ETFs for domestic equity exposure

Our top ETF choices for exposure to what, for most Canadian investors, is the largest portion of the portfolio

John Gabriel 12 March, 2015 | 5:00PM
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Note: This article is part of Morningstar's March 2015 ETF Investing Week special report.

A common complaint I often hear from investors is that the plethora of ETFs available makes the selection process daunting. That's when I reemphasize that the first question is not, "which ETF should I buy?" but rather, "which asset class would I like exposure to?" Identifying the asset class allows investors to ignore the vast majority of ETFs out there and only focus on those which track the given asset class. From there the selection process is much less daunting.

Here we review ETF options that track the Canadian equity market, which tends to represent the largest portion of most Canadian investors' portfolios. As such, it is worthwhile to review the various ETFs within the category with the aim of helping investors wade through the vast and ever-growing ETF landscape.

A simple screen of ETFs in the Canadian Equity category (as defined by the Canadian Investment Funds Standards Committee) with more than $100 million in assets offers up a great list of candidates to select from.

Canadian Equity ETFs
Name Ticker Assets
iShares S&P/TSX 60 XIU 11,382 0.15 Sept. 1999
iShares Core S&P/TSX Capped Composite XIC 2,053.7 0.05 Feb. 2001
BMO S&P/TSX Capped Composite ETF ZCN 1,298.1 0.05 May 2009
Horizons S&P/TSX 60 ETF HXT 628.5 *0.07 Sept. 2010
BMO Low Volatility Canadian Equity ETF ZLB 467.3 0.35 Oct. 2011
Vanguard FTSE Canada ETF VCE 324.4 0.05 Nov. 2011
iShares Canadian Fundamental CRQ 258.7 0.65 Feb. 2006
PowerShares FTSE RAFI Canadian Fdmt ETF PXC 247.2 0.45 Jan. 2012
Vanguard FTSE Canada All Cap ETF VCN 205.0 0.05 Aug. 2013
First Asset Mstar Canada Value ETF FXM 188.6 0.60 Feb. 2012
First Asset Mstar Canada Mom ETF WXM 173.3 0.60 Feb. 2012
*Annual mgmt fee rebated by 0.02% to an effective mgmt fee of 0.05%, until at least Sept. 30, 2015
Data as of Feb. 28, 2015. Source: Morningstar

iShares S&P/TSX 60 XIU
Institutions favour this ETF for its liquidity, but retail investors can get cheaper access to domestic equities. This fund is by far the largest and most heavily traded ETF in Canada. As such, some institutional investors who need to move large chunks of assets in very short periods may choose to stick with XIU thanks to its unrivaled secondary market liquidity.

The S&P/TSX 60 Index lacks exposure to small-cap stocks, but it is frequently used as a proxy for the full Canadian market and has been perfectly correlated with the broader Canadian stock market over the past three years. This large-cap fund, which sports a weighted average market capitalization of more than $36 billion, may lag during periods of small-cap outperformance, but because it represents more than 70% of Canada's equity market capitalization, it should never fall behind by more than a few percentage points per year.

Investors may consider this fund as a relatively low-cost way to gain domestic large-cap equity exposure. It should be noted, however, that there are a handful of ETFs available that track the broader Canadian market for a fraction of the price.

iShares Core S&P/TSX Capped Composite XIC
The S&P/TSX Composite Index covers about 95% of the Canadian equity market, which makes it an excellent market proxy. It's worth noting that XIC's benchmark, the S&P/TSX Capped Composite Index, has been nearly perfectly correlated (99%) with the S&P/TSX 60 Index, another popular proxy for the Canadian stock market, over the past five, 10 and 15 years.

The primary differences to consider are the number of holdings and market-cap profiles of the two benchmarks; XIC has about 250 holdings and has roughly 20% exposure to mid-cap stocks, while the S&P/TSX 60 Index holds just 60 stocks and has only 5% exposure to mid-caps. As a result, XIC sports a weighted-average market cap of less than $21 billion, compared to more than $36 billion for the S&P/TSX 60 Index.

Hence, those seeking more diverse and smaller-capitalization exposure to Canadian equities could choose XIC over more narrowly focused funds that track the S&P/TSX 60 Index. Although XIC reaches further down the market-cap spectrum and holds nearly four times as many securities as the S&P/TSX 60, the two indexes do have very similar sector weightings.

BMO S&P/TSX Capped Composite ZCN
On Sept. 21, 2012, the fund switched its benchmark to the S&P/TSX Capped Composite Index. From its inception until that date, it had tracked the Dow Jones Canada Titans 60 Index.

In the spring of 2014, both ZCN and XIC cut their management fees to 0.05% per annum, making them about as cheap as they come. For some context, consider that the average Canadian-listed equity ETF charges a management fee of 0.48% and a management-expense ratio of 0.54%, while the average equity index fund and actively managed equity mutual fund charge MERs of 1.62% and 2.47%, respectively. The average advisor-class equity ETF, which includes an embedded trailing commission, charges an MER of 1.54%.

Horizons S&P/TSX 60 HXT
Horizons S&P/TSX 60 Index can be an effective way to get core Canadian equity exposure at a very low cost. Even so, there are a few considerations that investors should take into account before investing in this fund. Whereas traditional exchange-traded funds like XIU invest directly in stocks, HXT instead uses a total-return swap structure to obtain its index exposure.

