[Building an Exchange Traded Fund (ETF) Portfolio]
October 18, 2017
[Learn basic strategies for using Exchange Traded Funds (ETFs) to build an investment portfolio.]
[This event will begin shortly.]
Hello, everyone. Thank you for taking the time to join us today. On behalf of CIBC Investor's Edge, I would like to welcome everyone to the Webinar with Mark Noble. My name is Ammar and I will be your host for this event. Now just a few things to note before we get started.
CIBC Investor Services Inc. does not provide investment or tax advice or recommendations. So everything we share today is for education purpose only. We are recording today's session and a replay will be available on our website. You will find the link to the replay on our homepage.
Also, if you wish to view this full screen, you may do so by clicking on the expander arrows located on the top right-hand corner of your screen. And should you have any questions during the presentation, please take note you will have the opportunity to submit your question after the presentation.
[SPEAKER Mark Noble, Senior Vice-President, Head of Sales Strategy, Horizons ETFs Management (Canada) Inc.]
We are very excited to present Building an Exchange Traded Fund Portfolio where we will cover the importance of asset allocation, different ETF strategies, and also some tips when buying or selling ETFs. We are thrilled to have Mark Noble as our speaker. Mark is Senior Vice-President and Head of Sales Strategy for Horizons ETFs. Mark has worked with various teams of Horizons ETFs to build client education tools and initiatives that help Canadians become better investors. And previously, Mark was a personal finance journalist at the Advisor Group. With great pleasure, please join me in welcoming Mark Noble.
Thank you so much, Ammar.
[HORIZONS ETFS BUILDING A BETTER PORTFOLIO USING ETFS]
It's a real pleasure to be here today and I'm really excited about this presentation because this is probably my favorite presentation to give as it kind of runs through basically the basics of how to become what I hope is a better ETF investor. So where I want to go with first is just say, first of all, congratulations. Congratulations because you're taking the first steps of what I'm hoping is a really positive investment journey as an ETF investor. And we're gonna go through... I'm just gonna pull the slide up here.
We're gonna go through a number of topics here today.
So we have a pretty packed agenda for the next 40 minutes. But my goal here is, at the end of this presentation, you should have a greater comfort level with looking at ETFs, determining if they're better for your portfolio than other securities, and hopefully, have a greater comfort level in understanding how they work and where they fit in. So our first item on this is gonna be what is an ETF? I'm assuming some of you here today, we have quite a few people on this Webinar are new to ETFs, I will go over what is an ETF and the basics, then we're gonna talk about the single most important aspect of this presentation which is asset allocation. So if you can, stay on at least for number two because that's really gonna get to the core of what we're talking about today. And then we'll talk about ETF particular features such as fees, types of ETFs that are out there, the types of considerations for fixed income and equity, and then we'll finish it up with some trading tips.
[EXCHANGE TRADED FUNDS]
So what is an ETF? Well, many of you may not be aware that ETFs are actually a made-in-Canada invention invented in 1990. The first ETF was listed on the Toronto Stock Exchange and covered the 30 largest stocks in Canada as an index product. Since then ETFs certainly a lot more successful than other Canadian inventions such as the Avro Arrow. They've gone on to represent roughly $4 trillion in assets globally and have become probably the fastest growing investment product structure in the world. What is an ETF though really? It's a type of technology. So the analogy I like to use with ETFs is I like to use the digital music as an example. So, you know, many of you are familiar that for many decades, vinyl records were the most popular way to get access to your favorite recording artists. Then we had CDs, they were a little bit easier, allowed you to port in some features, maybe even copy them for friends. And of course, most music today is done through digital distribution. Now for ETFs, it's a similar sort of concept in that the content that is the investment strategies that you can execute in an ETF are the exact same as they would have been done originally with stocks or mutual funds. I would just argue that ETFs probably make it a little bit more simpler and straightforward, which is why they've become more popular. I also like to use the analogy of music is because last year actually the fastest growing segment of music purchasing was actually vinyl records, people going back to records. And what I want to highlight with today's presentation is that this isn't about taking all of your portfolio and buying ETFs. In fact, there may be some things you like to do with mutual funds and stocks, so there's a place for them all. Really what ETFs are is they are a type of delivery mechanism for investment strategies. Now we refer to ETFs as an open-ended investment trust, an open-ended investment trust, this is really the key invention that occurred here. It means that the units, the underlying securities held within an ETF reflect the value of the price of that ETF. That is the price of the ETF represents the underlying value of the securities it holds. That was the "aha" moment for ETFs because up until that point the only securities that you could buy that did that were mutual funds. But mutual funds, you had to buy at the end of the day through a broker and usually directly from a fund company whereas ETFs trade just like a stock. So you can purchase them throughout the day any time and they have a listed symbol similar to a stock, and they can be bought through any type of brokerage account.
ETFs have also seen the rise occur with the growth of what we call passive index or benchmark investing. Index investing would be for example, the widely followed in Canada S&P/TSX Composite Index that we always see on the nightly news, that's of course, just an index of the largest stocks in Canada weighted by how large they are versus each other, so the largest stocks are the biggest holdings. That type of passive investing has become a huge growth area for investors globally. And ETFs are probably the lowest cost way to do this, so the growth of ETF investing has really followed the movement towards lower cost investing.
