The Canadian exchange-traded fund industry has expanded rapidly over the last several years. Assets under management (AUM) have swelled to more than $65 billion, nearly doubling over the past three years. As ETFs have grown in popularity, we have seen massive product proliferation (today there are roughly 300 TSX-listed ETFs) and a slew of new entrants in the industry.
Although a growing menu of choices and competition among fund providers are good for investors, the increasing complexity also poses a bit of a challenge for many investors. Namely, there is a heavier burden of “homework” to sort through the growing number of choices from an increasingly diverse group of providers.
ETFs have evolved well beyond traditional passive, market-capitalization-weighted indexes. The question is not only which asset class or segment would an investor like exposure to, but also how they would like to achieve that exposure. Along with the traditional passive options, investors can also select from a wide variety of strategy and factor indexes, including low-volatility, equal-weight, momentum, value, and so on.
Picking the right ETF can be a complicated process that often requires making trade-offs regarding liquidity, expenses and underlying index construction. An ETF that fits the profile for one investor may not be suitable for another. In an effort to help simplify the selection process, it can be useful to narrow down the available universe. Focusing on a short list of ETFs that cover all of the major asset classes should be much less intimidating. It also eliminates the risk of selecting a poorly conceived fund that is overly risky and unlikely to stand the test of time.
Investors can think of this list of ETFs as an “a la carte” investment menu, where the choices have already been vetted and tested for quality control. By design, the list is not comprehensive. The goal is to focus on the major asset classes that investors look to when constructing long-term portfolios. That includes Canadian, U.S., developed international and emerging market equities, as well as Canadian fixed-income. Within these asset classes, one solid strategy is to focus the lowest cost options that provide broadly diversified exposure to their respective asset class.
As a result, most of the ETFs on the list track plain-vanilla, market-cap-weighted indexes. That’s not to say that investors can’t build effective portfolios using more expensive ETFs that are actively managed or follow rules-based strategies. However, the aim of the list is to narrow the ETF universe down to the lowest-cost funds in the major asset classes, not to suggest certain market tilts or forecast which risk factors are poised to perform well in the near term.
Keep in mind that strategy funds can go through periods of strong performance and periods of underperformance based on the prevailing market and economic landscape. What works today may not work tomorrow. Investing in strategy or factor-based funds requires much more due diligence on the part of investors to understand the ins and outs of what drives performance. While traditional cap-weighted funds may not be the sexiest investments, they’ve proven extremely difficult to consistently beat over complete market cycles. Costs are one of the only things we have control over as investors, so we’re basically tilting the odds in our favour.
In addition to fees, a number of other factors were taken into consideration in order to create the list, including tracking efficiency, index construction, liquidity and diversification. Note that sometimes the cheapest ETF is not the most liquid, or the best constructed. Because there is no magic formula for how all of these factors should be prioritized, the final decision on whether to include a fund in the list is qualitative.
There are no leveraged, inverse or other speculative products on the list. While these products have their uses, they are not suitable as long-term portfolio building blocks. The list is designed with long-term investors in mind, not short-term traders.
There are also no U.S.-listed ETFs on the list. While Canadian investors can access U.S.-listed ETFs, which tend to offer higher liquidity and lower expense ratios, they often aren’t the best choice. This is due to currency conversion fees that can more than negate the benefit of a lower expense ratio. U.S.-listed securities must be traded in U.S. dollars, so unless investors maintain U.S.-dollar brokerage accounts, they will incur the conversion fees upon the purchase and sale.
iShares S&P/TSX Capped Composite Index
Management fee: 0.05%
This is the cheapest way to get domestic equity exposure. This ETF provides comprehensive exposure that goes beyond the S&P/TSX 60 Index to include mid- and small-cap stocks.
PowerShares FTSE RAFI CAD Fundamental Index ETF
Management fee: 0.45%
A fundamentally weighted option for those seeking an alternative to traditional market-capitalization-weighted indexes. Despite its higher fees, PXC has outperformed the “plain-vanilla” XIC by nearly 3% over the past two years, net of fees.
iShares S&P 500 Index ETF
Management fee: 0.10%
The cheapest ETF for U.S. equity exposure (iShares also offers XSP at a 0.10% management fee for those seeking currency-hedged exposure to the U.S.). The fund’s flagship benchmark tracks a quality portfolio of multinational firms.
Vanguard U.S. Total Market Index ETF
Management fee: 0.15%
The broadest and deepest ETF for U.S. equity exposure (Vanguard also offers VUS at 0.15% for those seeking currency-hedged exposure to the U.S.). The fund includes a healthy allocation to mid- and small-cap stocks, as it covers about 99.5% of the U.S. equity market, compared to the predominantly large-cap S&P 500 Index, which represents roughly 75% of the market.
iShares MSCI EAFE IMI Index ETF
Management fee: 0.20%
The cheapest and broadest ETF covering developed international stocks. Exposure to global currencies in this unhedged ETF could enhance its diversification benefits.
Vanguard FTSE Dev ex NA Index ETF (CAD-hedged)
Management fee: 0.28%
For those seeking currency-hedged international exposure, VEF is an excellent choice based on its low fees and broad portfolio. As of this writing, VEF was trading at tighter bid-ask spreads than XEF, making total all-in costs roughly equal despite VEF’s slightly higher management fee.
Emerging markets equity
Vanguard FTSE Emerging Markets Index ETF
Management fee: 0.33%
Currently the cheapest ETF in the category from an overall cost of ownership perspective. While iShares recently cut XEC ‘s management fee to 0.25%, that ETF currently trades at considerably wider bid-ask spreads, as it trades much less frequently, has a smaller asset base and holds a deeper portfolio that includes less liquid names.
Vanguard Canadian Aggregate Bond Index ETF
Management fee: 0.20%
Low-cost comprehensive exposure to the domestic fixed-income market, including federal, provincial and corporate bonds. BMO’s ZAG , which holds a blend of other BMO bond ETFs, charges the same management fee as VAB but has a slightly higher total cost of ownership. It is too soon to recommend iShares’ CAB , which recently changed its mandate and slashed its fee to 0.12%.
Vanguard Canadian Short-Term Corp Bond Index ETF
Management fee: 0.15%
Cheap corporate bond exposure at the short end of the yield curve. The aggregate bond portfolios are dominated by government bonds, so VSC can be a nice complement to bolster yield, while also reining in overall duration to protect against rising interest rates.
iShares 1-5 Year Laddered Gov Bond Index ETF
Management fee: 0.15%
A cheap fund for “safe haven” exposure to short-term bonds issued and backed by the government of Canada. Despite relatively low expected returns, the fund offers stability, a consistent monthly distribution and diversification benefits.
John Gabriel is an ETF strategist with Morningstar, responsible for Canadian ETF research.