Understanding Canadian Equity ETFs

Hello everyone. Are you ready for a crash course in understanding exchange-traded funds (ETFs)? That’s what my new “Understanding ETFs” video blog series is all about. Today, we’ll kick things off by popping the hoods on a sporty collection of Canadian equity ETF solutions for your portfolio’s domestic stock allocation.

What’s that you say? You’d rather buy stocks instead of ETFs? Don’t feel bad if you’re laboring under this misperception. I hear it all the time. Remember, ETFs are simply empty “containers” for holding your actual, underlying investments – be they stocks, bonds, REITs or other securities. In other words, by investing in any of the ETFs I mention in this video, you are investing in stocks, – in this case, Canadian ones.

We also prefer ETFs that fill their “containers” by tracking broad-market stock indexes (whose job is to efficiently and effectively proxy the entire stock market as closely as possible). This means no clever stock-picking monkey business is required or desired – by you or the ETFs in which you invest.

With that introduction, let’s start building a Canadian stock portfolio.

Anonymous TIPs

Some of you may be surprised to learn that the world’s first ETF was created here in Canada by the Toronto Stock Exchange in 1990. It was called the Toronto 35 Index Participation Units (TIPS 35 Fund), or TIPs for short. This fund allowed investors to participate in the performance of the Toronto 35 Index without having to purchase individual shares of 35 different companies.

TIPs was followed by a second ETF, the TSE 100 Index Participation Fund (TIPS 100 Fund), or HIPs for short. It tracked the broader TSE 100 Index.

In March 2000, TIPs and HIPs merged into today’s single fund, the iShares S&P/TSX 60 Index ETF (XIU). XIU is still the largest ETF in Canada today, with assets under management just shy of $10 billion. The XIU fund tracks the S&P/TSX 60 Index, which was created by Standard & Poor’s to track the performance of 60 large Canadian companies. Its largest holdings include a number of household names among Canada’s dominant industries.

Top 10 Holdings by XIU Weight

Source:  BlackRock Asset Management Canada Limited as of September 28, 2018

Each company in the S&P/TSX 60 Index is weighted according to its “float-adjusted” market capitalization. A company’s market capitalization (a.k.a. “market cap”) is calculated by taking its current stock price, and multiplying this figure by the number of shares the company has outstanding. For example, suppose Husky Energy (HSE) has 1 billion shares outstanding with a current price of $20 per share – its market cap would be $20 billion ($20 price per share × 1 billion shares outstanding).

If the market cap of all companies in the index had a worth of $1.8 trillion, HSE would make up about 1.11% of the index ($20 billion ÷ $1.8 trillion).

Under a “float-adjusted” market cap, index managers only count shares that are available to investors, rather than all of a company’s outstanding shares. They exclude shares that are closely held by control groups, other publicly traded companies or government agencies.

Example: Husky Energy is controlled by Hong Kong billionaire Li Ka-shing, who owns approximately 70% of the outstanding shares (which leaves only 30% of the shares for regular investors, or 300 million shares in our example).  If each share is worth $20, its float-adjusted market cap would be $6 billion (300 million shares × $20 per share).

Assuming the total float-adjusted market cap of all 60 companies within the S&P/TSX 60 Index was also lower (maybe around $1.7 trillion instead of $1.8 trillion), Husky Energy would make up only about 0.35% of the total float-adjusted index weight ($6 billion ÷ $1.7 trillion).

Float-adjusted market caps are meant to create an index where each component’s influence (weight) best reflects practical realities for the market involved. Still, some well-deserving large-cap companies may not make the cut. For example, companies like Shopify, Fairfax Financial, Canopy Growth Corporation and Aurora Cannabis are currently excluded from the S&P/TSX 60 Index, due to a Standard & Poor’s sector-weighting rule (to maintain sector weights similar to the overall Canadian stock market, S&P’s index committee replaces some large-cap companies with smaller ones). This may be a hard pill for passive investors to swallow, as this arbitrary sector rule could be considered by some indexing purists to be active stock picking.

If you feel like you’re missing out on the returns of these and other excluded Canadian companies, there’s another ETF that can complete your Canadian ETF package – the iShares S&P/TSX Completion Index ETF (XMD).

As the name suggests, XMD complements XIU by including the handful of omitted large-cap stocks just described, plus a healthy dose of mid- and small-cap stocks. The XMD fund follows the S&P/TSX Completion Index, which in turn tracks the performance of about 188 mostly small and medium (aka, small-cap, mid-cap) Canadian companies. By allocating about 75% of your investment dollars to XIU, and the remaining 25% to XMD, you gain exposure to most of the Canadian stock market (at an annual cost of about 0.29%).

Sources:  BlackRock Asset Management Canada Limited, S&P Dow Jones Indices as of September 28, 2018

By now, you may be thinking: “Wouldn’t it be easier if there were a single index that followed a combination of the S&P/TSX 60 Index and the S&P/TSX Completion Index?”

You’re right, which is why there’s the S&P/TSX Composite Index. Considered by many to be the benchmark index for Canadian stocks, it includes about 248 companies and covers approximately 95% of the Canadian stock market.

You also may wonder whether there’s a single ETF for investing in all 248 companies in the composite index – so you could invest in one fund instead of two (XIU and XMD), and achieve the same goal.

Good news: Not only is there an ETF for that, there are two possibilities. The iShares Core S&P/TSX Capped Composite Index ETF (XIC) and the BMO S&P/TSX Capped Composite Index ETF (ZCN).

Both ETFs have an annual cost that is much lower than the weighted-average cost of XIU and XMD, making them more cost-effective alternatives to the multi-fund approach.