[HOW MUTUAL FUNDS WORK]
Now to understand how an ETF works, I just want to quickly talk about how mutual fund works because as securities go, they're probably the two most closely related strategies. Mutual fund is a fairly simple process. What ends up happening is you find a mutual fund you want to buy, let's take Canadian Equity for example, and you go through and you find that fund and you put in your order. Pretty simple for you as the investor, you've put your money and you've put the order in, and what ends up happening is that order is routed through the fund company, and the fund company then is responsible for going to the stock exchange to buy those securities, those equities in that Canadian Equity ETF and then building you the units and giving them to you at the end-of-day net asset value. When I refer to the word net asset value or NAV, I'm referring to the market value of the underlying securities of that product. So the aggregate value of all those securities or stocks, when I take them and put them in proportion of a unit that has a net asset value per unit, so you get those at the end-of-day net asset value after the market closes, the next day you've got your mutual fund units. Very simple solution for investors who want to buy a diversified portfolio of securities, but it comes at a cost because you're basically, through your fees, having to pay for this fund company here to build all these for you.
[HOW ETFS WORK]
With ETFs, it's actually a more complex strategy in terms of understanding how it works, but it creates cost efficiencies and flexibility for the investor. So instead of having that mutual fund company there buying and selling the securities for you, what ends up happening is you as a buyer buy from the exchange. Now something can happen here. If there is enough outstanding inventory of an ETF, think of it similar to a stock, you may actually just be buying from other people on the exchange. That would be the posted volume that you see on your CIBC Investor's Edge screen. All that volume is available for you to buy and sell directly. So there's no cost, no one has to go and buy anything. It's literally almost like an eBay exchange if you want to think about it where the seller will sell you the units of the ETFs, and obviously, there's a market value that's determined by the brokerage. If new units of the ETF need to be created, this is the important part, the open-ended aspect that allows the ETF value to reflect the underlying value of the securities. There is a market maker, these are huge massive financial institutions in the capital markets of Canada that will go and create these units for you from the ETF provider. So that's where the ETF provider and these market makers will either redeem some of these ETF units for cash if someone is selling or they will create new units and put them on the exchange for people to buy. So you as a buyer here could either be buying from other sellers or you could be buying from a market maker, but all of this keeps it so that you're open ended. So that's the technology aspect, that's what ETFs are. And ETFs hold could be a wide range of things. We have over 600 ETFs now in Canada and they cover everything from equities, fixed income, commodities, alternatives, and even more esoteric asset classes now such as volatility, even marijuana stocks, I'm sure Bitcoin will be down the line, all these things are available through an ETF wrapper.
[WHAT MAY BE THE MOST IMPORTANT PORTFOLIO DECISION YOU CAN MAKE?]
So we've discussed what ETFs are, hopefully everybody understands the technology of ETFs. Let's get to the real meat and potatoes of this presentation. You know, I'm gonna ask a question, what may be the most important portfolio decision you can make? And, you know, there's a lot of questions, is it to find undervalued securities, do you want to buy low-fee investments, maybe more real estate, I mean, Canadians could always use more real estate I guess. Maybe find investments that earn a high income. Maybe you need to pay, you know, large bills and you want something that just yields you and income and you don't need to worry about where that comes from. Maybe you need to hire an advisor? I hope that that's not the case here. Everyone's, you know, taking this journey to be a direct investor through CIBC Investor's Edge. Well, really I'm going to tell you right now, the answer to this is none of the above. If these are some of the things that you're using to make your first line investment decisions, you're missing a very, very crucial step to being a successful investor. In fact, the first question that I always pose to investors is what is your asset allocation?
Okay. And asset allocation very simply means the mixture of assets that you have in your portfolio. Now even before we ask what asset allocation is, what is obviously the returning goals and objectives that you have as an investor? I can't answer that. They range for everybody. People who have lots of money may want to be, you know, in higher riskier investments to have discretionary spending, some people may be funding retirement, some people may be saving money for their kids. I don't know what that is, those returns and objectives have to be determined by you. But we can have a more universal discussion of what is asset allocation. So I've got a picture here from the great Gary Larson of The Far Side cartoon. And he's got that really important poster up for this gentleman which says, "First pants, THEN your shoes." I don't know if any of you have ever walked out the house without pants on, but generally speaking, if you go out into the marketplace and start willy-nilly buying securities without an asset allocation plan, that is effectively what you are doing. So the most important investment decision is to make sure that you have a broadly diversified portfolio across a number of asset classes. And then all other investment decisions such as what securities to own, finding, you know, fees and whether it's ETFs or mutual funds, all of those are secondary. So I'm gonna say something that may come of a bit surprise for someone who works in the ETF industry, but if you get your asset allocation right and you do that with mutual funds and stocks, you're doing most of your job right already, okay? Your decision to buy an ETF comes after we determine what is the appropriate asset allocation for you as an investor. And I'm gonna just highlight why this is important. This is obviously an academic thing right here, it's called the Brinson, Hood & Beebower study.
[OBSERVATIONS FROM BRINSON, HOOD & BEEBOWER (BHB)]
It's sort of akin in the investment world to some of the work that in physics Einstein would have done on gravitational waves and E=MC-squared, it's become sort of a maxim for investment strategists to follow and understand that if you do the math on where the majority returns have come from for portfolios over their longevity, it comes from this asset allocation, it comes from the mixture and diversification within asset classes, very simply, for example, how much stocks you own versus bonds and cash and alternatives is a more important investment decision than what you own within those buckets. So, for example, if you own TD and RBC, they're both Canadian bank sector stocks, owning one or the other is not as important decision as determining to own bank stocks as it is important to own Canadian equities as it is important own equities over bonds. Those are asset allocation decisions, and we see that 91% of the variance of returns of a portfolio, that's an academic term, but it just means the drivers of return, comes from this. And this is a landmark study done in early 1980s, and it's been subsequently, you know, stress tested by follow-up academic studies by other professors in finance and institutions and they always come to sort of a similar sort of conclusion that this asset allocation is your most important decision.
