Index ETFs — along with ETFs in general — have seen a huge rise in popularity in recent years. The combination of instant diversification coupled with low fees have made them a go-to choice for many investors.
With their ability to mimic the performance of indices like the S&P 500, the S&P TSX and the Dow Jones Industrial Average, index ETFs are a great way for individual investors to benefit from the performance of a large index by investing in just one fund. However, because they appear to “simply” mimic an index, index ETFs are often mistakenly labelled as passive funds: that is to say, that there is no active portfolio management involved.
This couldn’t be further from the truth. Many index ETFs are highly managed, with decisions being made constantly regarding the assets held within the ETF, how it’s balanced and its overall structure. Index ETFs can also vary in their total cost of ownership (it’s not just about management expense ratios) and the amount of support investors and advisors get from the ETF provider.
We understand that it can sometimes be difficult to tell index ETFs apart. This first part of two blogs on index investing will reveal ways you can differentiate between ETFs when it comes to index exposure (which means the index an ETF tracks and that index’s methodology) and product structure, and how those differences can affect your returns. You will discover how index ETFs can be far from equal.
The differences in index exposure
You would be forgiven for thinking that two different ETFs that provide exposure to the same market segment but track different indexes would end up with the same performance. However, index methodologies can vary, resulting in different performance outcomes. Let’s look at Canadian large cap equities as an example (these are Canadian companies with a market capitalization above $10 billion).
The Solactive Canada Large Cap Index and the S&P/TSX 60 Index both appear very similar, in that they provide exposure to the largest 60 companies in Canada. However, each index uses very different methodologies, which can in turn have a bearing on the corresponding fund’s turnover, tax outcomes, or returns — and sometimes all three. There are several index construction components that can affect an index’s performance (and therefore that of ETFs that track it):
The selection of assets: this can either be a rules-based approach, or a more subjective approach, where the index committee makes those decisions.
Weightings: this is the choice of how different proportions of components will make up an index. For example, equal weighting can be given to all assets, or more weighting given to larger companies (so the bigger the company, the bigger the percentage of the fund it takes up).
Maintenance frequency: how often and when the assets within the index are rebalanced and reconstituted.
Style, sector and/or theme definitions: every index provider can have their own definitions when it comes to value versus growth and large market capitalization versus mid market capitalization, for example.
Market cap buffer zones: many index providers introduced buffer zones to reduce unnecessary turnover. They are essentially overlapping thresholds, between what determines small, mid and large cap companies. Previously, any company that dipped over or under the threshold would have to be removed from the index. However, these buffer zones can vary from index to index, so the assets held within them can be considerably different.
Given how much these components can vary, it makes more sense to compare index ETFs by the index they track, rather than just their name.
ETFs can also sample or fully replicate an index. Some indices can be very difficult to fully replicate, particularly within fixed income, so providers will instead hold a sample of securities that reflect the characteristics of the index.
When sampling happens, there can be different levels of active management involved. A portfolio manager must decide daily as to which securities to include or exclude from the ETF. The level of active management, and the decisions made, will have an impact on the ETF’s performance.
The structure of an ETF and the country where it is listed can also have an impact on its performance. ETFs can contain either derivatives (underlying assets or a group of assets), securities (for example, shares or bonds) or a collection of other ETFs. They can also be listed in the US or Canada.
Each method can have a different impact on the ETF’s performance and its tax impact for the investor. Depending on the type of account that holds the ETF (for example, RRSP, TFSA or non-registered accounts), buying US-listed ETFs, for example, can result in withholding tax. It can also have an impact on total returns due to currency exchange.
US-listed ETFs that hold emerging market debt can end up being charged withholding tax twice: once in the country of origin and again in the US. Investing in Canadian-listed fixed income ETFs can reduce the withholding tax, and therefore increase your overall returns, considerably.
An ETF provider can sometimes choose to lend some of a fund’s eligible securities to other financial institutions, in return for a fee. This can lead to an increase in an ETF’s returns.
How much the investor benefits from the lending fee depends on where the ETF is listed. In the US, for example, ETF providers are allowed to keep some of the lending fee that they charge, rather than passing it all on to the investor. In Canada, however, all revenue from lending fees must go back to the investor.
Dig deeper into index ETFs
Our white paper, Due diligence on index investing, provides a much deeper dive into what you need to look out for when choosing index ETFs for your portfolio. You can read the whitepaper here.
Stay tuned for part two of our index ETFs blog.
For more information on how to choose the right index ETFs, advisors can talk to their Mackenzie sales representative and investors should talk to their advisor.