Switching from Index Mutual Funds to ETFs

The following question is from Ed, who wants to switch from index mutual funds to ETFs:

Many years ago I set up my RRSP using TD’s low MER e-Series index mutual funds. I learned quite awhile ago that most actively managed funds cannot beat the indexes over the long haul. I’m now thinking of moving from index funds to ETFs. Is there a website(s) somewhere with a good list of available ETF’s? I currently have a TD trading account so flipping over from TD index funds to ETF’s should easily be done not forgetting penalties for redeeming within 90 days.

While index mutual funds are a great option for small portfolios, ETFs could be an even cheaper option for larger portfolios. Though hundreds of ETFs are available, most investors need to be aware of only a handful. You can obtain the list of ETFs that track broad indices under the ETF category on this website or the websites of the major purveyors - Vanguard and iShares (Canada and US). I use the ETF Connect website for looking up more obscure ETFs.

The following table lists the TD e-Series Index Fund and the equivalent ETF:

TD e-Series Fund	ETF
TD Canadian Bond Index (TDB909)	iShares CDN Bond Index (TSX: XBB)
TD Canadian Index (TDB900)	iShares CDN Composite Index (TSX:XIC)
TD US Index (TDB902)	iShares S&P Index (IVV)
TD US Index Currency Neutral (TDB904)	iShares CDN S&P 500 Index (TSX: XSP)
TD International Index (TDB911)	Vanguard Europe Pacific ETF (VEA) or iShares MSCI EAFE Index Fund (EFA)
TD International Index Currency Neutral (TDB905)	iShares CDN MSCI EAFE Index (TSX: XIN)

Note that a better substitution for the TD US Index (TDB902) could be the Vanguard Total Stock Market ETF (VTI). Also, an initial currency conversion charge will be incurred when buying ETFs that are listed on US exchanges. Throw in an emerging market ETF and REITs into the mix and you’ll end up with a well-diversified portfolio.

Best Canadian Online Brokerages

The weekend edition of Report on Business ranked twelve Canadian online brokerages on ten different criteria. BMO InvestorLine took the top honours closely followed by E*Trade Canada and TD Waterhouse.

RBC ActionDirect, which I use exclusively for our retirement accounts and trading Canadian equities, received poor marks and ended up in the bottom of the pack. It is easy to see why: the webpage is clunky (in my opinion), accounts are updated only once every day (really, how hard is it to have this feature?) and I’ve never been able to locate their equity research.

For US equities, Ameritrade Canada is the clear winner. I care most about equity research, ease of use and low commissions (in that order) and Ameritrade is a clear winner in those categories. It would be interesting to see what happens when TD Waterhouse acquires Ameritrade Canada.

How to Open a RRSP Account?

I received a query from a reader about how to open a no-fee (or low-cost) RRSP account that provides a good selection of mutual funds. I thought I would expand my answer into a blog post.

If you want the flexibility to trade stocks and bonds, a RRSP account can be opened with any of the discount brokerages (Check out an earlier post on Best Canadian Online Brokerages for some options). They typically charge an annual fee for smaller portfolios (for example: RBC Action Direct charges a $50 fee for accounts less than $25,000). Opening an online RRSP account is as simple as visiting the brokerage webpage and clicking on the Open an account link.

If you want to buy mutual funds from various fund companies, you might want to consider ING Direct Funds. Please note that actively managed funds charge high fees that would make administration fees seem very small by comparison. (Example: on a $10,000 account, a $50 administration fee translates into an annual expense of 0.5%. On the other hand, the average mutual fund in Canada charges a fee of 2.1% and the vast majority of them have also underperformed their benchmark indices).

You can also open a RRSP account at your local bank branch or with an independent mutual fund company like Investors Group. But, your options will usually be limited to the in-house mutual funds. Note, that these mutual funds also have a high MER and you might have to pay a fee to move the RRSP account to another institution.

In my opinion, the best choice for small portfolios is TD eFunds. The index funds offered have a MER ranging from just 0.31% to just 0.48%. You would be able to quickly create a fairly diversified portfolio like I described in an earlier post. Opening an account is a fairly easy process and can be done online.

Reader Question: How to Open a Vanguard Account?

The following question is from reader Joe:

How do we open a Vanguard Account? I went to their website and it seems it is only for US residents.

