Which Canadian equity ETF is best for you?

Whether you favour active versus passive management, the array of inexpensive ETFs representing the broad Canadian equity market is impressive.

Five of the six ETFs we’ll discuss in this column (see “Canadian equity market ETFs”) have management fees of 0.05% or less. Canada, the originator of the ETF, can now boast the lowest-priced ETF at 0.03% (including a 4-bps rebate): Horizons S&P/TSX 60 (HXT). (Disclosure: my firm sub-advises for Horizons.) In the dominant U.S. market, the lowest cost ETFs are from Schwab: Multi-Cap Core (SCHB) and Large-Cap Core (SCHX), both at 0.04%.

But is price always the best arbiter of suitability? Also, why does iShares S&P TSX 60 (XIU), with the highest management fee, have the most assets? And which passive Canadian equity ETF should an investor choose?

We examine four factors in selecting an ETF: cost, diversification, liquidity and tax-efficiency.

Cost

Controlling cost is one active decision investors and their advisors can make that will have an immediate impact on performance. iShares S&P/TSX 60 commands the largest market share, with more than $10 billion invested, and charges the highest management fee of the group at 0.15%. Established in 1999, XIU is also the oldest of the cohort. Liquidity and the ability to make and receive in-kind transfers may explain the institutional attraction. But liquidity is a function of the underlying components, so all S&P/TSX 60-benchmarked ETFs should technically have the same liquidity. In-kind transfers are also possible with all of them.

The least expensive ETF, HXT, costs 0.03% after a rebate, and it holds derivatives. Institutions go through additional hurdles to research and approve counterparties when derivatives are involved, and the cost of swap fees can be a deterrent. According to Horizons, there is no swap fee for Horizons S&P/TSX 60. However, there is possible credit risk related to the ETF’s exposure to National Bank as the counterparty. We estimate that risk should command a premium of 0.09% per year (based on the yield spread between a National Bank one-year bond and the Government of Canada benchmark).

The actual implied cost of HXT is the 0.03% management expense, plus an implied 0.09% for credit risk. Unitholders only pay 0.03%, but assume an extra 0.09% as potential credit risk if the counterparty goes under. After one year, unitholders could say they’ve “earned” an extra 0.09% for assuming the extra risk that did not materialize.

HXT’s structure allows unit-holders to defer dividend income, which is a benefit for taxable accounts. We estimate the effective difference between dividends and capital gains tax to be 5%—the notional difference between capital gains taxed at about 24% (for those in the highest tax bracket) and dividends of about 32% before the dividend tax credit. This will vary depending on the investor’s situation, but 5% of the index’s 3% yield suggests a 0.15% advantage from tax. Bottom line: the lower management fee of 0.03% appears to adequately compensate for credit risk for taxable accounts. Ranked by lowest cost, the order of ETFs is: HXT, XIC, ZCN, VCE, VCN and XIU.

Broad Canadian passive ETFs, ranked by factor

Liquidity

Liquidity of the underlying holdings of ETFs that focus on the largest Canadian companies should not be a problem. ETFs based on the S&P/TSX 60 and the FTSE Canada Index fall into this category. However, as smaller cap holdings are added, overall liquidity suffers. The MSCI Canada Composite and S&P/TSX Capped Composite offer better diversification (see “Broad Canadian passive ETFs, ranked by factor”) but investors may pay a price for reduced liquidity. We ordinarily rank ETFs by daily trading volume and bid-asked spread, sampled every 30 minutes over the past 21 days to show liquidity levels. Then, we average the two. For example, assume ETF “A” trades $10 million per day, ETF “B” trades $8 million per day and ETF “C” trades $7 million per day. Further assume their respective bid-ask spreads are 0.048%, 0.045% and 0.047%.

By volume, A=1, B=2, C=3. By bid-ask spread, B=1, C=2, A=3. Putting those two factors together, B=3, A=4, C=5 (a lower score is better; B is best). Measured this way, the most liquid rankings are: XIU, XIC, HXT, ZCN, VCE and VCN (as of September 30, 2015).

Diversification

Some investors believe that more holdings means better diversification. The purpose of diversification is to minimize risk. We’ve calculated the stock-specific risk remaining for each ETF. We use a proprietary risk model to calculate the amount of specific risk for each ETF and then rank them. Stock-specific risk is risk not explained by the market. Lower residual stock-specific risk means better diversification. In Canada, more holdings generally means lower specific risk. XIC, with 242 holdings, has a lower specific risk number than HXT and XIU, which only have 60. Tied for first place are XIC, VCN and ZCN, followed by VCE. Then come HXT and XIU, both based on the S&P/TSX 60, which are tied.

Tax-efficiency

Tax-efficiency is the estimated proportion of return spent on taxes, with appropriate tax rates applied to income, dividends, interest, capital gains and return of capital distributions. HXT is the winner because it is structured as a swap with all income distributions deferred. No distributions means no tax. The others are ranked by descending efficiency: VCN, VCE, XIC, XIU and ZCN.

Advisors must choose which of these areas is most important to their clients, and choose accordingly.

Canadian equity market ETFs

Mark Yamada is President of PÜR Investing Inc., a software development firm. Disclosure: PÜR Investing Inc. provides risk-based model portfolios to Horizons ETFs.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.