When MoneySense started suggesting exchange-traded funds as a cheaper alternative to mutual funds 15 years ago, investors had it easy. Once you decided to go the ETF route, there were only a handful to choose from, so picking a few for your portfolio was a breeze. Today there are almost 400 ETFs on the Canadian market alone, and more than a few investors get overwhelmed by the confusing cascade of three-letter tickers. Analysis paralysis is a major risk, and we know index investors who give up completely.
That’s why three years ago we introduced the ETF All-Stars, our guide to the best ETFs available in Canada in each of the major categories. Whether you’re looking for equities or fixed income, you can use our picks to quickly narrow down your choices.
SUBSCRIBERS ONLY: ETF All-Stars 2015
Because ETFs are passive index-tracking funds, our selection process is different than it would be for actively managed funds, where the focus is on absolute performance. Our goal with the All-Stars is simply to identify the ETFs that are most likely to efficiently harness the returns of the markets they track.
To do this, we assembled a panel of six of Canada’s top ETF experts. We asked them to pick the top Canadian equity, U.S. equity, international equity and fixed income ETFs listed on the Toronto Stock Exchange, based on a few broad criteria. We nudged them toward broad-market ETFs that track traditional indexes, rather than niche products or those using more elaborate strategies, and we awarded bonus points to ETFs that are more tax-efficient. As always, a key factor was which ETFs could offer all of this for the lowest possible cost.
We’re pleased to present our 2015 winners in the “ETF All-Stars.” Some readers will notice that eight of last year’s 12 picks are back, and that’s by design. After all, we’re not looking for flavours of the month: we want ETFs that readers can buy and hold for the long run. Nor do we apologize for keeping the number of ETF All-Stars to 12 this year. After all, because of the vast number of holdings within each ETF, you only need between three and six of them to build a well-diversified portfolio.
Our expert panel is similar to last year’s, but with two important changes. MoneySense’s own index investing expert Dan Bortolotti, now an investment adviser at PWL Capital, has joined colleague Justin Bender as a panel member. And we have added a new panelist: Tyler Mordy of Hahn Investment Stewards. Mark Yamada of PUR Investing, financial planner Fred Kirby, and Alan Fustey of Index Wealth Management are back again to round out our lineup.
The industry underwent some changes over the past year, which you’ll see reflected in our winners. As Yamada points out, the ETF price war began in earnest in 2014. iShares Canada made the first move in March, slashing fees on several popular funds to as low as 0.05%. BMO ETFs followed suit a month later with similar cuts. That left Vanguard—the perennial cost leader south of the border—to play catch-up in October. Bortolotti reckons ETF prices are now down “about as far as they can go in Canada” as a result. (Note that we’ve referred to management fees here to make it easier to compare established funds with newer ones. Full management expense ratios, or MERs, also include taxes and a few incidental costs but won’t be known until a fund has a full 12 months under its belt.)
This year, in addition to the dozen winning ETFs highlighted in the chart, we discuss a few others that didn’t quite make the cut. While there was a remarkable degree of consensus on our main picks, it was by no means unanimous, so we’ve included a few extras that some panel members felt strongly about in the “Honourable mentions” sidebar on page 50.
If you’ve already built an ETF portfolio, don’t feel compelled to switch based on this year’s choices. “If folks own last year’s picks I suggest they hold on,” Yamada says, “New purchasers can consider the lower-cost alternatives.” Remember, paying transaction costs solely to gain a few hundredths of a percent in management fees probably isn’t wise. Selling ETFs is less costly inside registered plans, because there are no immediate tax consequences. But in taxable accounts, the possibility of crystallizing capital gains should make you think twice about switching.
Domestic stocks are a core asset class for Canadian investors, and this has been Ground Zero for the ETF price war. All three of our 2015 Canadian equity picks have rock-bottom management fees of just 0.05%. You read that correctly: a miserly five basis points, or roughly 48 times less than the average 2.42% MER for Canadian equity mutual funds (2013 data from Morningstar Canada).