Unfortunately, it used to be extremely difficult for a Canadian resident to open an account with Vanguard to take advantage of their popular index mutual funds. With the tightening of regulations following the tragic events of 9/11, it is probably an impossible task now.

Canadian investors interested in index mutual funds are left with two good options: the TD e-Series funds (for smaller accounts) or the CIBC Index funds (for larger accounts due to their management fee discount). While their MERs are typically higher than Vanguard’s, they are still reasonable and on the bright side, you won’t take a currency-conversion hit when investing with Canadian dollars.

If you have a brokerage account, you have a much wider range of options. Many of Vanguard’s index funds have a corresponding exchange-traded fund (ETF), which are listed and traded on U.S. stock exchanges. The Vanguard Total Stock Market ETF, for instance, is listed on the AMEX exchange under ticker symbol VTI. If you have an online broker, investing in the ETF is as simple as entering the ticker symbol and clicking the buy button. Moreover, Vanguard isn’t the only provider of ETFs. Barclay’s offers many popular ETFs through iShares in both Canada (traded on the TSX) and the U.S.

the need for hedging the currency exposure

When investing in foreign stocks, should you hedge the currency exposure? That is a perennial question and Francis Chou provides a thoughtful answer in the 2007 Annual Report of the Chou Group of Funds. He cited two research studies that confirmed his view hedging wasn't necessary for long-term investors.

One, by Lee Thomas (The Performance of Currency-Hedged Foreign Equities), examined the return to a U.S. citizen from investing in six foreign countries from 1975 through 1988, and found “compounded annual returns on hedged and unhedged foreign equities were 16.4% and 6.5% respectively.”

The second, by Meir Statman and Kenneth Fisher (Hedging Currencies with Hindsight and Regret), also found that hedging didn’t matter over the long run: the “mean annualized return of the unhedged global portfolio was only slightly lower than the 8.6% mean annualized return of the hedged portfolio during the overall 1988-2003 period.”

But these study results pertain to past periods when imbalances in the U.S. economy weren’t as distended as they appear to be now. Perhaps the U.S. dollar could be under stronger downward pressures over the next decade or two? If so, one's hedging policy could make a big difference, with the edge going to unhedged positions.

Indeed, noted long-term investor Warren Buffett appears to be looking to increase his unhedged foreign portfolio. At Berkshire Hathaway’s Annual Meeting May 3, 2008, he outlined a strategy for increasing holdings in European companies because he felt the euro would hold its purchasing power better than the U.S. dollar over the longer term.

Maybe it makes sense for Chou to stay unhedged on his foreign bets too, as he prefers. His Canadian-based mutual funds have seen a huge climb in the Canadian dollar, so most of the damage looks like it has already been done. To hedge now would be suboptimal if the Canadian dollar is topping out and/or going into reverse.

To Hedge or Not To Hedge (Currency Exposure)

Rob Carrick, personal finance columnist for The Globe and Mail, debates the pros and cons of hedging foreign currency exposure in a portfolio. I found several points that were very interesting and relevant to my portfolio:

1. The differences between the hedged and unhedged returns in the S&P 500 and MSCI EAFE indices over the past 15 years range from small to negligible.
2. There is no need to hedge a diverse index like the MSCI EAFE as it is exposed to a basket of currencies.
3. According to money management firm Leith Wheeler, MNCs with global operations have “their own currency hedging program, which can be negated or compromised by another hedge on top of that.”

It seems to me that for truly long-term investors, the benefits of hedging are debatable enough that keeping it simple (i.e. unhedged) is not a bad option.

The Brandes Institute

Value vs. Glamour: A Global Phenomenon (September 2008)
In 1994, Josef Lakonishok, Andrei Shleifer, and Robert Vishny published a landmark study investigating the performance of value stocks relative to that of glamour securities in the United States over a 26-year period. Their research concluded that value stocks tended to outperform glamour stocks by wide margins. However, their study did not include the glamour-driven markets of the late 1990s and early 2000s. What effect might this period have on their conclusions? To find out, the Brandes Institute updated their Value vs. Glamour research, now through June 2008, to examine the comparative performance over a 40-year period. In addition, we also extended the scope of the initial study to include non-U.S. markets, seeking to determine if the value premium has been evident worldwide.

