Do XAW, VXC Represent Global Stock Market ?

Do you know what proportion of the global stock assets are represented by US markets? those in Canada? Europe? China? A surprising number of investors have either vague or out of date answers. This post will provide some data on the global equity space, along with reflections on how that might inform your investing choices.

While most investors exercise some degree of home country bias,  for a variety of good reasons, it makes sense to invest globally. In this posting I propose a simple idea: why not invest in different markets according to the size of those markets?

Some Data

The size of economies is somewhat different from the size of equity markets in those countries, and it is a good question whether we should use stock market or economy size. I will work with stock market valuations in this post.

There are about 60 stock markets globally, and their valuations are shown in a really nice data visualization here. You can get the raw data with the most recent statistics here from the World Federation of Exchanges.

Kim Iskyan wrote an article for Asia Wealth Investing Daily in November, 2016 that provides statistics (taken from Bloomberg) on the sizes and growths of different national stock markets, with a look at the top ten. You can read his report here courtesy of Stansberry Churchouse Research.

Not surprisingly the US stock market is the largest by a significant factor, at 36.3% of the total.   China was second, at 10.1%, followed by Japan at 7.9%, Hong Kong at 6.3% and UK at 4.6%. Canada, followed by France, Germany,  India and Switzerland complete the top ten.

 If we accept the premise of investing globally in proportion to equity assets, about 36% of your equity investments should be in the US, 10% in China (with another 6.5% in Hong Kong),  8% in Japan, about 3% in Canada.

The World It Is A Changing

The article cited earlier points out that a fairly dramatic change in the relative capitalizations of different markets is taking place.  For example, from October 2003 to 2016, the US stock market while increasing in an absolute sense, dropped as a fraction of global stock assets  from 45.2% to 36.3%. The big increases were all in Asia, with China going from 1.5% in 2003 to 10.1% in 2016, Hong Kong from 3.0% to 6.3%,  and India from 0.8% to 2.6%. Stock markets in Europe and Japan all fell as a global percentage. Interestingly the Canadian market, with a slight rise from 2.6% to 2.9%, was the only top 10 'developed' market to show an increase.

 Do XAW and VXC Represent World?

So how would you build an ETF portfolio consisting only of TSX listed ETFs that faithfully represented the entire global equity market. While specialized ETFs representing almost any market now exist, and you could build an ETF portfolio to almost exactly represent the world's equity markets, the MER would be high for so the many specialized products.

Most use ETF products like XAW from iShares or VXC from Vanguard Canada to represent most of the world.  These track different indices, with XAW tracking the MSCI while VXC tracks the FTSE global index.

Both XAW and VXC have excess weight on the US equity market, with XAW at about 54% and VXC at almost 56%, whereas the actual size of the equity markets suggest that only about 36% should be in US equities. Both under represent  emerging markets, with a total emerging market share of 11.5% in XAW and 7.8% in VXC currently. Note that VXC does not include any Canadian equity at all, so you should include at least 3% of your investments in a broad Canadian ETF such as VCN or XIC.

A simple way to make your global equity ETFs more representative of the entire world is to include about 20% of your holdings in XEC or VEE emerging market ETF (even though there are emerging holdings already in the XAW and VXC).  This would reduce the US holdings to about 44%, neareer to the 36.1% of the global equity assets, and similarly for other developed markets.

Another option would be to make up your global holdings using VEF (developed markets except the US, but including Canada), VUN (or some other widely represented US holdings) and XEC (or VEE) for the emerging markets component.  In this way you can adjust your US, other developed and emerging market holdings to the exact amounts you desire. If  Scotia iTRADE is your discount broker, VEF and XEC are both commission free to buy and sell, making this option even more attractive.  If you want to include China as a separate component, ZCH could be used, although remember you do have China represented in XEC or VEE. Also, the number of individual stocks within ZCH is limited.  If you want to add some Canadian home market bias (see below), XIC or VCN (or many others) could be added.

But I Want to Minimize Risk!

While it is natural to look backwards, as the excellent book The 3 Simple Rules if Investing reminds us: only look forward. It is true that volatility has in the past been greater in emerging markets. However, with high developed market equity valuations, unusually low interest rates, and political uncertainty in several developed economies, it can legitimately be asked whether the more governmentally controlled 'emerging'  economies such as China may offer lower future volatility.