[WHAT IS THE RIGHT ASSET ALLOCATION?]
So, of course, the next question is what is the right asset allocation? Well, the most important factor in your asset allocation is actually your risk tolerance. It's how much are you willing to lose, not how much are you willing to gain. Of course, we would all like to gain as much as we could. That's a very simple answer. How much are you willing to lose? And the way that asset allocation is done at most financial institutions is determined based on your age. The reason that is if you look, and we'll use the financial crisis as a perfect example, the biggest financial loss last 70 years occurred between 2008, 2009. However, had you stayed invested through equities through that, you saw a 300% return in your equities since then if you, you know, remained primarily in North American equities. So what happens is time is your friend as an investor. As you have a longer time horizon, you can absorb big shocks in the market and over time still have compounded growth to meet your returns. But as you age, the amount of shocks you can have to your portfolio declines significantly because you have a shorter amount of time before you have to transition your portfolio probably towards income, right? If we think about what is the point of our portfolio, at some point, I'm hoping, it's to actually have it pay for things whether it's fund retirement or discretionary expenses, which means it transitions to a portfolio where you're gonna be taking out money, you're gonna be using it to fund things, which means that it's not gonna grow anymore, it's gonna be declining in value as you take out of it. As you move towards that transition of taking out, any kind of large losses in the portfolio reduce the longevity of that portfolio. You have less money to take out and less time for it to grow back, so you have less money overall over a time period. And it's very funny, we refer to it in our financial services industry as 60/40 portfolio. You'll hear this term quite a bit. And what you find is that most portfolios are an iteration of a 60/40 portfolio which is 60% equities or stocks and 40% fixed income in bonds, and that's really because the average investment time horizon for most investors tends to be around 15 years.
So if I think of a 60, sort of 55 or 60-year-old investor, they tend to have the 60/40 portfolio because longevity of their portfolio is usually somewhere around 15 to 20 years. And if I look at the math of the transition, it means usually having equities, 60% equities to allow me to continue to grow the portfolio and 40% income to allow me to protect the portfolio is sort of what's used as the baseline determinant. And, you know, it's a simple metric and it actually works quite well. If I look over most time periods, people who have a 60/40 portfolio with 15 years to retirement generally meet, you know, their performance portfolio objectives. But basically what I want to highlight here is I don't know what the age of the people on the call, on this Webinar are, but you need to be determining when you want to draw out your portfolio. And the shorter the time horizon to when you want to draw it down, the greater amount of fixed income you want to have. And I was in the Globe and Mail recently having this conversation with the financial editor there. And, you know, he was asking, you know, "Well, if people want income, should they be worried about low interest rates?" Actually the main reason that you hold bonds in the portfolio is to absorb the shocks of a sell off. What we historically see is that treasuries in high-investment grade bonds do better in a sell off. So the reason you're holding bonds is not so much the income component but to protect your portfolio as it nears that draw down date.
[ETFS & ASSET ALLOCATION]
Now there's different types of asset allocation that you can do, and I'll go through these quickly. The most basic one is called strategic asset allocation. Strategic asset allocation just simply means that you've picked a set of assets that work for the longevity of your portfolio, and therefore, you're gonna keep it at that, and whenever there's a big rebalance, so when you're putting money in there or SPCs in or through your dividend reinvestment plan, whatever strategy you do to put more money in the portfolio, you rebalance it accordingly to that fixed mix. Surprisingly enough, this works quite well for a lot of investors. A great place to start to look at where this would be something like, Canadian Couch Potato. I have no affiliation with them whatsoever, but those are strategic asset allocation portfolios where they just choose an asset allocation based on historical metrics and you purchase ETFs accordingly or assets accordingly to fit that asset mix and you don't touch it
We also have what's called a tactical asset allocation. You don't need to worry about the ETFs that are down there, but the point is tactical asset allocation is when you take a more active approach to position a portfolio and make changes. And I'm not telling you whether to be passive or active to your allocation, some people like to make changes to their asset allocation based on what they see in market moves. And there's nothing wrong with that. It is a type of market timing, so it's riskier. But tactical asset allocation means that, you know, for example, right now with interest rates starting to rise, maybe fixed income is riskier than it has been, maybe you want to take some of that off and buy equities, maybe you feel energy prices in equities or energy prices are gonna support energy equities and you want to add some more of that, so you can have a tactical allocation. It still should follow some sort of baseline allocation based on your age, but you can move the underlying securities to sort of fit where you want to go. And then the version I find that a lot of direct investors actually tend to use with the online brokerage, and it works quite well if you're a direct investor, is a core and explore model. And very simply, the core model would be your core portfolio is a strategic asset allocation, this is money that follows a hard discipline and follows a rigorous asset allocation that works for you. But what kind of fun is that, building a portfolio that you're not gonna want to touch when you're spending this time trying to become a better investor? And I do use the word fun because as you learn investing, you know, you become more capable at it and you become a little bit more comfortable in determining, you know, things you'd like to buy. But we also know that we don't want to augment that discipline of when we choose to be drawing down on the portfolio or what our risk and return goals are, so core and explore means that your core is your fixed strategic asset allocation, and then in the explore, this is where you have money that maybe you could potentially stand to lose, again, remember risk is the determinant in your asset allocation, stand to lose, but you can buy some of the things that you think may offer some interesting returns. You may want to buy some of those energy equities or some of those new emerging technology stocks, maybe you want to buy hedge funds or real estate, these things can augment your returns to your core. So core and explore fund is usually the portfolio strategy, I'm not telling you it's portfolio strategy you should do, but it's one I find a lot of direct investors use because you've taken the time to become a better investor by empowering your own portfolio, taking control of your portfolio, and you want to, you know, unleash some of that skill that you've learned through the brokerage, and therefore, you use this strategy.
