thing, the first cancer ETF launched in October. The Loncar Cancer Immunotherapy ETF (CNCR/Nasdaq) focuses on 30 pharma and biotech stocks, including big names like Merck and many you won’t recognize. (Warning: Biotech is in a bear market right now.) Another interesting, but not new, option is the PowerShares Nasdaq Internet Portfolio (PNQI/Nasdaq). I chose it for my daughter’s TFSA because she loves tech stocks like Facebook, Amazon, Netflix, Google and Twitter: all PNQI holdings.
Less sexy is a yield-friendly domestic pick from Alan Fustey: Horizons Active Cdn Municipal Bond ETF (HMP.A/TSX) is the first Canadian ETF focused on the Canadian municipal bond market. It can provide higher yields than federal, provincial and some corporate bonds, yet with a low risk of default.
New ETFs keep coming in 2016. TD Asset Management, which flirted with ETF products a decade ago before retreating, has filed to launch four new ETFs based on major stock and bond indices. And BMO, the dominant ETF player among the big banks, has plans to promote its suite of ETF-based mutual funds to capture a broader investor audience. ETF-based mutual funds carry a higher
fee than pure ETFs but still create a low-cost alternative to high-fee funds for investors who don’t have the discount brokerage accounts required to buy ETFs directly.
ETF All-Star honourable mentions
Not every ETF All Star pick was a unanimous winner. The following are some of the funds individual panelists championed but missed the cut. In particular, the panel debated the merits of adding four low-volatility ETFs as core picks. According to PUR Investing’s Mark Yamada, adding low-volatility funds helps investors stay invested and “addresses the behavioral tendency to sell low and buy high as markets move to extremes.”
BMO Low Volatility Canadian Equity ETF (ZLB)
Why: In 2015, low-volatility strategies more than lived up to expectations, particularly for Canadian equities where the tumultuous loonie and falling oil prices have added to market volatility. While ZLB is one of the best single low-vol picks according to our panelists, ETF Insight’s Yves Rebetez cautions that “relative valuations versus traditional market cap could be a concern, and could erode their efficacy going forward.” Yamada is less concerned and likes the diversified construction of ZLB enough to use it as a core holding. “It’s about volatility, not valuation.”
iShares MSCI USA Minimum Volatility Index ETF (XMU)
Why: Reducing volatility is beneficial in all markets and the U.S. is no exception. Yamada likes XMU because it leans towards financials (21.7%), health care (19.6%) and infotech (14.8%), making it a good satellite choice. Alternatively, BMO Low Volatility U.S. Equity (ZLU) is the largest U.S. low volatility ETF in Canada. It’s also more defensive, featuring utilities (25.6%) and consumer staples (23.9%), making it a good core holding.
iShares EAFE Minimum Volatility Index ETF (XMI)
Why: Similar to other low volatility picks, XMI concentrates in financials (21.4%) consumer staples (16.7%) and healthcare (16.1%), making it a good satellite holding. “One would expect these weights to change with market volatility,” says Yamada, “making it a good offset to a cap-weighted core.”
MSCI Emerging Markets Minimum Volatility Index ETF (XMM)
Why: China makes up about 20% of most plain-vanilla Emerging Markets ETFs, but as we saw in August 2015 and January 2016, that long-term growth story comes with extreme volatility. If low-volatility ETFs make sense in developed markets, that goes double for Emerging Markets. “In exchange for less upside when all is going great, the stocks in these indexes tend not to explore any correction depths to the same degree as traditional benchmarks,” says Rebetez. “Sacrificing some upside for a higher floor could prove liberating.”
PowerShares QQQ (CAD Hedged) Index ETF (QQC)
Why: One sector lacking in the Canadian market is large-cap technology. Rebetez suggests a one-stop shopping tool to overcome this: the Nasdaq-listed QQC. It’s similar to the Nasdaq-listed QQQ, but hedged back into Canadian dollars. “QQC is in my view very much a case of an all-in one-ticket, accessing key additional sector exposures that are lacking domestically.”
Horizons Active Preferred Share ETF (HPR)
Why: Preferred shares are a tricky asset class, since they give Canadian investors bond-like performance with the tax efficiency of dividend-paying stocks. In the current rate environment there may be an argument in favour of active management ofthese securities, and both Rebetez and Tyler Mordy of Forstrong Global Asset Manangement chose HPR as a way to do this.
Our ETF All-Star expert panel
Justin Bender is a portfolio manager with PWL Capital in Toronto, and Dan Bortolotti is an investment advisor at the firm. They use ETFs for their full-service clients and also help do-it-yourself investors set up their own ETF portfolios. Tyler Mordy is president and chief investment officer at Vancouver-based Forstrong Global Asset Management, specializing in global ETF portfolios for retail and institutional clients. Mark Yamada is CEO of Toronto’s PUR Investing, which builds ETF portfolios for both individuals and institutional clients. Yves Rebetez, CFA, is the editor of ETF Insight. Prior to launching the website, he was vice-president of ETFs/Structured Products with RBC Dominion Securities from 2004 to 2011. Alan Fustey is a portfolio manager at Index Wealth Management in Winnipeg. He’s been using ETFs with clients for more than a decade.