Our panelists made a big decision this year to drop the country’s largest and oldest ETF—the iShares S&P/TSX 60 (XIU)—and replace it with the iShares Core S&P/TSX Capped Composite Index ETF (XIC). Their reasons? Following XIC’s recent price cut, XIU is now more than three times as expensive. And XIC is more diversified, holding some 250 stocks rather than concentrating in the 60 largest Canadian companies.
Those who prefer ETFs with a longer track record may prefer XIC, which has been around since 2001. But we’ll declare this one a draw with the Vanguard FTSE Canada All Cap Index ETF (VCN), which charges less than half of what it did a year ago. Launched in August 2013 and an All-Star last year as well, it provides exposure to the broad universe of Canadian stocks, albeit with a less well-known index.
For taxable accounts, the Horizons S&P/TSX 60 Index ETF (HXT) is back from last year and should appeal to investors who focus on large-cap stocks. But the main reason for holding HXT is its extreme tax efficiency: it uses an instrument called a “total-return swap” to defer the tax liability of dividends by in effect commuting them to capital gains that won’t be realized until you sell your shares. Launched in 2010, the fee on HXT is 0.07%, but after a rebate it’s 0.05%, an offer that will stay in place at least until September 2015.
Not much debate here: we’ve retained the Vanguard U.S. Total Market Index ETF (VUN) from last year as a top pick. With a management fee of 0.15%, it gives Canadians exposure to the entire U.S. market with a whopping 3,796 holdings, including a potential boost from its many small-cap and mid-cap stocks. (We say potential because in some years, including 2014, small caps actually detracted from returns).
If you’d prefer to focus on large-cap stocks, we’ve also recommended one of several ETFs tracking the popular S&P 500 index. Vanguard’s S&P 500 Index ETF (VFV) rolls in at a cost of just 0.05%. Panelist Tyler Mordy prefers it over VUN: “Granted, the S&P 500 is not a broad market index, but both indexes have nearly identical performance. Why pay more for the same results?”
Those who believe in reducing their exposure to the U.S. dollar can use currency-hedged versions of these two Vanguard funds (the tickers are VUS and VSP). But Mark Yamada says investors with a time horizon beyond five years should choose unhedged funds because “the cost of hedging can be high unless you have a view towards the currency.”
Fees continue to fall for ETF investors seeking international equity exposure. This year we’ve added a unique new product: the Vanguard FTSE All-World ex-Canada Index ETF (VXC). This fund isn’t even a year old, but both PWL panelists already recommend it for their clients, and the rest of the panel concurred. Talk about one-stop shopping: VXC holds almost 3,000 stocks in all major markets except Canada. Just over half is in U.S. stocks, so if you own VXC you won’t need to use one of our U.S. equity picks. Almost 40% is in international developed markets (Europe, Japan, Australia) and the rest is in emerging markets (such as China, India and Brazil). Justin Bender likes the simplicity of combining VXC with VCN and a Vanguard bond fund: “By combining just these three ETFs, a Canadian investor can create a passive portfolio that would make [Vanguard founder] John Bogle proud.”
For those who own plenty of U.S. equities, we’ve retained our two 2014 choices for international stocks. The iShares Core MSCI EAFE IMI Index ETF (XEF) provides exposure to developed markets, with a broad mix of large-cap, mid-cap and small-cap stocks. The related iShares Core MSCI Emerging Markets IMI Index ETF (XEC) does the same for emerging markets. (Note that 40% of XEF is in just two countries: Japan and the United Kingdom. Almost half (46%) of XEC is in just three: China, South Korea and Taiwan.) Last March, iShares added the name “Core” to these ETFs and slashed their fees to just 0.20% and 0.25%, respectively.
Since the financial crisis of 2008, the spectre of imminently rising interest rates has haunted fixed-income investors. But if nothing else, the post-crisis years have shown that changes in interest rates are just as impossible to forecast as the direction of stock markets.