Investments by HXT shareholders are held as cash collateral in a custodial account. The interest income earned on the cash goes to the ETF's bank counterparty. In exchange, the counterparty delivers to the ETF the total return of the S&P/TSX 60 Index. Therefore, even though the ETF does not physically hold the index constituent securities, it still maintains direct exposure to the performance of the S&P/TSX 60.

Since HXT tracks the total-return version of the index, the value of the ETF should reflect the price return of the S&P/TSX 60 plus the value of any reinvested distributions by the stocks in the index. The value of any dividend distributions made by the constituent stocks of the index is immediately reflected in the net asset value of the ETF, but no taxable distributions are actually paid out to investors. All gains made by the ETF are expected to be treated as capital gains, which will occur only when the investor sells his or her ETF shares for a gain.

Swap structures have grown in popularity due to their low cost, relative tax efficiency and minimal tracking error. Since there is no portfolio of physical securities to trade and manage, costs are kept low. Moreover, because the counterparty is obligated to deliver the return of the reference benchmark, tracking error is essentially nil; any deviation from the index should be fully attributable to fees.

BMO Low Volatility Canadian Equity ZLB
This fund uses a rules-based methodology to select the least market-sensitive stocks based on five-year beta. The 40 lowest-beta stocks from the 100 largest and most liquid securities in Canada are selected. The underlying portfolio is rebalanced in June and reconstituted in December.

Vanguard FTSE Canada VCE
This ETF offers large-cap exposure similar to that of the S&P/TSX 60 Index. It holds 77 stocks and charges a management fee of 0.05%. Its index represents approximately 75% of the Canadian stock market, which is a tad higher than the S&P/TSX 60. Still, investors should expect near identical performance between the two indexes.

PowerShares FTSE RAFI Canadian Fundamental Index PXC
This fundamental index offers a value tilt on Canada's large-cap stock universe and can be considered a fine core Canadian equity holding. Investors should be comfortable paying a premium for the fund's fundamental strategy, which may endure significant periods of underperformance relative to traditional market-cap-weighted indexes.

Investors seeking passive exposure to Canadian large-caps who are also loath to go the route of a traditional market capitalization-weighted index could find this ETF's quantitative, rules-based fundamental approach to be a refreshing alternative. This fund tracks the FTSE RAFI Canada Index, which contains about 90 stocks selected and ranked based on a proprietary model that accounts for total cash dividends, free cash flow, total sales and current book value. Note that the fund has some considerable sector tilts. For instance, it has more than 43% of assets parked in the financials sector.

iShares Canadian Fundamental Index CRQ
This fund tracks the same index as PXC, but charges a management fee that is 0.20% higher. As such, investors interested in the fundamental indexing strategy are better off going with PXC.

Vanguard FTSE Canada All Cap VCN
Just as its sibling VCE is the near equivalent to the S&P/TSX 60 Index, VCN is the near equivalent to the S&P/TSX Capped Composite Index.

First Asset Morningstar Canada Momentum WXM
This ETF tracks a unique index that uses proprietary methodologies developed by Morningstar's CPMS division to screen for liquid Canadian stocks that display positive technical price momentum indicators. The portfolio contains 30 stocks that are equally weighted and rebalanced quarterly. As a result of its equal-weight strategy, the fund has a fairly significant tilt toward small-cap stocks. For example, WXM's holdings weighted market cap is $7.2 billion compared to $35.6 billion for the S&P/TSX 60 and $21 billion for the S&P/TSX Capped Composite. Given the size tilt, some investors may elect to use this fund as a complementary strategic holding.

Since launching in February 2012 the fund has handily outperformed its passive cap-weighted rivals. The strategy differentiates itself by going a step beyond simple technical indicators and liquidity screens. WXM's methodology also screens for firms with above-average returns on equity, with a focus on companies with upward earnings estimate revisions.

First Asset Morningstar Canada Value FXM
FXM also uses CPMS methodologies to screen for companies that display traditional value characteristics. Metrics for inclusion include low price-to-earnings, low price-to-cash flows, low price-to-book value and low price-to-sales ratios. On top of these metrics, the fund's methodology also identifies firms whose earnings estimates have been revised upward.

Like its sibling WXM, this fund also holds an equally weighted portfolio of 30 stocks. This means that it too offers a meaningful tilt toward smaller cap companies, with a weighted average market cap of about $5.2 billion. FXM has also outperformed its passive cap-weighted rivals by a wide margin since its February 2012 inception.

My picks

My top picks for the asset class are XIC, ZCN and VCN. All of these ETFs offer nearly identical exposure and charge the same fee. Nothing fancy here. Just comprehensive market beta at the lowest possible cost. Remember, these are building blocks for a portfolio, not short-term tactical picks.

I offer these picks in an effort to simplify the process for investors, but any one of the 11 ETFs highlighted can work. Which fund you ultimately select from the list isn't likely going to determine whether or not you meet your long-term investment goals. The asset allocation decisions, as well as investor behaviour (i.e. timing of buying or selling) will, more often than not, have a much greater impact on an investor's portfolio.

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About Author

John Gabriel

John Gabriel  John Gabriel is a strategist for Morningstar’s manager research team.

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