Global Small-Cap Stocks: Reexamined and Redefined (September 2008)
The small-cap premium has not been apparent consistently outside the United States since 1989. Why? In this comprehensive study, the Brandes Institute investigates existing methodologies for defining the global small-cap universe and their relationship to performance. We also introduce regional and country universes designed to analyze constituent-level fundamentals and their influence on historical performance differences.

Our research reveals that North American small caps have shown differentiating fundamental traits vs. their non-North American small-cap peers. But these differences in fundamentals may not fully explain the performance disparity. Perhaps the origins of a company and its point on its “lifecycle” are different across regions. The Institute intends to examine the performance characteristics of lifecycle groupings among small caps across regions and sectors.

Fixed Income Falling Knives Phase Two: Examining the Relationship Between Issuer-Specific Bond and Equity Returns (October 2007)
Previous research by the Brandes Institute documented the opportunities available by investing in falling knives (securities whose prices have fallen sharply). Now, in new research on this topic, we investigated the relationship between bond and equity prices in this context. Specifically, we looked for evidence of whether a company’s stock price before a fixed income falling knife event gave any indication of its subsequent bond prices, or vice versa.

Global Small Cap Stocks: Reexamined and Redefined (July 2007)
The small-cap premium has not been apparent consistently in developed markets outside North America since 1989. Why? In this comprehensive study, the Brandes Institute investigates existing methodologies for defining the global small-cap universe and their relationship to performance. We also introduce regional and country universes designed to analyze constituent-level fundamentals and their influence on historical performance differences.

Our research reveals that North American small caps have shown differentiating fundamental traits vs. their non-North American small-cap peers. But these differences in fundamentals may not fully explain the performance disparity. Perhaps the origins of a company and its point on its “lifecycle” are different across regions. The Brandes Institute intends to examine the performance characteristics of lifecycle groupings among small caps across regions and sectors.

Most Recent Articles:

Structured Products: Asset Backed Securities – Opportunities Resulting from Systematic Mispricing (September 2008)
Asset-backed securities have attracted attention in the recent months amid the uncertainty surrounding the mortgage sector and securitized debt. This paper examines the “boom/bust” cycle of subprime mortgage pools, and demonstrates how long standing perceptions of rating agencies and their ratings could potentially be either a risk or an opportunity.

Value Investing: Has It Worked In Emerging Markets (August 2008)
The Brandes Institute’s Value vs. Glamour research has demonstrated the persistent outperformance of value stocks over glamour stocks in developed markets worldwide over long time periods. Investors may wonder if the value premium is also evident in developing countries. In this article, we investigate whether “glamorous” companies in developing countries have outperformed their “value” counterparts over the last few years. We also reveal whether value investing has worked in emerging markets over the long term.

Value vs. Glamour: Bond Performance (July 2008)
Previous research by the Brandes Institute has shown the historical long-term performance advantage of value stocks over glamour stocks. What about corporate bonds? Here, we show that bonds issued by value companies have provided greater appreciation than those issued by glamour companies.

The Investor’s Paradox: Making Intelligent Decisions Amid More Choices (June 2008)
Having more choices is always a benefit – or is it? In the book The Paradox of Choice (New York: HarperCollins, 2004), Professor Barry Schwartz convincingly argues that the process of making constant decisions amidst a sea of overwhelming choice – be it health care options, televisions, or investment products – can and often does result in behavioral biases, stress, and poor decisions. In this article, we share insights from The Paradox of Choice and discuss the implications for investors.

Currency Effect on Foreign Equity Holdings

Many investors are interested in investing in currency neutral versions of foreign equity index funds given the recent rapid appreciation of the Canadian dollar. The Brandes Institute has researched the effects of currency on a portfolio and in a report titled Currency Hedging Programs: The Long-Term Perspective concludes that:

We believe that it’s appropriate for investors to choose either a hedged or an unhedged benchmark, and then stick with it for the long term (a 10-year horizon or longer).

You may also want to check out an earlier report published by the institute on the same topic that looked at the results of hedging for Canadian investors from the start of the floating exchange rate era to the end of 2005. The study found that the impact of hedging to be strongly cyclical and each cycle, on average lasting just under three years.

