Investing In The Tide With ETFs

A rising tide lifts all boats, and a falling tide lowers them. So why not invest in the tide?

Much of the impetus behind the daily fluctuations of share prices is simply a reflection of whether or not people like owning stocks, as opposed to bonds, GICs or hiding their money under the mattress. Investors’ comfort level toward equities affects the share prices of all companies, well managed or not. If investors don’t like owning stocks, there is little point in trying to outperform the market by looking for “undervalued” companies whose shares trade at low multiples to their future earnings, nor in studying charts to spot price patterns.

To outperform the market, you have to a) identify genuinely undervalued companies whose prospects are better than other investors believe they are and b) other investors have to eventually recognize the company’s bright future and force up the price. Patience is essential since you must still own the shares if and when b) occurs. The plan is ruined if you panic and sell during a downturn, or if you die waiting for the rest of the market to recognize your prescience.

Outperforming the market is possible, however, if you assemble a portfolio of companies with dividend reinvestment plans, or DRIPs.

Dividend reinvestment plan members have several advantages.

1. As a DRIP member, you are a long-term, buy-and-hold investor unlikely to watch your shares every day. This alone gives you an edge, since you are less prone to selling at a loss at the first sign of trouble, nor to taking profits and losing out on a stock that has just begun a long climb.
2. Companies often offer discounts to DRIP plan members, allowing them to get more shares with their reinvested dividends than they would by buying on the market.
3. Shares bought with reinvested dividends every quarter are a form of dollar-cost averaging.

The total returns offered by the dividends, the reinvestment discount and the dollar-cost averaging gives DRIP participants an edge in trying to outperform the index.

There are still some investors who don’t have the time, money or expertise to buy individual stocks, however, so they can do the next best thing: Buy units in exchange-traded funds that match broad stock-market indexes, which do climb over the long run.

Canada has 55 equity exchange-traded funds, with offerings from iShares, Bank of Montreal, PowerShares, Horizons, and First Asset. BlackRock Canada’s iShares dominate the market, sponsoring eight of the 14 largest funds by market capitalization. We’ll look at a few of them here. 

BlackRock’s iShares family of Canadian equity ETFs include the XIU and XIC funds, XCG, XMD, XCS and XVX.

XIU: The largest Canadian ETF, the 15-year-old XIU fund, has $12.5-billion in assets and a low management expense ratio (MER) of 0.18%, but most importantly, it holds stakes in the 60 biggest companies in Canada. The fund’s 10 largest holdings: Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Canadian National Railway Co., Suncor Energy Inc., Canadian Natural Resources Ltd., Bank of Montreal, Enbridge Inc., Valeant Pharmaceuticals International and Manulife Financial Corp. These 10 holdings make up almost half the fund’s portfolio.

The 60 companies held in the XIU fund so dominate our economy that almost every other Canadian exchange-traded fund and large-cap mutual fund follows in the XIUs’ tracks: falling when the XIU falls and rising when it rises. When the fund’s 2.3% dividend yield is factored in, it is nearly impossible to achieve a better total return than the XIU without taking on more risk. A $10,000 investment in the fund when it was launched in 1999 is now worth about $30,000.

There are similar large-cap ETFs, like the BMO S&P/TSX Capped Composite Index ETF (ZCN/TSX), Vanguard FTSE Canada Index ETF (VCE/TSX) and the synthetic Horizons S&P/TSX 60 Index ETF (HXT/TSX). They hold roughly the same weighting of shares in the same companies with similar dividend payouts. As a result, their long-term chart lines are almost indistinguishable.

XIC: The $1.7-billion iShares S&P/TSX Capped Composite Index ETF (XIC/TSX), set up in 2001, is an excellent choice for investors who want broad exposure to the Canadian market combined with a tiny management expense ratio, in this case just 0.05%. The fund has 251 holdings, combining the same top 10 as the XIU fund with another 241 that make up the rest of the index.

A $10,000 investment in the XIC fund when it opened in February, 2001, would be worth about $25,000 today, thanks largely to a 28% gain in the past year.

