Buy the market with these Canadian exchange traded funds

In the past, buying all the shares that make up a stock index was a course of action available to only the largest investors. These days, however, Canadian stock-market investors can buy into the S&P/TSX 60 Index or the S&P/TSX Composite Index with a relatively small commitment of money in either of these exchange traded funds.

In the market setback of 2008 to 2009, many investors sold their Canadian mutual funds and bought GICs for protection. But this was the worst move they could have made, as markets have roared back since the dark days of early 2009. And even though many global stock markets seem fairly valued now, equities are still the place to be for the long term.

Studies have shown that equities remain by far the most profitable asset class. According to the Credit Suisse Yearbook for 2012, for example, the compound annual growth rate of Canadian equities from 1900 to 2011 was 8.9 per cent. During the same period, long-term conventional bonds had an annualized return of 5.3 per cent, and treasury bills (or cash) returned 4.6 per cent.

Problem is, these equity returns were achieved while incurring greater volatility than the other two assets classes. The standard deviation, which is a measure of historical volatility, for each asset class was as follows: equities, 17.2 per cent; bonds, 10.4 per cent; and treasury bills, 4.9 per cent.

These numbers tell us how much the return for each asset class deviates from its expected normal return. If equities are expected to return 8.9 per cent, for example, then they will commonly deviate by 17.2 percentage points both to the upside and the downside. Thus you would expect stocks to generally return anywhere between 26.1 per cent (8.9 + 17.2) and -8.3 per cent (8.9 – 17.2) in any given year.

Keep adding to your equity funds with these ETFs

Studies in the U.S. and elsewhere show similar results between assets classes. So a case can be made for holding on to — and even adding to — your equity funds. Besides, changing your investment strategy usually produces poor results. So we recommend index exchange traded funds, or ETFs, as an alternative to standard mutual funds.

When you buy an ETF like iShares S&P/TSX 60 Index ETF (TSX─XIU), you buy into a pool of shares based on the Toronto Stock Exchange’s Standard and Poor’s 60 Index. The S&P/TSX 60 Index reads like a Who’s Who of corporate Canada. iShares S&P/TSX 60 gives you diversification similar to that of a mutual fund. The 60 companies are spread over five broad sectors of the economy — resources, manufacturing, consumer products, financial services and utilities. The financial sector has underperformed the market lately, but it, along with the much smaller utility sector, gives the overall Index greater stability.

The largest holdings are Royal Bank, TD Bank, Valeant Pharmaceuticals, Bank of Nova Scotia and Canadian National Railway Company.

iShares S&P/TSX 60 is managed by BlackRock Asset Management Canada Ltd. The shares trade on the Toronto Stock Exchange in the same manner as shares of listed companies.

As with regular mutual funds, dividends are used to pay the fund’s expenses and the remainder is distributed to shareholders. Every December, March, June and September, you receive the dividends in cash. Unlike an ordinary stock fund, which automatically reinvests dividends unless you specify otherwise, iShares’ dividends are not automatically reinvested unless you join its dividend reinvestment plan, or DRIP. You can opt into the DRIP by contacting your broker, provided it participates in the plan.

Market-cap indexes explained

The S&P/TSX 60 Index, and its larger counterpart, the S&P/TSX Composite Index, are market-capitalization indexes. That means that the individual weighting of each stock in the indexes are determined by its market capitalization. A company’s market capitalization is simply its share price multiplied by the number of its shares outstanding.

Royal Bank, for instance, has a recent share price of $76.30, and it has 1,443 million shares outstanding. Multiply these two figures and you arrive at a market capitalization of about $110 billion. This is the largest market capitalization of any company in the country. Consequently, the bank has the largest weighting in the S&P/TSX 60 at 7.8 per cent. Its weighting in the S&P/TSX Composite Index is smaller at 5.9 per cent. That’s because the latter ETF is composed of about 250 stocks, compared to the former’s 60 issues.

You can gain exposure to either of these indexes through exchanged traded funds. iShares S&P/TSX 60 Index (TSX─XIU) gives you exposure to the smaller index, and iShares Core S&P/TSX Capped Composite Index ETF (TSX─XIC) offers exposure to the larger index.

ETF trades near its net asset value

iShares S&P/TSX 60 Index looks a lot like a closed-end fund in that it’s not available from the issuer, as an open-end fund is. But it always trades close to its net asset value. That’s because the only money moving into and out of the actual underlying portfolio involves large blocks of stock called creation units. These are the smallest bundles of shares possible to replicate the index faithfully. Creation units typically have value in the range of several hundreds of thousands of dollars.

Plus, any one holding the securities that constitutes a creation unit can trade these for units of the ETF. And any one holding sufficient units of the ETF can request delivery of the actual stocks in exchange for the fund units.

Clearly, few entities deal in creation units. Pension funds, insurance companies and even other mutual funds, however, can and do deal at this level. These features serve to keep the market valuation of ETF units close to their net asset values.

iShares S&P/TSX 60 shares another advantage with closed-end funds. Because it doesn’t have to put money aside to handle redemptions, your money remains fully invested at all times.

The ETF, however, offers no geographical diversification. All of the 60 companies are Canadian corporations. Keep in mind, though, many of these companies, such as Bank of Nova Scotia and Valeant Pharmaceuticals, do a tremendous amount of business in other countries.

The ETF’s management expense ratio is an attractively low 0.17 per cent. iShares S&P/TSX 60 Index is a buy if you want long-term capital gains from an ETF and you can tolerate medium risk.

 

Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846