Now the key to asset allocation is diversification. And I'm gonna just explain why diversification is important.
[PITFALLS OF 60/40 INVESTING - ILLUSTRATIVE EXAMPLE]
And here's that 60/40 portfolio, that default portfolio that you tend to get put in if you go to most bank brokerages, usually it's an iteration of this, and I said it works quite well. It's a great sort of standard rule, general rule for people to invest it. But the point is that it doesn't always have the same amount of risk. So if I look at this from March 2002 to March 2016, this is an illustrative example, I see that generally speaking about a 60/40 portfolio, my risk was sort of in the same range, right? So the portfolio was doing what it was supposed to do. But then we see what happens in the financial crisis and we see that I had a 25% standard deviation which probably led to losses in my equity portfolio of over 40%. That's fine if I'd been a, you know, 35, 40-year-old investor who had 15 years more to reach the 60/40 threshold to get it back. But it's a real cruel irony that if I would retired in 2002 and I met my objectives, but if I had to make retirement or transition my portfolio to the drawdown phase in 2009, I've lost years and years of returns that have been lost to this equity pullback, you know everything came back. So understanding this risk means that you need to find asset classes that are going to work in these huge drawdowns, particularly big equity market sell offs because if you're 60% equities during a big sell off, well, guess what, 60% of your portfolio is gonna lose a lot of money. So you need to find diversification in asset classes that are gonna work for you.
[THE NEED FOR DIVERSIFIED ASSET CLASS EXPOSURE]
And here's, again, just explaining, you know, this idea for need for diversified asset class. So if I came to you and said, I'm gonna give you a portfolio that has global equities, which is the MSCI World, tech equities or NASDAQ, Canadian equities and corporate bonds, you know, well, you might think, "Wow, that sounds like a diversified portfolio." But here we see that on the equity bucket basically if there's a sell off, correlation of one means they move in the same direction, these are all gonna lose money at the same time and they're gonna make money at the same time, but they're gonna lose money at the same time. And you only have a few asset classes, gold, you know, the Barclay CTA hedge, which is like a hedge fund index of managed feature where you have less correlation. So really you may think you have diversification in your portfolio but you don't, and we're seeing that actually increases. More money in technology comes into the global capital markets, we're seeing more asset classes move in the same direction, and that's very true with equities. And the fact of the matter is, I mentioned TD and, you know, Royal Bank, both moving in the same direction, well, the same thing could apply to TD and Royal Bank and banks from Europe and those stocks moving in tandem basically with the rest of the market. In fact, if I look at what has driven returns in the North American equity market this year, it's about 8% of the stocks, right, a lot of what we call the FANG, Facebook, Amazon, Netflix, Google, those stocks have driven huge returns and have driven most returns up in the index, but it's been a small breadth of stocks and everything kind of moves in tandem with it because they're all part of the same index of equities. So correlations are high, which means you need to find some diversification particularly as you near retirement.
[WHAT DOES A DIVERSIFIED PORTFOLIO LOOK LIKE?]
Now what does a really diversified portfolio look like? This is a portfolio that you would never want to execute as an investor because you have a short time horizon. But really if I had an unlimited time horizon, which is what an endowment fund has, this is probably what a diversified portfolio would look like. And this is the most famous endowment fund in the world. This is the Yale Endowment Fund. The Yale Endowment Fund is run by a very famous investment strategist named David Swenson. And as you can see, on a 10-year basis, he has generated 8.1% annualized returns, which is a terrific overall absolute return over a long period of time like that. What you'll notice here is he doesn't have a lot of equities. He has only 4% equities and only has about 5% fixed income, and he has all kinds of other asset classes that, you know, are somewhat hard to get access to as an ETF investor. There are alternative ETFs you could use to get some of these asset classes, but this endowment fund is supposed to last forever. And as a result because you never know when it's gonna need to be drawing down from it, they have this maximum diversification. Again, I wouldn't say this is not something that is potentially gonna fund your retirement, but it gives you an example of how people think about diversification. And as you can see, these two smallest buckets of asset classes that they have in this portfolio are probably the two largest buckets that you as an individual investor have which are stocks and bonds. So something very important to keep in mind that as you build your portfolio, look at things that may not work well in an equity market horizon, but you do want to have some things that are gonna protect the safety of portfolio particularly as that portfolio gets closer to its drawdown phase.
[THE IMPACT OF LOW FEES]
The other second aspect, that's asset allocation, and you notice I really didn't talk about ETFs at all because that's basically basics of building a portfolio. And so I'm really, you know, if you leave now... Please don't leave now, but if you leave now, I feel good that you've got that real core there and I feel like you've already starting off the better journey of being a better portfolio investor, building a better portfolio. But now we're gonna look at some of things that are more related to ETFs, and the big one is impact of management fees. So if you recall I talked about how most investments have a very high correlation to each other especially on the equity side, they tend to deliver returns that are very similar to the indices, which is why it's driven people to move towards index ETF products.
