Tuesday, January 26, 2010

Lower costs, better portfolios (sometimes)

Exchange-traded funds (ETFs) are less expensive than mutual funds by a wide margin. Embedded mutual fund distribution costs, paid to financial advisors for selling them, are most of the difference. Claymore is the only ETF sponsor in Canada paying advisors from a separate ETF series that is 0.50-0.75% more expensive. While brokerage costs must also be considered when acquiring ETFs, improving transparency is helping investors make more informed choices.
Canadian Median Mutual Fund MER vs. ETF MER

Canadian Equities Mutual Fund Median 2.45%
0.16% BMO Dow Jones Canadian Titans 60 (ZCN)
0.17% iShares Large Cap 60 (XIU)
0.25% iShares CDN Composite (XIC)
0.65% Claymore Canadian Fundamental (CRQ)
1.15% HBP S&P TSX 60 Bull Plus (HXU)

Canadian Bonds Mutual Fund Median 1.96%
0.15% Claymore 1-5 yr Laddered Gov’t Bond (CLF)
0.325% BMO Canadian Gov’t Bond Index (ZGB)
0.35% iShares CDN Government Bond (XGB)

Int’l Equities Mutual Fund Median 2.69%
0.455% BMO International Equity Hedged (ZDM)
0.49% iShares MSCI EAFE Hedged (XIN)
0.65% Claymore International Fundamental (CIE)

Emerging Markets Mutual Fund Median 2.93%
0.535% BMO Emerging Mkts Equity Index (ZEM)
0.65% Claymore BRIC (CBQ)
0.82% iShares CDN MSCI Emerging Markets (XEM)
1.15% HBP MSCI Emerging Mkt Bull Plus (HJU)

Commodities Mutual Fund Median 2.60%
0.40% iShares COMEX Gold Trust (IGT)
0.75% HBP COMEX Gold (HUG)
1.15% HBP COMEX Gold Bullion Bull Plus (HBU)

Among the Canadian Equity ETFs shown, newcomer Bank of Montreal (BMO) undercut comparable and more established iShares LargeCap 60 by 0.01%. and similarly positioned themselves in bonds, U.S. and international equities, and emerging markets.

Sometimes costs reflect structural differences. Higher-priced iShares CDN Composite at 0.25%, includes a broader holdings base (S&P/TSX Composite’s 204 issues). Claymore’s Canadian Fundamental (0.65%) would appear to be out of step with the group, but includes an “embedded strategy” namely a value bias in the construction of its index. Claymore is actually offering an actively-managed ETF in passive clothing.

Distinguishing passive ETFs from those with embedded strategies is a good starting point for portfolio building. One is not better than the other, but those with embedded strategies are usually more expensive. Director of Quantitative Strategies at PŮR Investing, Ioulia Tretiakova, maintains: “You never know what the future return of an ETF is going to be, but you do know its cost.”
Embedded strategies try to offer something in return for their higher cost. In Claymore’s RAFI Fundamental series, it is a tilt towards value stocks. If this is what you want, ETFs can give you effective access. The Horizon BetaPro (HBP) Plus ETF series offers two times the DAILY return for the “Bull” version and two times the inverse DAILY return for the “Bear” series. This powerful leveraging capability comes at a cost of 1.15% but considering the “double exposure” makes the effective MER 0.575%. This appears expensive in the Canadian equity category with offerings at 0.16-0.17%, but in emerging markets, where iShares cost 0.82%, HBP appears more competitive.

While lower cost is a key ETF benefit, management expense ratios tell only part of the story. Studies of U.S. mutual funds showed that annual trading costs were 1.44% per year (Edelin/Evans/Kadlec, 2007). Canadian mutual fund trading costs are not available, but exchange traded fund trading costs are certainly lower than mutual fund costs for two reasons:

1. the index nature of ETFs means little trading is required for rebalancing;

2. market-makers for Canadian ETFs assume the cost and risk of rebalancing including index composition changes. Elsewhere in the world, the cost of an index change is borne by the ETF unit-holder. If the annual trading cost for an active Canadian mutual fund is 1.0%, and the comparable ETF cost is 0.0%, it is little wonder that active funds have so much difficulty beating index and ETF performance.

Canadian investors, like counterparts around the world, focus most investments in their domestic currency. This makes sense because liabilities and expenses are Loonie-centric. Some international ETFs are offered “hedged”. This comes at a cost. Is it better to buy the hedged or unhedged ETF? The answer is related to your expected holding period. Here’s a guideline:

1. The longer the holding period (over 4 years) you may be better off unhedged. The cost of hedging is fixed and compounds over time.
2. If you have a view about the direction of currencies, hedging for protection or unhedging for exposure can become part of your strategy.

