Hello everyone. Are you ready for a crash course in understanding exchange-traded funds (ETFs)? That’s what my new “Understanding ETFs” video blog series is all about. Today, we’ll kick things off by popping the hoods on a sporty collection of Canadian equity ETF solutions for your portfolio’s domestic stock allocation.
What’s that you say? You’d rather buy stocks instead of ETFs? Don’t feel bad if you’re laboring under this misperception. I hear it all the time. Remember, ETFs are simply empty “containers” for holding your actual, underlying investments – be they stocks, bonds, REITs or other securities. In other words, by investing in any of the ETFs I mention in this video, you are investing in stocks, – in this case, Canadian ones.
We also prefer ETFs that fill their “containers” by tracking broad-market stock indexes (whose job is to efficiently and effectively proxy the entire stock market as closely as possible). This means no clever stock-picking monkey business is required or desired – by you or the ETFs in which you invest.
With that introduction, let’s start building a Canadian stock portfolio.
Anonymous TIPs
Some of you may be surprised to learn that the world’s first ETF was created here in Canada by the Toronto Stock Exchange in 1990. It was called the Toronto 35 Index Participation Units (TIPS 35 Fund), or TIPs for short. This fund allowed investors to participate in the performance of the Toronto 35 Index without having to purchase individual shares of 35 different companies.
TIPs was followed by a second ETF, the TSE 100 Index Participation Fund (TIPS 100 Fund), or HIPs for short. It tracked the broader TSE 100 Index.
In March 2000, TIPs and HIPs merged into today’s single fund, the iShares S&P/TSX 60 Index ETF (XIU). XIU is still the largest ETF in Canada today, with assets under management just shy of $10 billion. The XIU fund tracks the S&P/TSX 60 Index, which was created by Standard & Poor’s to track the performance of 60 large Canadian companies. Its largest holdings include a number of household names among Canada’s dominant industries.
Top 10 Holdings by XIU Weight
| Company | Symbol | Weight (%) |
|---|---|---|
| Royal Bank of Canada | RY | 8.8% |
| Toronto-Dominion Bank | TD | 8.5% |
| Bank of Nova Scotia | BNS | 5.6% |
| Canadian National Railway Co | CNR | 5.0% |
| Suncor Energy Inc | SU | 4.8% |
| Enbridge Inc | ENB | 4.2% |
| Bank of Montreal | BMO | 4.0% |
| Canadian Imperial Bank of Commerce | CM | 3.2% |
| Canadian Natural Resources Limited | CNQ | 3.1% |
| Brookfield Asset Management Inc Class A | BAM.A | 3.0% |
Source: BlackRock Asset Management Canada Limited as of September 28, 2018
Each company in the S&P/TSX 60 Index is weighted according to its “float-adjusted” market capitalization. A company’s market capitalization (a.k.a. “market cap”) is calculated by taking its current stock price, and multiplying this figure by the number of shares the company has outstanding. For example, suppose Husky Energy (HSE) has 1 billion shares outstanding with a current price of $20 per share – its market cap would be $20 billion ($20 price per share × 1 billion shares outstanding).
If the market cap of all companies in the index had a worth of $1.8 trillion, HSE would make up about 1.11% of the index ($20 billion ÷ $1.8 trillion).
Under a “float-adjusted” market cap, index managers only count shares that are available to investors, rather than all of a company’s outstanding shares. They exclude shares that are closely held by control groups, other publicly traded companies or government agencies.
Example: Husky Energy is controlled by Hong Kong billionaire Li Ka-shing, who owns approximately 70% of the outstanding shares (which leaves only 30% of the shares for regular investors, or 300 million shares in our example). If each share is worth $20, its float-adjusted market cap would be $6 billion (300 million shares × $20 per share).