[THE COSTLY IMPACT OF HIGHER MANAGEMENT FEES]
You can't control what those returns are going to be. At the end the day, we can't control things like government action that can affect, you know, equity valuations. We can't control, you know, which companies are gonna to be profitable. Those things are out of your control. You can obviously do balance sheet analysis of stocks to figure things out like that. But generally speaking, most of that is out of your control. What you can control is the amount of money you pay to access an investment. So if we know that and then we use the equity or stock example, if we know that most equity products move fairly correlated to each other, then I know that one of the ways that I can generate longer returns over time is actually to reduce the fees I pay to get access. And so one of the big reasons that ETFs have taken off is that they generally have fees that are around average equity ETF in Canada is around 35 basis points, 0.3%, whereas the average mutual fund is around 1.5% for F-class, right, so taking out advisor compensation. So if I have those two kind of examples, here I'm using slightly higher example, but 1.6 to 0.5, and these two securities effectively do the same thing. Well, you make significantly more money being a lower cost product, so in this example, I'm just using a 10-year example here, if I invested $100,000 in a product that generated a 4% return, so not a huge return, that's almost fixed income returns, and I pay 50 basis points, my return is about $141,000. Now if I buy the exact same thing but now I pay an additional 1% or so, the difference between what we see in the mutual funds and ETFs, I see that my return is $126,000. So for doing absolutely nothing different in terms of what I'm holding from an asset allocation or security selection standpoint except choosing to buy a lower cost product, I save myself roughly $14,000 or 14%. That's a significant amount of return for not having to do a whole lot different other than choosing to buy a lower cost product. Remember, when you're buying investments, it's not like buying an automobile, right? I could probably make a good case why you want to buy a BMW versus a Honda Civic, they're both gonna get you from A to B, but I can understand why you want to pay more for the BMW potentially, for the drive, for the luxury. Nobody has said, "You know, I really enjoy the experience of making less money on my portfolio," okay? So really what you want to do is you want to take that kind of humility and look at lower cost investments because it is a much better way to reliably save yourself returns.
[FEES HAVE A GREATER IMPACT IN DRAWDOWN PHASE]
It's even more significant as we transition into the drawdown phase because now we're taking money out. Well, of course, if you're taking money out, then you have less money for it to compound over time. So these fee savings now work significantly to your advantage on the drawdown phase. In fact, they're bigger, okay? The overall return is bigger in the drawdown phase than it is in the accumulation phase because now you're compounding on less money. So now the differential between the two same examples, if I'm taking $10,000 out of here, is I'm now saving myself $33,000 with a lower cost ETF portfolio. Again, you cannot control the market, but you can control what you pay to get exposure to it. And so this is a crucial determinant after your asset allocation for determining how you want to get exposure to it.
[TYPES OF ETFS]
Now we're gonna talk about what types of ETFs.
[ETF GROWTH IN CANADA]
And really, you know, we've had massive ETF growth here in Canada. We have about $140 billion, I think it's over $150 billion now probably getting going into Q4 in Canada, huge amount of growth. And a lot of that has come from equity and fixed income. Fixed income interestingly enough, we have the largest proportion of fixed income ETFs in the world than Canada. Canadians like to pay a lot for cell phones, bonds, and real estate, so it's a lot of fixed income. But we've seen this wholesale movement towards ETFs and the main driver, to be quite candid, is fees. So a lot of ETFs deliver returns that are very similar to the types of mutual funds for the respective asset classes, I'm gonna use Canadian equity again because it's simple. But if I look at any sort of Canadian equity mutual fund other than a small handful of those mutual funds, most of them have returns that are very similar to indices, and as a result, people are opting for lower cost exposure to index ETFs because, back to my other point, you can't control the market but you can control what you pay to get exposure to it. And that's really driven this big move towards ETFs. It also helps that they are easier to trade through the day and some of those other aspects.
[KEY CONSIDERATIONS FOR EQUITIES]
Now I want to talk about key considerations for equity ETFs. I want to highlight very, very quickly that the majority of mutual funds and actively managed strategies in Canada don't outperform the index over time, the main reason is because of fees. As you pay higher fees, the more years you have that investment, those fees compound against you, make it even harder for active managers. That's not to say active managers don't deliver value, it's just that when I put 1% to 2% on top of their annualized returns, they get significantly more difficult for them to outperform in the market. So with something like US equities, for example, about 90% of the mutual funds under-perform on a 5-year basis, and it's around 75% for Canadian equities. So a big question to ask is the ETF Index. That's probably your first question. The ETF index, is it tracking an index? Is it the index you're familiar of? Do you know what the index owns? So the common indices that you'll see are for Canada it's the S&P/TSX Composite Index. S&P/TSX 60. And then for US equities S&P 500, which is the 500 largest US equities. Is it using strategic factoring? What factors is it using? That sounds very technical. It is. I've talked about those broad based benchmarks, there's also a lot of ETFs now that tend to wait on a certain type of factor. So the most popular factor in ETFs is dividends on equity side. Are you a dividend-focused investor? Do you want to earn a little bit income, maybe give up some of the upside price return for quarterly dividends? Lots of ETFs have that factor. Do you want to hold stocks that have lower volatility in the broad market? A lot of ETFs have lower volatility Take a look at what it is offering, you'll find that, generally speaking, in the Canadian ETF industry, most equity categories have about six options, you know, for any given type of strategy and something like S&P 500, I think there's like 12 to 14 S&P 500 ETFs in Canada. So that means you want to look obviously the sector as well as the cost, okay? These are the questions I want you to ask before you look at an index ETF. They are very basic, but as you go into your due diligence and look at answering each of these questions, you'll find a shorter list of ETFs that meet your investment objectives, okay? So these are the questions. If you want to write some of these down, some of the questions you want to ask before buying equities.