Three of our four bond ETF picks are the same as last year. For investors looking to diversify with a single fund, we recommended the same two Vanguard products we featured last year. In this low-interest-rate environment, it’s particularly important that costs stay low, and Vanguard is the leader here. Long-term investors with no view on interest rates (call them fixed-income agnostics) may find Vanguard Canadian Aggregate Bond Index ETF (VAB) appealing. It includes 80% government and 20% corporate bonds with an average term of about 10 years and a fee of just 0.12%. Tyler Mordy likes VAB, but suggests the iShares Core High Quality Canadian Bond Index ETF (XQB) is equally attractive. “It’s tied with VAB for lowest MER, but tracks the most liquid Canadian bonds through the FTSE TMX Canada Liquid Universe Capped Bond Index.” But there’s an important difference, Bortolotti notes: XQB’s 40% exposure to corporate bonds makes it somewhat riskier than VAB.
If and when rates do start to rise, both of these funds will lose more than shorter-term vehicles will. If you want to reduce that risk, consider the Vanguard Canadian Short-Term Bond Index ETF (VSB). Kirby notes that it has an average term of just three years and a management fee of 0.10%.
While both of these ETFs make excellent core holdings, they should be held in an RRSP or TFSA. Like almost all traditional bond ETFs nowadays, these funds are filled with “premium bonds,” which were issued when interest rates were higher. Premium bonds are notoriously tax-inefficient, which is the main reason we dropped the popular iShares 1-5 Year Laddered Corporate Bond Index ETF (CBO) from our lineup.
This year’s All-Star list includes a unique new ETF designed specifically to address this problem. The BMO Discount Bond Index ETF (ZDB), launched in February 2014, provides a tax-efficient solution for non-registered portfolios. ZDB is designed to mirror the broad Canadian market with about 70% government and 30% corporate bonds and an average term of about 10 years. However, it buys only bonds trading at a discount, or less than their par value. While their total return should be the same as premium bonds of the same maturity and quality, discount bonds should incur less tax.
Also of interest to taxable investors, and returning from last year, is the BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR). Canadian preferred shares provide conservative investors with a bond-like investment that’s taxed favourably because they pay dividends, not interest. The holdings in ZPR keep interest-rate risk to a minimum by focusing on “rate reset” preferreds that can be reissued at higher rates when they mature. The ETF also divides the preferred shares into five equal “rungs” so they mature between one and five years from now, further lowering interest-rate risk.
These ETFs almost made it to our All-Stars (but not quite).
For those who are concerned about an overheated stock market but are averse to outright market timing, Fred Kirby suggests considering the newer “low-volatility” ETFs. For Canadian exposure, he suggests the BMO Low Volatility Canadian Equity ETF (ZLB), which holds 40 stocks deemed to have the lowest risk. For U.S. stocks he likes the BMO Low Volatility US Equity ETF (ZLU), which uses the same methodology and holds 100 companies. For international equities, Kirby likes the iShares MSCI EAFE Minimum Volatility Index ETF (XMI).
“These ETFs automatically position the cautious investor for any additional future gains without having to make a market-timing re-entry decision,” Kirby says. “This could be just the sort of compromise that lets some investors stick with their investment plans even when they do not want to.”
“Volatility drag is the culprit that impedes compounding of returns, so we like low volatility strategies also,” says Yamada.
Some panelists considered adding these to our All-Star list, but others found them to be too “active” and preferred focusing on plain-vanilla ETFs so we left them off.
SUBSCRIBERS ONLY: ETF All-Stars 2015
Our ETF expert panel
Justin Bender is a portfolio manager and Dan Bortolotti is an investment adviser at PWL Capital in Toronto. 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 co-chief investment officer for Toronto-based Hahn Investment Stewards, 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. Fred Kirby is a fee-for-service financial planner who writes an investment and retirement planning newsletter from the outskirts of Armstrong, B.C. Alan Fustey is a portfolio manager at Index Wealth Management in Winnipeg, and has been using ETFs with clients for more than a decade.