Assuming the total float-adjusted market cap of all 60 companies within the S&P/TSX 60 Index was also lower (maybe around $1.7 trillion instead of $1.8 trillion), Husky Energy would make up only about 0.35% of the total float-adjusted index weight ($6 billion ÷ $1.7 trillion).
| Market Cap (CAD Billions) | Float-Adjusted Market Cap (CAD Billions) |
|
|---|---|---|
| Husky Energy Inc (A) | $20 | $6 |
| S&P/TSX 60 Index (B) | $1,800 | $1,700 |
| Company Weight in Index (A / B) | 1.11% | 0.35% |
Float-adjusted market caps are meant to create an index where each component’s influence (weight) best reflects practical realities for the market involved. Still, some well-deserving large-cap companies may not make the cut. For example, companies like Shopify, Fairfax Financial, Canopy Growth Corporation and Aurora Cannabis are currently excluded from the S&P/TSX 60 Index, due to a Standard & Poor’s sector-weighting rule (to maintain sector weights similar to the overall Canadian stock market, S&P’s index committee replaces some large-cap companies with smaller ones). This may be a hard pill for passive investors to swallow, as this arbitrary sector rule could be considered by some indexing purists to be active stock picking.
If you feel like you’re missing out on the returns of these and other excluded Canadian companies, there’s another ETF that can complete your Canadian ETF package – the iShares S&P/TSX Completion Index ETF (XMD).
As the name suggests, XMD complements XIU by including the handful of omitted large-cap stocks just described, plus a healthy dose of mid- and small-cap stocks. The XMD fund follows the S&P/TSX Completion Index, which in turn tracks the performance of about 188 mostly small and medium (aka, small-cap, mid-cap) Canadian companies. By allocating about 75% of your investment dollars to XIU, and the remaining 25% to XMD, you gain exposure to most of the Canadian stock market (at an annual cost of about 0.29%).
| Tracking ETF | Symbol | MER (%) | Underlying Index | Number of Companies | Dividend Yield (%) |
|---|---|---|---|---|---|
| iShares S&P/TSX 60 Index ETF | XIU | 0.18% | S&P/TSX 60 Index | 60 | 3.0% |
| iShares S&P/TSX Completion Index ETF | XMD | 0.61% | S&P/TSX Completion Index | 188 | 2.7% |
Sources: BlackRock Asset Management Canada Limited, S&P Dow Jones Indices as of September 28, 2018
By now, you may be thinking: “Wouldn’t it be easier if there were a single index that followed a combination of the S&P/TSX 60 Index and the S&P/TSX Completion Index?”
You’re right, which is why there’s the S&P/TSX Composite Index. Considered by many to be the benchmark index for Canadian stocks, it includes about 248 companies and covers approximately 95% of the Canadian stock market.
You also may wonder whether there’s a single ETF for investing in all 248 companies in the composite index – so you could invest in one fund instead of two (XIU and XMD), and achieve the same goal.
Good news: Not only is there an ETF for that, there are two possibilities. The iShares Core S&P/TSX Capped Composite Index ETF (XIC) and the BMO S&P/TSX Capped Composite Index ETF (ZCN).
Both ETFs have an annual cost that is much lower than the weighted-average cost of XIU and XMD, making them more cost-effective alternatives to the multi-fund approach.
| Tracking ETF | Symbol | MER (%) | Underlying Index | Number of Stocks | Dividend Yield (%) |
|---|---|---|---|---|---|
| iShares Core S&P/TSX Capped Composite Index ETF | XIC | 0.06% | S&P/TSX Capped Composite Index | 248 | 3.0% |
| BMO S&P/TSX Capped Composite Index ETF | ZCN | 0.06% | S&P/TSX Capped Composite Index | 248 | 3.0% |
Sources: BlackRock Asset Management Canada Limited, BMO Asset Management Inc., S&P Dow Jones Indices as of September 28, 2018
You may notice, each of the ETF names include the term “Capped.” Not to be confused with our earlier conversation about market caps (i.e., market capitalizations), the similar term indicates that all company weights will max out – be capped – at 10% if they happen to get too big for their own good. This was the case with Nortel in 2000, when its uncapped value would have accounted for more than a third of the S&P/TSX Composite Index.