The Costs of Currency Hedging

With the steep increase in the value of our dollar compared to other currencies, hedging against currency fluctuations has become popular and many US and international equity funds are now available in currency-neutral flavours. There are two schools of thought on currency hedging: one holds that currency fluctuations “cancel out” for a long-term investor and the other holds that currency fluctuations have a significant effect on equity performance and should be hedged away. Even if you are convinced of the need for hedging the currency exposure, there is one reason for thinking twice about hedging: cost.

Let’s take the iShares CDN S&P 500 Index Fund (XSP), which holds the iShares S&P 500 Index (IVV) and hedges the exposure to US dollars for an extra MER of 0.15%. At first glance, it seems to be a small price to pay for hedging. However, the extra MER doesn’t seem to be the only overhead for hedging. The total cost of the hedging shows up in the tracking error. IVV posted a total return of 15.78% and 5.3% in 2006 and 2007 respectively compared to the total return from XSP of 14.06% and 3.01%. In other words, XSP trailed IVV’s return in US dollars by 1.72% and 2.29% in 2006 and 2007.

Another example is the difference is performance between the TD US Index (US$) e-Series Fund (TDB952) and the TD US Index Currency Neutral (TDB904). The currency neutral version charges an extra MER of 0.15% but the tracking error was 1.8% in 2007 and 1.1% in 2006. Since the benefits of hedging are debatable but the costs are certain, it may be best to stick with direct exposure to foreign equity markets.

SPDR S&P 500 ETF

SPDR S&P 500 ETF (SPY)

Index ETF

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Fund Quick Facts

As of 09/22/2008

Closing NAV:	$120.55		Current Distribution Rate:	2.28%
Closing Share Price:	$121.31		Premium/(Discount):	0.63%

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52 Week High-Low NAV: $156.39-$121.48	As of 08/31/2008
52 Week High-Low Share Price: $156.4800-$120.9900

	Fund Basics

Category:	Growth - Domestic	Inception Date:	02/18/1993*
Fund Sponsor:	State Street Global Advisors	Inception NAV:	$43.30
Portfolio Manager:	Arlene M. Rockefeller	Inception Share Price:	$43.41
		Cusip Number:	78462F103
AMEX -symbol:	SPY	NASDAQ Symbol:	--
*The actual inception date of this fund is 01/29/1993. Historical data, prior to the Inception Date listed above, is being sought for this fund. Please check back soon.

	Investment Objective

The Trust's Holdings are comprised of the 500 stocks in the S&P 500 Index, which is designed to capture the price performance of a large cross-section of the U.S publicly traded stock market. The main objective of the fund is to replicate the total return of the S&P 500 Index. The SPDR Trust, Series 1 seeks to match the total return of the S&P 500 Index. To accomplish this, the trust utilized a full replication approach. With this strategy, all 500 securities of the S&P 500 Index are owned by the Trust in their approximate market capitalization weight.

	Share Price and NAV History

Data reflects performance over the previous 12 months | since inception

As of 08/31/2008

Show chart data

	Premium/Discount History

Data reflects performance over the previous 12 months | since inception

As of 08/31/2008

Show chart data

	Distribution History

Payable Date	Ex Date	Distribution Amount	Long Gain	Short Gain
10/31/2008	09/19/2008	0.6909	0	0
07/31/2008	06/20/2008	0.6692	0	0
04/30/2008	03/20/2008	0.6420	0	0
01/31/2008	12/21/2007	0.7754	0	0
10/31/2007	09/21/2007	0.7187	0	0
07/31/2007	06/15/2007	0.6556	0	0
04/30/2007	03/16/2007	0.5513	0	0
01/31/2007	12/15/2006	0.7927	0	0
10/31/2006	09/15/2006	0.5793	0	0
07/31/2006	06/16/2006	0.5555	0	0
04/28/2006	03/17/2006	0.5195	0	0
01/31/2006	12/16/2005	0.6717	0	0

This data shows both historical and future distributions as reported by fund sponsors to our data provider, Thomson Financial.
Distribution History Since Inception

	Performance History

Calendar Year Total Returns As Of 08/31/2008 since inception					Annualized Total Returns As Of 08/31/2008
NAV					NAV
1999 20.84%	2000 -9.15%	2001 -11.90%	2002 -22.07%	2003 28.36%	1 Year	3 Year	5 Year	10 Year	since inception
2004 10.76%	2005 4.79%	2006 15.65%	2007 5.43%	2008(YTD) -11.39%	-11.16%	3.58%	6.81%	4.58%	9.13%
Share Price					Share Price
1999 20.39%	2000 -9.73%	2001 -11.79%	2002 -21.54%	2003 28.13%	1 Year	3 Year	5 Year	10 Year	since inception
2004 10.72%	2005 4.83%	2006 15.81%	2007 5.17%	2008 -11.04%	-10.96%	3.57%	6.82%	4.60%	8.99%
Source: Thomson, as of 08/31/2008