[INDEXING: YOUR BEST DEFAULT]
Interesting, I talked about indexing, and this goes back to what I said before. So we're all familiar with Warren Buffett, most famous investor that ever lived. And his advice to his trustee, and this is actually advice he gave back in 2014, is that when he passes on, let's hope not any time soon, but when he does, he's going to ask that 10% is put in government bonds and 90% of his estate to his family is put in S&P 500 Index. And that is because it goes back to my first example of he doesn't know what active management decisions other managers are going to make, but he knows that if he indexes as a default, he's probably gonna have top 20 percentile returns by being invested in the equity market, and therefore, it's a really safe bet that in lieu of him not being able to choose who manages his family's money, he knows by being in the S&P 500, he's gonna get the return trajectory, most returns that he wants over time. So even Warren Buffett the most famous investor of all time says indexing is probably your best default.
[A HISTORY OF UNDER-PERFORMANCE]
And these are the stats again just to highlight what I was saying earlier. I said about 25%, we actually see it's closer to 30% on a 5-year basis with Canadian equity managers outperforming the benchmark index. And this is taken from the S&P Dow Jones called the Index Versus Active Benchmark, and it just determines the effectiveness of active management.
[INDEXING: NOT A ONE-SIZE-FITS-ALL SOLUTION]
Now I've talked all about this great active management, I just want to highlight though that indexing isn't a one-size-fits-all solution. It's a great default, but there are certain asset classes where indexing may not work as well. I want to highlight those in the bottom here. These are asset classes that would be considered not as efficient. So they don't have the same amount of trading activity or offerings, sometimes they're tightly-controlled markets such as preferred shares and bonds where you may find some value in active management. So I highlighted that on the equity side, the majority of managers under perform. We've actually seen stats suggesting that on a fixed income side, the majority of active managers outperform, and that's because index waiting on fixed income.
[KEY CONSIDERATION FOR FIXED INCOME]
And that's what we're gonna get into here. So this is on the fixed income side. What are your key considerations for fixed income when looking at ETFs? Again, is it an index strategy? What's the credit risk? This one drives me crazy because most investors are focused on yield, so they buy whatever is paying the highest amount of yield, but it should be fairly intuitive that the higher something yields, the riskier it is. So if you're buying high yield bonds, great, they're yielding 5% to 6%, but that also comes with a significant amount of credit risk. So you need to understand what the credit risk of your portfolio is, what is the interest rate risk, and are there any liquidity concerns.
[DIFFERENCE BETWEEN STOCK AND BOND INDICES]
And I'm just showing you again that with fixed income indices and why they may not work as well is where I see a S&P 500 weights everything based on, you know, how successful the company is based on its market size, another pretty good basket of stocks here on the S&P 500. If I look though on the fixed income side, everything's being weighted by how much outstanding debt it has. So I'm not saying that Anheuser-Busch InBev, which is a massive beer conglomerate, shouldn't be your highest weight in your portfolio isn't a bad company. But do you really want the largest company in your fixed income portfolio? Maybe yes, but generally speaking, this weighting thing is based on their outstanding debt, it doesn't take into consideration things like their default risk, you know, their ability to service that debt. So it's a very different metric, and that's what creates some of that inefficiency in fixed income ETFs.
[TYPES OF FIXED INCOME ETFS]
Again, I won't belabor this too much because time is coming out, but, you know, this is the credit risk aspect, high-yield bonds are lower quality corporate bonds and government bonds are basically risk free. As the risk goes up in the bond product, the higher it is as a yield. I would say as a general rule of thumb right now, if you have a product that yields above 3%, it has a lot of risk associated with it. You need to understand that, okay? Fixed lower risk treasuries kick government bonds, like a 5-year government bond yields 1.7%, that's your risk free bond rate for five years. Anything above that is taking on a risk. If you're twice that yield, well, guess what, you're twice basically that risk, bonds are very mathematical that way.
[SELLING FUNDS AND STOCKS TO BUY ETFS: ETF TRADING TIPS]
Now we're going to go through ETF trading tips. And this is a really interesting section. You know, you're new to ETFs you're probably familiar with buying stocks, you put in the ticker symbol. You like the stock, you like the price, you buy it. Same thing with mutual fund, you like the mutual find, you find the code for it, you put it in, you buy it.
Because ETFs are buying on the exchange, obviously there's a different aspect to it which is intraday liquidity. So if you buy an ETF, you can place that order any time throughout the day, right? So maybe something is happening, especially if you're someone who likes to trade throughout the day, a lot of retirees I talk to, you know, they manage their portfolio throughout the day, and you find a blip that allows you to find a good entry point, you can buy that ETF. With a mutual fund, you're going to place the order at the start of the day and it gets filled at the end of the day. So you don't get access to any of this market activity. Same thing with selling, you don't get access to any of the daily market activity.