ETFs offer an increasing palette of risk shapes and colours giving investors broad scope to construct portfolios that reflect their views and address their needs. Cost is a rare certainty in a financial world filled with unknowns. Consequently, it is one of the most important considerations in building any portfolio.

PŮR Investing Inc. is a registered portfolio manager specializing in risk management using exchange traded funds. PŮR’s free ETF screener is available at: http://purinvesting.com/demo/Screen.htm .

Taxes, like hemorrhoids, are annoying ETFs can provide relief

People don’t like to talk about them and they are decidedly a pain . . . but taxes are the bane of an investor’s existence.

Investment professionals know that three key characteristics make exchange–traded funds (ETFs) tax efficient:

  1. Index-based ETFs have extremely low turnover. Transactions trigger gains taxable in the hands of unit holders.

  1. The redemption of ETFs allows for in-kind transfers, allowing sponsors to transfer out the lowest cost shares without incurring tax. This maintains the adjusted-cost base closer to the market value. Unit holders pay most taxes when they sell the ETF, effectively deferring taxes until realized.

  1. The creation method and exchange-traded nature of ETFs means that supply and demand are balanced in the marketplace and units do not have to be sold (incurring a possible tax liability) to meet redemption requirements as mutual funds do. As a consequence, ETFs hold less cash to earn taxable income. (albeit not much lately given low interest rates).

These tax minimizing characteristics are a big relief for taxable investors. Had they owned mutual funds, they could be subjected to big taxes unrelated to their actual investment results. Paying for the capital gains or income received by others is just silly.

Tax losses

ETFs are ideally suited for capturing tax losses. The conventional way is to replace a losing stock position with an ETF. Example: sell Research in Motion (RIM) at a loss to buy iShares Canadian Tech Sector ETF (XIT). The loss in the stock position is captured, to be used to offset capital gains in the current year, back three years or carried forward indefinitely. The portfolio exposure, to the technology sector in this case, is maintained.

Another effective tactic is to swap between ETFs with similar underlying risk. An example is iShares S&P 500(IVV) and SPDR 500(SPY). Both have the S&P 500 as their underlying index but because the ETFs have different sponsors, BlackRock and State Street Global Advisors respectively, they are considered different securities for tax purposes. Therefore, they may be traded simultaneously to capture a loss. The 30 day waiting period to avoid a superficial loss is not required.

Holding a core portfolio of ETFs and owning a satellite portfolio of individual stocks is a good way to protect capital gains generated by the stock portfolio by applying tax losses generated from the core. Some firms may offer a tax-loss-capture module, like PŮR Investing’s, that does this automatically.


Ms. Ioulia Tretiakova, Director of Quantitative Strategies for PŮR Investing, says that while ETFs have tax efficient characteristics, some have shocked investors at tax time.

The 2008 experience with some leveraged Rydex Inverse sector series ETFs is shown here.



Rydex Inverse 2x Sector Energy


Rydex Inverse 2x Sector Technology


Rydex Inverse 2x Sector Financial


Ms Tretiakova explains that inverse, leveraged long and leveraged inverse ETFs use swaps and derivative instruments rather than securities that can be transferred in-kind. This creates potential tax liability when the contracts are closed out. Capital gains, influenced by volatility and the expiration of futures contracts related to the underlying sectors on January 1, 2009, were huge for several Rydex ETFs. In Canada, a similar situation is not expected although in 2012 the Horizons Beta Pro’s leveraged ETF products listed below have OTC derivative contracts maturing. A different Canadian structure, unavailable in the U.S., allows sponsors to better minimize taxes. At any rate, leveraged ETFs should always be watched carefully.




HBP S&P/TSX Financials Bull Plus ETF

HBP S&P/TSX Financials Bear Plus ETF

June 11, 2012

June 11, 2012



HBP S&P/TSX Energy Bull Plus ETF

HBP S&P/TSX Energy Bear Plus ETF

June 18, 2012

June 18, 2012



HBP S&P/TSX Global Gold Bull Plus ETF

HBP S&P/TSX Global Gold Bear Plus ETF

June 25, 2012

June 25, 2012



Screening ETFs for tax efficiency

While it should be clear by now that taxable investors should always use ETFs rather than mutual funds, differences in the tax efficiency of ETFs bears some attention. Like other forms of investing, “tax” should never be the prime reason to make an investment, however, it is common sense to be mindful of an instrument’s tax impact.

Screening ETFs by the proportional size of their historical distributions is a fair way to assess their tax efficiency. It is these distributions that incur the tax that investors seek to avoid. To be fair, indexes that change their components or are in start-up mode, may incur more transactions and more taxable activity. This should diminish over time.

When choosing between similar ETFs, picking the one with better tax efficiency may improve your after tax return. To see the tax efficiency of ETFs trading in Canada, check the free screener at: http://purinvesting.com/demo/Screen.htm