	Sector and Holdings Summary

As of 05/31/2008
Holding	Dollar Value	% of Total Portfolio
Exxon Mobil Corp	N/A	3.89
General Electric Co	N/A	2.51
At&T Inc	N/A	1.97
Microsoft Corp	N/A	1.86
Chevron Corp New	N/A	1.69
Procter & Gamble Co	N/A	1.66
Johnson & Johnson	N/A	1.55
International Business Mach	N/A	1.47
Apple Inc	N/A	1.36
Cisco Sys Inc	N/A	1.3

Industry Diversification As of 05/31/2008	Creation/Redemption Features As of 08/31/2008 Creation Unit 50000 Creation Unit Fee 3000 Maximum Creation Fee 3000 Redemption Unit 50000 Redemption Fee 3000 Max. Red. Fee 3000
Country Diversification 2 Countries with 5% or more As of 05/31/2008	ETF Facts As of 08/31/2008 Marginable Yes Option Tradable Yes Short Selling Yes Min. Secondary Share Purchase 1 Expense Ratios 0.10%

	Other Portfolio Data

Fundamental Data As of 05/31/2008 Common Average Weighted Maturity (years) -- Average Priced-to-Date Average Coupon -- Average Duration (years) -- Average Bond Price of Portfolio -- % of Portfolio Pre-Refunded -- %AMT (as of 05/31/2008) -- Derivatives -- Semi Annual Fund Data *Data is from latest annual/semi-annual report. As of 06/30/2008 Total Net Assets $71,654,684,000 Common Total Common Assets $71,654,684,000 Shares Outstanding 560,392,836

Monthly Fund Data As of 08/31/2008 Common Net Asset Value Per Share $128.62 Share Price $128.7900 Premium/Discount 0.13% Distribution Per Share (As of 09/19/2008) $0.6909 Current Distrib. Rate (on share price) 2.08% Average Daily Volume (shares) 222,420,000

	Past performance is no guarantee of future results.
	Investing in ETFs involve certain risks such as:
>	Market risk - General stock market fluctuations and volatile increases and decreases in value as market confidence in and perceptions of the issuers change. Investor perceptions can be based on various and unpredictable factors including expectations regarding government, economic, monetary and fiscal policies, inflation and interest rates, economic expansion or contraction, and political climates. The value of any security can rise or fall and when liquidated, may be worth more or less than the original investment.
>	Interest rate risk - The risk that a rise in interest rates will cause the value of an investment to decline.
>	Lack of Diversification - A concentrated or sector fund may be subject to greater price volatility or adversely affected by the performance of the securities in that particular sector. In addition, it may be more susceptible to any single economic, political, or regulatory occurrence than the holdings of an investment company that is more broadly diversified.
>	Foreign Investment risk - Investing in foreign countries or securities may involve additional risks and considerations, including but not limited to, currency risk or the risk that a currency devaluation or exchange rate will result in the decline in the value of an investment; market risks; and unfavorable political developments that are not usually associated with investments in the U. S.
>	Liquidity Risk - The risk that the market cannot accommodate an order to buy or sell a security in the desired timeframe, or the risk that trading on a stock exchange may be halted because of market conditions.

Footnotes

1. Annualized total return is determined by subtracting the initial investments from the redeemable value of the investment at the end of the investment period, dividing the remainder by the initial investment and expressing the result as a percentage. For multiple years, 1 would be added to the results, this number could then be raised to the power of 1/years annualized - 1 to find the result of a multiple year annualized return. The calculation assumes that all income and capital gains distributions by the Fund have been reinvested at net asset value (share price) on the ex dates during the period.

2. Country Diversification shows the percentage of the fund invested in a country based on total assets. A country is only listed if the investment in the country is more than 5% of the total assets.

3. Income from this fund may be subject to state and local taxes, as well as to the alternative minimum tax. Capital gains, if any, will be subject to tax.