In Part 1 of this series (AER, March 2017), we explored the composition and characteristics of passive Canadian equity ETFs, their concentration, liquidity, diversification, yield, valuation and cost. In this article, we examine popular passive U.S. equity ETFs trading in Canada using similar criteria.
As know your product (KYP) standards change to address trends in best interest and fiduciary standards, the responsibility to understand products for client portfolios is expanding. The industry trend toward passive management means that the changing market characteristics reflected in capitalization-weighted indexes must be tracked.
Witness the spike in the technology sector’s weight in the S&P 500 to over 30% at the height of the tech boom in 2000, compared with 6.3% in 1990 (see Chart 1). This was a warning that index risk was shifting.
The U.S. equity market is the largest in the world. Three popular indexes are the S&P 500, the Dow Jones Industrial Average and the NASDAQ Composite. Most Canadian ETF sponsors want, need and have an S&P 500 product (see Table 1).
The S&P 500 is a popular benchmark among institutional investors, as is the Russell U.S. 1000, 2000 and 3000 series (not yet available in a Canadian-traded ETF). The S&P 500 offers broad large-cap exposure that represents corporate America, with a median total capitalization of US$19.5 billion (compared to US$2.1 billion for Canada’s S&P/TSX Composite).
The index’s selection criteria reinforces this institutional view, requiring at least a US$5.3-billion market cap, broad public float with over 50% of shares available, financial viability measured by positive current and annual earnings capability, and minimum monthly trading volume to provide liquidity.
The selection of component S&P 500 companies is by committee (rather than rules-based, like the Russell 1000), and the S&P 500 is rebalanced quarterly (rather than annually, like the Russell 1000). More frequent rebalancing can keep indexes better aligned with the markets they represent. According to S&P Dow Jones, US$7.7 trillion in assets are benchmarked to the S&P 500, and US$2.2 trillion are indexed to it. For consultants and advisors, few will criticize you for selecting this index.
Table 1: Characteristics of U.S. ETFs and indexes
|S&P 500||Dow Jones Industrial Average||S&P U.S. Total Market||CRSP U.S. Total Market||NASDAQ 100 CAD-hedged|
|Number of holdings||505||30||3,803||6,564||100|
|Concentration: top 10 holding % of total market cap||18.2%||54.0%||15.0%||16.8%||50.1%|
|Median total market cap (smallest; in millions)||$19,507|
|Diversification: lowest residual stock-specific risk (rank)||3||5||2||1||4|
|Performance—annualized total return|
|1-yr return ending February 28, 2017||24.2%||29.3%||26.3%||26.3%||28.3%|
|3-yr return ending February 28, 2017||9.9%||11.2%||9.9%||9.9%||14.4%|
|5-yr return ending February 28, 2017||13.3%||12.8%||13.8%||13.8%||16.9%|
|iShares (management fee)||XUS (0.10%)||XUU (0.07%)||XQQ (0.35%)|
|BMO (management fee)||ZSP/U (0.08%)||ZDJ (0.23%)|
|Vanguard (management fee)||VFV (0.08%)||VUN (0.15%)|
|Horizons (management fee)||HXS.U (0.10%)*||HXQ (0.64%)*|
|Powershares (management fee; CAD)||QQC (0.32%)|
|TD (management fee)||TPU (0.10%)|
|As at February 28, 2017. *Derivatives based|
Dow Jones Industrial Average
First published in 1896, the Dow Jones Industrial Average (DJIA), is a price-weighted index that remains a favourite of the media. Component companies are selected by committee. The index is calculated by adding the prices of all component company shares and dividing to adjust for stock splits and dividends.
It includes more industrials relative to other indexes, reflecting holdings like Caterpillar, DuPont, GE, United Technologies and the major oil companies. Goldman Sachs, with its relatively high stock price of about US$229 per share (as of April 6, 2017) is DJIA’s largest current holding. This illustrates the unusual nature of having a weighting scheme based on the stock’s price rather than total market capitalization, unlike other passive indexes.
For those who believe Goldman Sachs is expanding its influence with the U.S. government, the Federal Reserve and the Bank of England, however, this may be the index for you. If Alphabet (GOOG) were to be inserted into the Dow, its US$800+ share price would distort all weights with a larger skew towards technology and therefore change the DJIA’s character significantly, making it perhaps less representative as a long-term traditional benchmark.
Among Canadian sponsors, only BMO’s ZDJ offers access to the DJIA, and it’s currency-hedged. That may limit some investors, as we typically recommend that clients with investing horizons longer than three years stay unhedged. That’s because there is a cost to hedging that won’t be recouped unless they have a strong, accurate view about the loonie. Otherwise, incorporating currency risk into the investment decision makes good longer-term sense, regardless of whether your future view of the currency is positive or negative.
Source: Courtesy S&P Dow Jones Indices
The S&P U.S. Total Market and CRSP U.S. Total Market ETFs represent a broader swath of U.S. companies: 3,803 from the S&P and 6,564 from the CRSP. Those funds also include mid- and small-cap stocks. These ETFs may work for smaller portfolios because of their diversification and low management costs: 0.07% for XUU and 0.15% for VUN.
It is important to note that XUU consists entirely of other ETFs, including the iShares Core S&P 500/Total US/Mid-Cap/Small-Cap; however, the management fee is only 0.07%, making it a relative bargain.
Technology continues to be a key global economic driver, but Canada lacks diversified technology exposure. The NASDAQ 100, with a 58% information technology weight, can be a good way to participate. Be aware that the largest 10 holdings account for more than 50% of the entire index, making it almost as concentrated as the DJIA (where the top 10 equals 54%). The higher valuation of 4.2 price-to-book value versus 3.5 for the S&P 500, and the lower dividend yield of 0.90% versus 2.42% for the S&P 500, are expected. The NASDAQ 100 is more liquid than the NASDAQ Composite Index because it is more selective in component companies and focuses more on liquidity, conventional business structures and geography. Almost all NASDAQ 100 ETFs in Canada are currency-hedged, which again may limit longer-term investors.
Although 80% correlated with the S&P/TSX Composite, the S&P 500 remains an important diversifier if only because of its tech exposure. Canadian active managers find it difficult to outperform the U.S. equity market, as SPIVA has shown—so using an index is not only strategic, it’s smart.