Selecting ETFs – Look Under The Hood

Posted on by Rizwan

In the last post on asset allocation, I went over the details on how to select the most efficient portfolio and how to make asset allocations within that portfolio. As you probably realized by now, I have structured each post that builds upon the previous ones to make the concepts easy to follow and understand. Or at least, I hope to do so! We are now at the “nuts and bolts” stage where selecting ETFs is the primary goal.

I am going to focus specifically on exchange traded funds (ETFs) and their specific benefits over mutual funds. When selecting ETFs, your goal is to maximize your after-tax returns. In this post and the next one, I am going to show you how to select the right ETFs which meet your investment goals, considering differences between US and Canada.

Selecting ETFs

ETFs – Innovation At Play And Why Are They So Good

In an earlier post about the merits of passive investing, I paraphrased from John Bogle’s book “The Little Book of Common Sense Investing” that the compounded returns earned by corporations year after year, through their resourcefulness and innovation, is nothing short of a miracle. When it comes to fund selection, you can witness that ingenuity first-hand. How come?

The concept of indexing was introduced in 1975. However, the only way to passively invest at the time was through index mutual funds which were expensive and illiquid. The game-change in the industry was achieved through the introduction of exchange traded funds (ETFs), which had two massive advantages:

1. Accessibility – Unlike mutual funds, ETFs trade openly on the stock market and anyone having access to a brokerage account can buy them.

2. Cost – Mutual funds have higher costs because of the administrative overhead required to process the orders and manually execute the buy/sell orders. With ETFs, the stock exchange (also known as the market maker) manages the whole process which is seamlessly executed through computers. The result is that ETFs have much lower fees.

Initially, the cost advantage of ETFs was not that great as most brokerages charged costs to execute the trade. However, with the competition among brokerages, the trade commissions have vastly reduced. With most online brokerages, you can now purchase ETFs commission-free although fees are charged upon selling.

Geography – Stay At Home Or Not

Selecting ETFs - Geography

When selecting which markets to track, most investors tend to usually stay in their backyard. This is especially true in the United States, which is the world’s biggest economy and has the most developed financial infrastructure. The traditional advice is to avoid home country bias and seek diversification not only in stocks but in geographical areas as well.

If you want to take this approach, that is ok. However, in my opinion, it does not really make much of a difference. Many large-cap US companies are multi-nationals and earn profits from different parts of the world, not just the US. So just because a company is incorporated in the US and is listed only the NYSE does not mean it earns all of its revenues from the US.

Tax Tip For Canadians

For Canadians, just a word of caution. Canada has a much smaller economy and much smaller population than the United States. For that reason, most Canadians understandably want a majority of their portfolio oriented towards the US stock market. However, as I mentioned in my earlier post about developing your tax-efficient investment strategy, eligible dividends (dividends paid to a Canadian resident by a Canadian corporation) have the least amount of taxes levied upon them. The preferential tax treatment of investing at home means that it is advantageous to have Canadian exposure in your investment portfolio, even though the pre-tax returns on US-denominated funds might be higher. This is precisely why the Canadian tax laws are structured in this particular way to discourage a full-fledged flight of capital from the country.

The tax issues associated with Canadians investing in the US are too complex to discuss here. Here is a link to an excellent article that can get you started. Do talk to a tax professional if you need to.

Selecting ETFs – How To Go About It?

With the growth in the ETF industry, there is an array of choices that are available. For example, an investor looking to get exposure to large-cap US stocks can purchase ETFs issued through Vanguard, Blackrock, Charles Schwab or State Street Global Advisors (not a complete list). So which ones should you select?

Much has been said about low costs when selecting ETFs and rightfully so. But there are other considerations as well. The four important aspects that you compare and select ETFs are:

1. Cost – What is the MER? Low cost means higher returns.

2. Underlying Index – which index does the ETF track? ETFs should either track the same or comparable indexes.

3. Tracking – what is the difference between ETF return and index return? A well-run ETF should have negligible tracking difference.

4. Liquidity – what is the value of assets under management and what is the average daily volume? Higher number is better as it means you do not have worry about funds closing down and forced liquidations occurring (which may trigger a taxable capital gain when you don’t want it to).

There are finer aspects as well but as an index investor, for the most part, that is sufficient. Here is a link to an excellent article on how to select the right ETF.

Selecting ETFs – A Quick Example

Assume that you are looking for exposure to US large-cap stocks in your portfolio. Here is a simple process that you can use to select the best ETF:

1. Go to Vanguard’s website and select the lowest cost ETF in that category. In this case, it happens to be VTI.

2. To see comparable ETFs, if any, go to www.etf.com and type VTI in the search bar. You will then be able to see the details of the ETF. You will also see competing ETFs from other issuers.

3. For each ETF, click on the overview, efficiency and tradability tabs to find the metrics identified above.

4. Select the best ETF.

For the example, the numbers are shown below for four different ETFs. Note that these numbers are current as of the time of this post and your values maybe different.

ETF MetricVTIITOTSCHBIYY
IssuerVanguardBlackrockCharles SchwabBlackrock
Expense Ratio0.03%0.03%0.03%0.20%
Underlying IndexCRSP US Total MarketS&P Total Market IndexDow Jones Broad US Stock MarketDow Jones US Index
Median 12m Tracking Difference0.00%-0.01%0.00%-0.19%
Assets Under Management$139.84B$24.58B$14.59B$1.20B
Average Daily Volume$824.86M$205.92M$128.57M$8.45M

Costs and Tracking Difference

Straight away, we can reject IYY as it is six times more expensive than the other ETFs. Looking at the other three ETFs, their expense ratios and median tracking differences are almost identical. All good there.

Underlying Index

Each one of the ETFs is tracking a separate underlying index. However, each one of those indexes aligns well with the broader segment index (which happens to be MSCI USA IMI Index). You can find the broader segment index in the overview tab. So, the indexes are comparable to one another and the difference between them is negligible.

Liquidity

VTI has the largest assets and largest trading volume. However, the other two funds are equally good as you do not have to worry about funds closing down and forced liquidations occurring. When it comes to selection, there is no real difference between VTI, ITOT and SCHB. You can select either one based on your preference.

For Canadians, you can view the equivalent ETFs on each issuer’s individual website and compare them individually. For example, the Canadian equivalent to VTI is VUN (which also tracks the CRSP US Total Market Index).

Also note that if your employer offers a 401(k)/RRSP matching plan, then you in all likelihood will not have the option of selecting your own ETF. In that case, simply pick whatever the lowest-cost ETF or index mutual fund that is available. Once you leave your employer or retire, you can always switch the funds to a traditional IRA or a self-directed RRSP and then select accordingly.

Summing It Up

The underlying philosophy of investing is to keep it as simple and efficient as possible. Selecting ETFs is a very simple process when you have fully internalized the concepts of tax efficiency and the modern portfolio theory. Remember, the more simple you keep it the more money you make!

Yours truly,

Rizwan.

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