[MARKET MAKERS: A PILLAR OF THE ETF ECO-SYSTEM]
Now the market makers are there to make sure that the ETFs trade near their NAV, their net asset value. So generally speaking, when you buy an ETF, the price of ETF you pay, so that's a price that's being quoted on the ask... Sorry. The ask for your price on your brokerage account, that is going to be fairly close to what the underlying value of those securities are. And that's these market makers which are actually legally obligated to ensure that ETFs trade relatively close to their net asset value. Any difference between what you pay for the ETF and the net asset value is actually a cost of acquisition for you as the investor. And it's a function of a number of things, it's a function of the underlying security, for example, buying preferred shares and bonds is a lot more expensive in the market from a commission standpoint than equities.
[DETERMINING BID-OFFER SPREAD]
So all of these things come into what we call the bid-offer, right? So that's the difference between what someone's willing to pay for it and what someone is willing to buy it for. So that is all a cost that you will pay. And for every penny wide, we say, or penny beyond the net asset value is a cost for you as the investor. So if you have a $10 ETF, the NAV of the ETF is $10, and it's a 2-cent difference between the bid and the ask, well, then effectively you're paying about 10 extra basis points for exposure. And we do see some ETFs that trade 9 cents wide on a $10 ETF, now you're getting closer to paying something like 45 basis points, that's getting expensive. So you do need to be aware of this cost and understanding what goes into it. Generally speaking, the market makers make the same commission which is about a half penny on executing these trades for you, the additional cost is all of this acquisition charge on ETF bid-offer.
What I also want to highlight is liquidity of ETF is not related to its volume. So we do know that the volume of an ETF or a stock is something that usually determines that there's lots for me to buy. Just because only a certain amount of units are available on ETF doesn't mean that you can't go to the market and buy more of those units because, remember, this is an open-ended investment fund, the market makers can go and create more units for you. So if you see an ETF trading a million units a day or you see an ETF trading 10 units a day, at the end of the day if they invest in the same thing, if they both invest in large cap Canadian stocks, then probably actually the cost of acquisition is effectively the same which means you can buy more very easily. I like to use it as an Amazon example. You know, you put it in order on Amazon and you see, you know, out of stock, and then the next day they have it all back in stock at the same price. It's the exact same thing with ETF except I don't have to wait a day, I have to only wait a fraction of a second for the market makers to build new units of the ETF. So unlike a stock where the volume does determine how much is available to buy, ETFs have implied liquidity that is much larger than their underlying volume.
We see that for example on this ETF here. These two ETFs track the exact same amount of securities. Now one of them is the largest ETF in Canada, XIU, it trades 10 million units a day, the other one trades quite a bit less. Now we see that on this particular ETF HXT the amount of volume is only about 570,000, but the implied volume, that is how much could be executed, is 30.8 million. It's the exact same for both ETFs despite the fact that XIU has, you know, 500 times the volume. So again, just highlighting volume does not equal liquidity.
And I love this screen, I love this ETF Centre. I don't actually use CIBC Investor's Edge, but I do think that in terms of using this particular, you know, this is my first time seeing this, and I think what they've done here is fantastic. Now I may have to open an account, guys. This is great. So if you look at the ETF Centre, you can get all of the stats to look at the bid-ask spread. In particular I really want to highlight this area here. This is telling you how much ETF is trading at a premium. And so that's really your cost of acquisition. You want the ETF trading as low to a premium as possible. That means it's trading close to its NAV. So this is again making you control your cost so you can see exactly, you know, what you're paying to buy, and you see with this ETF, it trades very close to its net asset value, only had 55 days where it's only slightly above. So use these metrics to determine how expensive it is going to be to buy. You also get a lot of other excellent information here. You get how many assets are there, you get how much shares are outstanding, and other important factors such as yield and the management fee up here. So I would say personally before you buy an ETF, create that list of ETFs that meet the questions you want to answer and look at this ETF Centre before buying, wonderful resource from our friends at CIBC Investor's Edge.
[KEY TRADE EXECUTION TIPS]
Last piece here, I'm just going to finish up, we're out of time, but I want to make sure that one thing you do, you always use limit orders when you're buying ETFs. That protects you. So, you know, the market will give you a certain price, but if you determine a price you want to pay, put in a limit order, that includes both selling, as well avoid 9:30 and 9:45 in the morning and 3:45pm to 4:00pm in the day, that's because the market makers are rebalancing their exposure. So those are really key tips when you're buying ETFs to avoid, you know, getting surprises in terms of the execution cost.
And with that, I'm just gonna leave it at that. You know, really happy to be here to talk to you guys today. Again, congratulations on your ETF journey. And I look forward to answering any questions you may have. [Host:] Thank you, Mark. That was a very insightful presentation. We encourage questions from our audience, so if you have them ready, please type them into the Q & A panel, it's located on the right-hand side of your screen now.
[Q & A]
While we wait for questions to come in, as Mark was talking about, I would like to point out that CIBC Investor's Edge clients have access to the ETF Centre on our website. You will find the link to this after logging into your Investor's Edge account and then clicking on Quotes and Research, and below that you will see the ETF Centre link. In the ETF Centre, we have great research tools such as Screener to help you look for ETFs and also a Compare tool to directly compare four ETFs side by side. In addition, we also have resources such as analyst reports and education center with videos. So it looks like we are receiving questions slowly, so I'll pass it back to Mark so we can go through some of the questions now.