Sources:  BlackRock Asset Management Canada Limited, BMO Asset Management Inc., S&P Dow Jones Indices as of September 28, 2018

You may notice, each of the ETF names include the term “Capped.” Not to be confused with our earlier conversation about market caps (i.e., market capitalizations), the similar term indicates that all company weights will max out – be capped – at 10% if they happen to get too big for their own good. This was the case with Nortel in 2000, when its uncapped value would have accounted for more than a third of the S&P/TSX Composite Index.

Standard & Poor’s launched its capped index in January 2001 – around the same time, Nortel’s price steadily fell from $124/share to $22/share between August 2000 through March 2001. After the 82% decline, Nortel ended up accounting for less than 10% of the index on its own. In fact, no security in the S&P/TSX Composite Index is currently above 10%, so it is essentially identical to the S&P/TSX Capped Composite Index at this time. That said, it’s good to know the cap is there if we ever need it.

Top 10 Holdings by XIC Weight

Source: BlackRock Asset Management Canada Limited as of September 28, 2018

Playing FTSE

When Vanguard arrived in Canada in 2011, it launched the Vanguard FTSE Canada Index ETF (VCE), which follows the FTSE Canada Index. FTSE stands for the Financial Times Stock Exchange, and is typically pronounced “foot-see.” Just as Standard & Poor’s manages its S&P indexes, the FTSE Group (a subsidiary of the London Stock Exchange Group), manages the FTSE indexes. The FTSE Canada Index includes about 61 Canadian large-cap stocks … so very similar to the S&P/TSX 60 Index.  If you combine about 79% of this large-cap index, with roughly 21% of the FTSE Canada Small Cap Index, you end up with the FTSE Canada All Cap Index, which is very similar in composition to the S&P/TSX Capped Composite Index.

Sources:  Vanguard Investments Canada Inc., FTSE Russell Indices as of September 28, 2018

In 2013, instead of augmenting VCE with a small-cap ETF complement, Vanguard jumped directly to competing with XIC. It did so by launching the Vanguard FTSE Canada All Cap Index ETF (VCN), which follows the broader FTSE Canada All Cap Index. This index includes the same 61 larger companies in the FTSE Canada Index, plus another 151 or so smaller companies. The reference to “All Cap” in the name indicates that the index tracks the performance of small-, mid- and large-cap companies. (This time, not to be confused with “capped” ETFs, as described above!) Although VCN holds 36 fewer stocks than XIC, these 36 stocks account for less than 4% of XIC’s total value. Shopify is the most obvious exclusion from VCN, due to FTSE’s choice to allocate the company to its US equity indices instead of their Canadian.  A number of Brookfield Limited Partnerships are excluded from VCN as well, as LPs are ineligible for inclusion in FTSE’s global equity indices.

Sources:  BlackRock Asset Management Canada Limited, Vanguard Investments Canada Inc., as of September 28, 2018

However, these and other stock exclusions are unlikely to have a material impact on the future return differences between VCN and XIC. In fact, since 2003, both of the ETF’s underlying indices have returned an identical 8.7% on an annualized basis.

A kick at the RCAN

RBC was a little late to the game, but in 2017 they launched the RBC Canadian Equity Index ETF (RCAN), which tracks the FTSE Canada All Cap Domestic Index.

The term “Domestic” in the name indicates that this particular index methodology does not apply any foreign ownership restrictions when calculating each individual company’s weight in the index (whereas the FTSE Canada All Cap Index does adjust the company weights for foreign ownership restrictions).  It’s interesting to note that the S&P/TSX Capped Composite Index does not adjust their company weights either with regards to foreign ownership restrictions.

For example, Bell Canada (BCE) is subject to the Telecommunications Act, which governs the Canadian ownership and control of Canadian telecommunications carriers.  The Act restricts foreign investment in voting shares of BCE to a maximum of 33 1/3%.  If we view the weight of BCE in each of the broad-market ETFs we have just discussed, we find that all of them have a 2.1% weight to BCE, with the exception of VCN, which has a lower weight of 0.7%.  If we divide 0.7% by 2.1%, we end up with 33.33%, the maximum foreign ownership of the company allowed.

Sources:  BlackRock Asset Management Canada Limited, BMO Asset Management Inc., RBC Global Asset Management Inc., Vanguard Investments Canada Inc., as of September 28, 2018

At the beginning of 2019, RBC and BlackRock Canada announced an ETF partnership under the brand RBC iShares. On or around April 5^th, 2019, they will be merging RCAN into XIC (which may have tax consequences for the current unitholders of RCAN). Due to this upcoming taxable disposition, it would be prudent to avoid RCAN as a core Canadian equity ETF holding going forward.

Going Global for Effective Diversification

So there you have it: a collection of ETF solutions to consider for creating broad-market Canadian equity exposure. Don’t obsess over which one is the best. Any of them should get the job done, and all of them are strongly preferred over expending time and energy trying to pick individual stocks on your own.

Before we wrap, I’ve got one more point to make. It’s well known that our Canadian stock market is over-exposed to four sectors: financials, energy, industrials and materials. No matter which Canadian broad-market ETFs you choose, these four sectors will end up representing approximately three-fourths of the value of your holdings. The best way to easily diversify away from this sector risk is to include a healthy dose of global stocks in your overall equity allocation.

Fortunately, that gives me plenty more to discuss in future installments of my “Understanding ETFs” series. Next up, I’ll take a closer look at broad-market U.S. equity ETFs.

Sources:  BlackRock Canada, BMO Asset Management Inc., Vanguard Investments Canada Inc., as of September 28, 2018