Just as passive investors are urged to own all (or really a major part) of a domestic market,  it could be argued that the same principle would argue to hold most of the world equity assets proportionately in a global equity portfolio. 

Why Home Bias?

I'm sure they have been written, but I can't recall reading an investment commentary on the virtue, or lack thereof, of home bias.  This is a topic for a future column, but I considered reasons that you would want to show some home bias in your investments.

• Your income needs are related to the inflation rate in your home economy, so significant Canadian holdings make sense.
• As we argued in a post about holding individual stocks, it makes sense to invest in what you best understand, and that for most is the Canadian market.
• While government intervention is only one of many factors, it does influence the rewards and risks of different types of investments. You will understand the political climate of your own country best.

Only you can decide what amount of home bias you want to have in your investments.  It probably makes sense to have less home bias in your accumulation phase than in retirement when you are withdrawing regularly from your funds.

Concluding Thoughts

Of course there are good reasons to not weight investments only according to the relative size of that countries equity assets.  For example, risk will vary in different countries. Also, average valuations, as expressed by P/E or other measures, may be significantly different in different regions.  Also, we know the North American stock market much better, and that familiarity might help us make better choices.

You should expect more than a rule of thumb about what fraction to be held in Canada, US and internationally based on the situation of ten years ago.  Make sure that your financial advisor discusses international holdings, and in particular emerging economies, in a current, evidence based fashion. If you do decide to have extra North American assets, make sure that it is a deliberate choice.

The international ETF space continues to change, so make sure to investigate the holdings of each ETF with current data before you make any decisions. We will be reviewing emerging market ETFs in a future post.

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds the following ETFs mentioned in this article in one or more account I manage: XEC, XIC, VCN, VEF and VXC.  I use Scotia iTRADE discount brokerage services.  No compensation by any company has been offered, requested or received for writing this column.

Some Canada For Your Garden

It's about time we got down to some specifics in terms of what investments to consider for your funds garden. We will start with Canadian equity (stocks). using ETFs as our investment vehicle.

It is generally agreed that Canadian stocks should be a core component of a Canadian portfolio.  For most individual investors, rather than holding those stocks directly, it makes sense to use an ETF.

Another option would be Canadian stock index mutual funds, but that will result in a higher MER.  If you don't want to bother with a discount brokerage account, mutual funds might still be a good option for you. Also, if you are funding your investments in small amounts at a time, mutual funds will avoid the discount brokerage commissions on ETF purchases. We will cover Canadian stock index mutual funds in a future post.

Fortunately, there are a number of great Canadian stock ETFs with very low management expense ratios (MER).  At the time we are writing this (early March 2017) the information on the most popular choices in this category are given in the following table (click on it to make the image easier to read).

The Toronto Stock Exchange (TSX) actually has two branches. the main TSX which with 1561 companies listed, and a venture category for smaller and newer companies, that as of the time of writing, had 2424 listed companies.  You might be surprised by these numbers, since most financial news talks about either the TSX composite, that contains about 250 of the larger companies from the entire TSX, or the TSX 60 which, as the name implies, is the 60 largest companies.  As companies grow, or reduce in net worth, the exact companies on the two lists change slightly from time to time.

Is it better to hold an ETF that tracks the TSX 60 or the TSX composite? The advantage of the TSX 60 is that they are all large, for the most part very stable and well established, companies. This is very much a 'blue chip' list, and most of the companies are household names. It is important to realize that the TSX, and especially the TSX 60, is far from diversified, however.  For example, at the current time the three largest companies are all banks (Royal, Toronto Dominion and Bank of Nova Scotia), and together they account for almost 24% of the entire TSX 60 value!  Even in the broader TSX composite, these three companies represent nearly 18% of the index value.

The main Canadian stock ETFs track either the TSX 60 index or the TSX composite index. From the ETFs shown in the table, VCN, XIC and ZCN track the composite index (or a slight alteration of it), while HXT, VCE and XIU track the TSX 60. As you can see, competition in this investing space has resulted in very low and similar MER of 0.06 on most products (XIU being the exception).

If MER is not a distinguishing characteristic, how do you choose between the ETF options?  The simple answer is that the products are very similar, will yield nearly the same performance, and really you should not worry too much about which to choose.  