Perfect. So first question, do ETFs have a corporate class set up? The answer is no, they do not. There was one set I do believe through one provider, but generally speaking, corporate class is something that you would get on the mutual fund side. And that's just because it has to rely on the daily buying and selling in the market. So that isn't the same as corporate class, the tax efficiency of actually corporate class mutual funds has declined substantially over the last two years because the federal government actually eliminated the ability to tax free switch in the corporate class structure. So there are certainly ETFs that actually are tax efficient, meaning similar to a corporate class fund, they manage distributions to lower the tax impact returns. In fact, there's a lot of what we call Total Return Index ETFs, they don't pay any distributions at all, but they reflect in the vale of the ETF. You don't pay any tax on those, but the ability, historically, of the corporate class funds to be able to tax free switch, that no longer exists. So there aren't really corporate class ETFs, and it's not really a big deal because the advantages of the corporate class have been significantly reduced over the last couple years. How are dividends from ETF holdings distributed? Well, this really depends on the ETF provider. I find most dividend ETFs pay distribution on a quarterly basis. Most of the time the dividend is paid out physically, meaning you actually get the cash paid out to you. If you're a long-term investor, you may want to consider a dividend reinvestment plan where you take those dividends and have them buy new units of the ETF. Sometimes you can have also something called a phantom distribution. This is something you need to be very close to watching. Make sure that any ETFs you have, you look at what they're distributing. Sometimes for non-dividend ETFs, they still may have dividends or capital gains accrued in the ETF and they may pay year-end distribution. But instead of physically paying that out to you, you just get more, the NAV increase in the ETF. You're still however on the government basis required to pay tax on that. That's a little bit complicated and only applies to a very, very small number of ETFs.
The majority of ETFs pay out the dividends physically almost always it's on a quarterly, sometimes monthly basis. Great question on hedged or non-hedged ETFs. What you'll find in Canada is, for foreign equity, particularly US equity, there's hedged and non-hedged ETF units available for most of the major asset classes. For S&P 500 for example, almost all of the ETF providers have a hedged and non-hedged version. What you need to understand about hedging is that the Canadian dollar, and the US dollar is probably the most important hedge decision. US dollar tends to run contrary to most of the other currencies in the world. So if you're investing overseas foreign, you probably don't need to be too concerned about hedging, if, you know, in international stocks, but US, it is something you want to consider. General rule from an academic standpoint is make a decision, one or the other, moving back and forth can be very detrimental to your returns. Hedge products generally cost a little bit more, but over time, it ends up kind of being a wash because there's efficiency in the currency markets. So I say to most investors, choose one, are you going to a hedge or you just care about the capital returns, do you want to have non-hedged exposure, you want to take full advantage of currency movements, choose one, and once you do, my recommendation typically would be to stick with that strategy. Great question.
What's the difference between ETF and an ETN? This trips up people even in the ETF industry. And ETNs aren't really widely available in Canada, but they certainly are in the US. That's actually a debt instrument. So an ETN is 100% credit risk, it's similar to a bond, where the other side of the ETN provider is actually taking on a risk to provide you the returns. I'm not saying it's a high risk, but they're obligated to delivery of those returns, whereas ETF physically holds or has a physical holding where it generates the returns from. And so as a result, there's not as much credit risk or in some cases no credit risk. ETNs are 100% credit risk, there are debt obligations similar to basically a bond except that they trade on a daily basis. Are ETFs the only passively managed? Are there any ETFs that are actively managed? Great question as well. The majority of ETFs in Canada are passively managed, meaning they track an index. But Canada actually has the highest proportion of actively managed ETFs in the world, so roughly 30%. So therefore the very answer to your question is 66% of the ETFs in Canada are passively managed and roughly 33% are actively managed. It's very important that you ask that question, which is why when I said equity and fixed income, is it actively managed as an index, you need to determine based on the investment objective what it is. You can usually tell by the fees. So index ETFs generally charge between 30 basis or lower, actively managed ETFs tend to charge around 50 to 80 basis points roughly. And that fee differential usually determines that it's more of an actively managed strategy.
Is there an ETF website that ranks ETF fund returns on a daily basis across all providers? That's a tough question. Obviously, I would look at your ETF Centre, they have a great screening tool. And that's probably the best part to start. You can also look at Morningstar as an additional resource, but most screening tools will be able to provide that for you. And I've seen, you know, that available, and I see it's also available on the ETF Centre here.
I had a question, is the S&P 500 guaranteed to have the exact same performance during the year as the S&P 500 or is there an acceptable deviation? Wonderful question. The answer, in short, is yes. And S&P 500 ETF should have the same return as the S&P 500 minus the fees you pay for it. And with any index strategy, the bigger the deviation you have between the return of the index and the return of the ETF means the more money you're losing or the more loss potential you have. So that's why fees are so important. And what you'll find, it's just simple math, the lower fee you pay to get index exposure, the closer the returns of that underlying index.
Thanks again, Mark. It looks like that's all the time we have. Mark, that was a very informative presentation. And I'm sure the audience is eager to start building their own portfolios right away.
[The webinar is over. Thank you for joining us. We'll send you a link to the replay soon.]
So thank you for a great presentation.
Thanks so much, guys.
A reminder to the audience that if you wish to listen to this webinar again, a link will be emailed to anyone that registered or you may visit CIBC Investor's Edge website. I would like to thank the audience. We really appreciate you being here. Should you have any questions or comments, please visit Investor's Edge website or get in touch with us by phone, chat, or email. Thank you for joining us today. We will see you next time.