on the TSX
FTSE RAFI Canada
Sector Allocation (%):
Market Cap Allocation (%):
Sources: BlackRock Canada, Claymore Investments, Dimensional Returns 2.2, FTSE, Morningstar EnCorr, S&P
Sources: Morningstar EnCorr, Claymore Investments, Dimensional Returns 2.2
Index Weighting Methodology: I always tend to favour indices that in no way attempt to forecast any inputs used for their weighting methodology. The Dow Jones Canada Select Value Index relies on projected price-to-earnings ratios as well as projected growth values to weight their index, while the FTSE Canada Index obtains all their data from the companies’ annual statements.
Number of Holdings: CRQ is the marginal winner here, with a basket of 82 holdings - versus XCV with only 70 holdings.
Average 3-Yr. Portfolio Turnover Rate: With an average portfolio turnover rate of nearly half of XCV, CRQ is the first choice (21.36% versus 40.41%), especially when holding the ETF in a non-registered account.
Top 10 Holdings Concentration: Fortunately, the Dow Jones Canada Select Value Index has a cap of 10% per security, or else the security concentration could be an even bigger concern. With CRQ having much less single security risk than XCV, it is the preferred choice for the investor looking for greater diversification.
Sector Allocation: Both CRQ and XCV are concentrated heavily in the Financials sector – with XCV being the biggest culprit, at nearly 53% of the overall portfolio.
Market Cap Allocation: Similar for both CRQ and XCV.
Assets under Management: Although the risk is small that BlackRock Canada would shut down XCV, CRQ dwarfs it by over 4 times the amount of assets under management.
MER: Here’s where both ETFs (especially CRQ) could use some improvement. Passive investment works when the investment vehicles are low-cost – with an MER of 0.71%, or even 0.54%, serious thought should be given in determining if the high fee justifies the expected higher returns from a value-based stock selection approach.
Annualized Returns: XCV has a slightly higher return since November 2006 than CRQ (4.14% compared to 4.02%).
Annualized Standard Deviation: CRQ had lower volatility than the XCV since November 2006 (16.77% compared to 17.68%).
AND THE WINNER IS: CRQ
Although the MER is too high in my opinion (I would ideally prefer to invest in a value-based index ETF or mutual fund with a cost of 0.40% or below), CRQ may be appropriate for investors seeking a higher long-term expected return for a portion of their portfolio’s Canadian equity allocation, especially when holding it in a non-registered account.
Vanguard researchers have determined in a recent paper that historically, rebalancing only once or twice a year, and only when the portfolio’s asset-allocation target is off by at least 5%, is probably good enough for most investors.
Larry Swedroe, in his book, “The Only Guide You’ll Ever Need for the Right Financial Plan,” discusses the 5/25 rebalancing rule. In the 5/25 rule, your portfolio is only rebalanced if an asset class wanders either plus or minus 5% from the original asset-allocation target, or plus or minus 25% of the original asset-allocation target (whichever one is less).
To further illustrate this concept, I’ve included a sample target allocation for a balanced portfolio in Table 1 below, followed by acceptable overweights and underweights, using both the 5% and the 25% rule. The lower absolute amounts using either the 5% or 25% rule for each asset class (highlighted in light blue) are then added and subtracted from each target allocation to determine the maximum and minimum asset class thresholds.
In Table 2 below, a sample rebalancing table is shown, with the target allocations, as well as the minimum and maximum asset class thresholds. Investors can create a personalized rebalancing table in order to bring greater discipline to their rebalancing schedule.
As with any rule, there will always be exceptions. However, creating a rebalancing table is just one more step that investors can easily take that will encourage a more systematic and unemotional investment process.
Vanguard has recently announced their initial Canadian product line-up – generating mostly luke-warm interest from investors:
“…the initial line-up are likely to be disappointing for investors wanting currency unhedged exposure to US and EAFE markets”
- Canadian Capitalist
“Unfortunately, they also incorporate currency hedging back to Canadian dollars. This takes away the risk protection that I’m looking for…”
- Michael James on Money
“Canadian investors already have an extreme bias to their home market, so when buying foreign equity funds they need meaningful diversification, which includes currency.”
- Tom Bradley, President of Steadyhand Investment Funds
Why have Vanguard’s proposed currency-hedged products been drawing such criticism? The answer may lie in the historical volatility of currency-hedged products in Canada. In the graph below, I’ve compared the historical 3-year rolling standard deviations of two hypothetical balanced portfolios; one with currency-hedged products and one without. As can be seen below, the portfolio that hedged the exposure of foreign currency risk (grey line) has been consistently more volatile than the portfolio that didn’t hedge away this risk (dark blue line) throughout the measurement period.
If investors have historically received a more volatile investment experience by investing in currency-hedged ETFs, perhaps the increased supply of these products lies in their superior past performance. However, the annualized performance of the above hypothetical portfolios from December 2005 to August 2011 (the longest period that both iShares products, XSP and XIN, followed a currency-hedged index), rebalanced annually, would counter this argument. Not only did these currency-hedged portfolios have more volatility on average than their unhedged counterparts (9.32% compared to 7.90%), they also had lower returns (3.75% compared to 3.81%):
In the future, my “Wishlist” from Vanguard would include unhedged versions of their MSCI Total Stock Market ETF (VTI) and MSCI International Stock ETF (VXUS). It is true that these products can already be purchased and sold on the U.S. exchange, but the excessive currency conversion charges levied by our Canadian brokerages can prohibit efficient portfolio construction and tax-loss selling.
Chris Philips, CFA, a senior analyst in Vanguard's Investment Strategy Group, gave his opinion on Fitting International Stocks in a Portfolio from a U.S. investor’s viewpoint:
“We think that for most investors, a great starting point is 20%. You get a significant amount of historical diversification benefit. You get some exposure to non-U.S. stocks and the fluctuations of currency, of markets, of economies globally. We do believe that if you are so interested, you can extend that to maybe 30% or 40%, and we'd actually be comfortable going all the way up to maybe market-cap-proportional, which would currently be around 55%. But that 20% range is probably a great starting point for somebody to look at.”
From a historical Canadian viewpoint, diversifying up to 50% of your equity holdings to non-Canadian stocks has resulted in a significant reduction in volatility. Incremental reductions in volatility have been obtained by diversifying even further than 50% away from Canadian stocks (although some investors may be uncomfortable with the additional currency risk inherent with this strategy). In the graph below, historical 3-year rolling standard deviations are shown (vertical axis) for four hypothetical balanced index portfolios (rebalanced annually) with various allocations to Canadian, U.S. and International equities:
As can be seen in the graph above, in almost all periods studied, balanced index portfolios with higher allocations to U.S. and International stocks (Portfolios 2, 3 and 4) have exhibited lower volatility, relative to a balanced index portfolio comprised entirely of Canadian stocks (Portfolio 1).
There are a number of reasons for this large reduction in volatility, mainly:
Interestingly enough, the historical annualized returns (from December 1979 to June 2011) are almost identical for all four hypothetical balanced index portfolios, showing that a globally diversified portfolio has historically resulted in similar returns with reduced volatility (something all nervous investors would have been delighted with):