There is one significant difference between HXT and the other offerings in the table, however.  All of the others hold the actual TSX stocks. That is, they take the funds invested in the ETF, and then buy proportionately the different stocks in the index.  The down side of this is that when the index changes, the fund will need to do a bit of buying and selling, triggering some capital gains, and for short periods of time drifting very slightly from the index. The plus side, though, is that you really are owning the actual stocks by holding the ETF. 

The HXT product is an example of what is called a swap-based ETF.  Rather than buying the stocks, it gives the money to a bank that agrees to return to HXT the return of the TSX index over the period of time. The process is well explained in this post from the Canadian Couch Potato site (note the MERs have changed in the several years since that post was written, but the explanation of how the swap works is still valid). 

There is an important tax (and income) difference that should be understood as you make the choice between HXT and one of the other Canadian index ETFs.  No dividends are paid by HXT, although they are worked into the appropriate changing price of the ETF.  This means that swap based products are not good choices when you want a regular income stream.  There is a potential tax advantage, though, in that you do not need to pay annual tax on dividends earned. It is important to realize that you will still be taxed, but as a capital gain when you sell your units of HXT. What you are really doing is deferring the tax, and it will appear as a later capital gain rather than as a regular annual dividend. Whether this is a positive or negative will depend on your personal financial situation.  Swap based products are good if your income from other sources is variable, and you can cash in the  HXT units in a tax year when your other income is relatively low.

For any ETF, a consideration is how widely traded the product is.  We have shown (using data from morningstar.ca) the mean daily volume of each ETF.  For example, the mean number of units of HXT that traded in a day were 212000 (we have written this as as 212k, with k meaning thousands, in the table).  We also show the total assets held in each of the ETFs - e.g. ZCN has about 2.4 billion dollars invested in the fund.  Both of these numbers will change over time, so you should check for current values if this information is important to you. These are all pretty widely held, however, and the concerns about specialized ETFs that are only lightly traded do not hold for any of these products.

 I have also included in the table (using morningstar.ca data) the spread between the mean ask price at which the ETF is offered for sale, and the price being bid by someone looking to purchase the ETF.  A smaller spread is desired, since that implies it will be easier to quickly buy or sell the ETF without paying a premium on the transaction. Naturally widely held ETFs with high daily trading volume are generally expected to have a lower spread. The figures here represent a snapshot at the time I am writing this post, and would change from day to day according to overall trading volume and other factors.  By showing patience and using limit orders you can usually get a stock or ETF at a fair price.

Some of these products have been around much longer than others - e.g. iShares XIU entered the Canadian ETF space earlier, as one of the first Canadian ETFs, and that largely accounts for the fact it has much more money in assets.

If you use Scotia iTRADE as your discount brokerage, HXT can be bought and sold without commission.  I believe that QTrade Investor and Virtual Brokers also offer HXT without commission, but check with them to be sure.

Personally I prefer the slightly broader holdings of the composite index. Within that space I see little difference between VCE, XIC and ZCN - I personally use XIC, but that is mainly because I was invested in XIC units before the other two started operation.  I do like for some accounts (e.g. my TFSA) the swap based HXT. Also if I am investing in small amounts. I use HXT since it is commission free in my Scotia iTRADE account.

There are a number of other ETFs that operate in the Canadian equity index space, and we may cover some of them in future posts.  For most investors, however, we feel that one or more of the options shown in the table would well serve your needs.

You should discuss with your investment advisor which of these products are best for you, and have her/him explain in more detail the implications of swap-based vs. directly held ETFs. Your investment advisor can also help you determine how much of your portfolio to hold in Canadian equity ETFs or mutual funds.

Before ending this posting I want to stress how incredibly low the MER are for these products.  You can have $10000 invested across about 250 different companies in the composite TSX index, and your annual fees are $6.00.  That is truly good news for investors!

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds the following ETFs mentioned in this article in one or more account: HXT, VCN, and XIC.  I also use Scotia iTRADE discount brokerage services.  No compensation by any company has been offered, requested or received for writing this column.

When is the MER not what you think it is?