XMD: Another iShares ETF, the $256-million iShares S&P/TSX Completion Index fund, established in 2001 (XMD/TSX), holds stakes in 191 companies, all members of the S&P/TSX Composite that are outside the S&P/TSX 60 index. The Completion Index fund carries a 0.6% MER. The top 10 names, which account for 19% of the fund: Alimentation Couche Tard Inc., Inter Pipeline Ltd., Fairfax Financial Holdings, Intact Financial Corp., Tourmaline Oil Corp., Franco Nevada Corp., Great-West Lifeco Inc., RioCan REIT, CI Financial Corp. and Power Financial Corp. Together with the XIU, the two funds cover off the entire composite index, but you may as well simply buy the XIC fund, which does this at a much lower cost.

XCG: The relatively small iShares Canadian Growth Index ETF (XCG/TSX), with assets of just $31.9-million, was set up in 2006. The fund, which carries a 0.55% MER, is based on the Dow Jones Select Growth Index, which in turn is based on criteria for identifying growth characteristics. XCG is relatively concentrated, with just 51 holdings and the top 10 of these accounting for more than 55% of its assets. The fund’s biggest positions are in Canadian National Railway Co. (11% of assets), Enbridge Inc. (9.8%) and Canadian Pacific Railway Ltd. (7.6%). Concentration is usually a good thing for a fund, but in this case, the half-baked effort to focus on “growth” companies has flopped, as XCG’s one-, three- and five-year returns are nowhere near as impressive as XIC’s.

Use Managed Funds To Invest In Smaller Companies

Investors focused on Canadian stocks should use exchange-traded funds with the lowest MERs to invest in large-cap companies, but consider actively managed funds, even mutual funds, if you want to dabble in micro-caps, start-ups and junior resource stocks. That’s because a professional fund manager can usually separate companies with genuinely good prospects from promotional junior stocks, which are essentially charities without the tax break. Of course, the more thought that goes into selecting the holdings in any fund, the higher the management expense ratio.

XCS: The $202-million iShares Small Cap Index ETF (XCS/TSX), which carries a reasonable MER of 0.6%, is an unmanaged index that holds stakes in more than 200 companies. Energy represents about 30% of the fund; materials 23%. Its top 10 holdings, which account for 14% of the fund: Air Canada, Secure Energy Services Inc., Capital Power Corp., HudBay Minerals Inc., Superior Plus Corp., Canadian Energy Services & Technology, FirstService Corp., Surge Energy Ltd., Rona Inc. and Nuvista Energy Ltd.

Units in the fund sold at $20 when the fund launched in May 2007, started falling immediately and reached a low of $9.14 in February 2009. They’re now back around the $18 mark. The fund had a banner year as of the end of July, up 27%, but it’s three-year return was just 1.4%, a reflection of the fact that an index ETF does not discriminate against questionable holdings.

XVX: The iShares S&P/TSX Venture Index ETF (XVX/TSX), set up in September 2011, focuses on the Canadian small-cap sector. It has only $6.8-million in assets and carries a relatively high (at least for an ETF) MER of 0.89%. The fund has 55 holdings, with about 45% of them in the energy sector and 23% in materials, or mining.

A $10,000 investment in the fund three years ago would be worth about $6,800 today, although it has managed a 20% gain over the past year. The fund’s top 10 holdings? Well, you probably haven’t heard of them so we won’t mention them here.

In the Canadian small-cap sector, the ability of fund managers to recognize and avoid stock promotions and other questionable investments often makes high fees worthwhile.

One of many examples: The $278-million HSBC Small Cap Growth Investor fund, launched in 2004, comes with a cash grabbing 2.27% management expense ratio. The MER would be absurd if the managers simply bought and held large-cap stocks - although many Canadians are sold costly mutual funds whose managers do just that - but in this case, the fund has achieved excellent long-term results. The fund’s top 10 holdings, which account for 34% of its assets: Canadian Energy Services & Technology Corp., Home Capital Group Inc., Constellation Software Inc., Stella-Jones Inc., Winpak Ltd., Stantec Inc., Equitable Group Inc., Delphi Energy Corp., Descartes Systems Group Inc. and ShawCor Ltd.

Summary

 The most likely method of outperforming the market is to assemble a diversified portfolio of dividend-paying stocks that offer dividend reinvestment plans. Participate in the DRIPs and hold the portfolio forever.

 Broad-based equity index ETFs with low management expense ratios are the next best choice, ensuring you will match the index.

 For those interested in small-company investing, a professionally managed fund is the best route.

Richard Morrison, CIM, is a former investment columnist.