Although I don't follow the model portfolios exactly, I am a big fan of the principles of the Canadian Couch Potato. It has demonstrated the virtue of staying invested in a diversified, low cost, small and easily understood set of broad index funds.  It is called couch potato since you rebalance about every year, but otherwise just leave it alone. The simple couch potato portfolio has had solid performance and limited volatility over the long run, bettering many mutual funds, all with very low fees.

I suspect most readers are already very familiar with the Canadian Couch Potato  but in case you are not, I urge you to regularly consult their website, and to give full consideration to their model portfolios. Recently they have also started a podcast series that I also recommend.

The folks at Canadian Couch Potato have model balanced index portfolios for conservative to aggressive investors. They show how to implement them using ETFs, Tangerine investment funds, or TD e-series products. Interestingly, the long term performance only varies slightly across the different risk portfolios, but that is a topic for another post.

The other day I was examining their ETF based model portfolio (see screen capture below), and I was struck that the values they gave for weighted MER for each portfolio seemed too low to me.

Screen capture (Feb 2017) of the Couch Potato model ETF portfolios. Note the weighted MER line.

Although I don't hold the BMO bond ETF ZAG, I had recalled that the MER for it was 0.23%, and I knew that the Vanguard Canada broad Canadian equities ETF VCN (which I do own) has a MER of 0.06% and the iShares All World Except Canada equity ETF XAW (which I also own) has a MER of 0.21.  Even without a calculator, there was no way, using these numbers, the weighted average MER on the conservative couch potato portfolio would be only the 0.12% stated.

Just to be certain, I first checked with both morningstar.ca and with BMO directly, and sure enough both currently (late Feb 2017) give 0.23% as the MER for ZAG. I proceeded to calculate the weighted MER for some of the portfolios using that value, and for the conservative model portfolio it was 0.209%, versus the Couch Potato value (see screen shot above) of 0.12%, while for their balanced portfolio, with 40% Zag, 20% VCN and 40% XAW, I calculated a weighted MER of 0.188 versus the stated value of 0.14.

I could see from the weighted MER values in the model portfolios that the difference must be in ZAG, since the differences were higher for the portfolios more highly weighted in that, so I dug around a bit more. The ZAG MER value that they used in their calculations was 0.10%, not 0.23%, I was able to determine by backward engineering from the weighted MER. If I assume that value for the ZAG MER, I obtained 0.118 for the conservative portfolio and 0.136 for the balanced one, both consistent with the weighted MER given on the Canadian Couch Potato site. So you ask, which is the correct value for the ZAG MER, 0.23% or 0.10%?

The stated MER for funds is normally obtained from audited financial statements.  Of necessity that is based on results from the recent past, since the auditors only get to work after the financial documents for the financial year have been completed. In the BMO ZAG case an asterisk notes that the MER is based on the 2015 year audited statements.

Since that time, BMO have announced lowering of management fees on a number of their ETFs, including this one. For ZAG, they lowered the management fee to 0.09, and they estimate that that will result in a current MER of about  0.10. Problem solved.

There are several implications for investors, however. The true MER is based on audited financial documents.  Since management fee is the dominant component of most ETF MERs, if that is announced as lowered, we can expect the MER will drop by a similar amount. For most ETFs the MER is pretty stable from year to year.  If the MER has dropped significantly, we need to evaluate whether we are confident that it will stay at this lower value, and if the return of the fund will change due to the different amount of investment advice, supposedly related to the management expense.

Secondly, when making long term ETF choices and comparing similar products, it is important to go beyond the stated MER, to make sure that there are not significant recent changes that will influence the current and future effective MER. For example, with the previous MER for ZAG, it appears obvious that the similar bond ETFs VAB from Vanguard Canada and XQB from iShares have lower MER values.  That situation is reversed, however, with the lowered management fees for ZAG.

While the MER is to be based on audited statements, the management fee can be adjusted to the current value.  An easy way to check if there has been a significant change is to examine both the MER and management fee for the fund you want.  Normally the management fee makes up most of the MER.  If they are very different, check around for announcements of recent management fee changes, and in particular check company statements about whether the lowered fees are temporary or a long term change.

Some readers will correctly point out that the difference here is small enough that it may well be lost in your overall financial fees.  If you had invested $10,000 in ZAG the difference per year in the two MER values would be $13.

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds the following ETFs mentioned in this article: VAB, VCN, XAW and XQB.