Standard & Poor’s launched its capped index in January 2001 – around the same time, Nortel’s price steadily fell from $124/share to $22/share between August 2000 through March 2001. After the 82% decline, Nortel ended up accounting for less than 10% of the index on its own. In fact, no security in the S&P/TSX Composite Index is currently above 10%, so it is essentially identical to the S&P/TSX Capped Composite Index at this time. That said, it’s good to know the cap is there if we ever need it.
| Company | Symbol | Weight (%) |
|---|---|---|
| Royal Bank of Canada | RY | 6.6% |
| Toronto-Dominion Bank | TD | 6.4% |
| Bank of Nova Scotia | BNS | 4.2% |
| Canadian National Railways | CNR | 3.8% |
| Suncor Energy Inc | SU | 3.6% |
| Enbridge Inc | ENB | 3.2% |
| Bank of Montreal | BMO | 3.0% |
| Canadian Imperial Bank of Commerce | CM | 2.4% |
| Canadian Natural Resources Limited | CNQ | 2.3% |
| Brookfield Asset Management Inc Class A | BAM.A | 2.2% |
Source: BlackRock Asset Management Canada Limited as of September 28, 2018
Playing FTSE
When Vanguard arrived in Canada in 2011, it launched the Vanguard FTSE Canada Index ETF (VCE), which follows the FTSE Canada Index. FTSE stands for the Financial Times Stock Exchange, and is typically pronounced “foot-see.” Just as Standard & Poor’s manages its S&P indexes, the FTSE Group (a subsidiary of the London Stock Exchange Group), manages the FTSE indexes. The FTSE Canada Index includes about 61 Canadian large-cap stocks … so very similar to the S&P/TSX 60 Index. If you combine about 79% of this large-cap index, with roughly 21% of the FTSE Canada Small Cap Index, you end up with the FTSE Canada All Cap Index, which is very similar in composition to the S&P/TSX Capped Composite Index.
| Tracking ETF | Symbol | MER (%) | Underlying Index | Number of Companies | Dividend Yield (%) |
|---|---|---|---|---|---|
| Vanguard FTSE Canada Index ETF | VCE | 0.06% | FTSE Canada Index | 61 | 3.1% |
| N/A | N/A | N/A | FTSE Canada Small Cap Index | 151 | 2.5% |
| Vanguard FTSE Canada All Cap Index ETF | VCN | 0.06% | FTSE Canada All Cap Index | 212 | 3.0% |
Sources: Vanguard Investments Canada Inc., FTSE Russell Indices as of September 28, 2018
In 2013, instead of augmenting VCE with a small-cap ETF complement, Vanguard jumped directly to competing with XIC. It did so by launching the Vanguard FTSE Canada All Cap Index ETF (VCN), which follows the broader FTSE Canada All Cap Index. This index includes the same 61 larger companies in the FTSE Canada Index, plus another 151 or so smaller companies. The reference to “All Cap” in the name indicates that the index tracks the performance of small-, mid- and large-cap companies. (This time, not to be confused with “capped” ETFs, as described above!) Although VCN holds 36 fewer stocks than XIC, these 36 stocks account for less than 4% of XIC’s total value. Shopify is the most obvious exclusion from VCN, due to FTSE’s choice to allocate the company to its US equity indices instead of their Canadian. A number of Brookfield Limited Partnerships are excluded from VCN as well, as LPs are ineligible for inclusion in FTSE’s global equity indices.
| Security | Symbol | Weight in XIC | Weight in VCN | Reason for Exclusion from VCN |
|---|---|---|---|---|
| Shopify | SHOP | 0.88% | 0.00% | FTSE allocated SHOP to their US equity indices |
| Brookfield Infrastructure Partners LP | BIP.UN | 0.63% | 0.00% | FTSE excludes Limited Partnerships (LPs) |
| Brookfield Property Partners LP | BPY.UN | 0.36% | 0.00% | FTSE excludes Limited Partnerships (LPs) |
| Brookfield Renewable Partners LP | BEP.UN | 0.21% | 0.00% | FTSE excludes Limited Partnerships (LPs) |
| Brookfield Business Partners LP | BBU.UN | 0.11% | 0.00% | FTSE excludes Limited Partnerships (LPs) |
| Total | 2.19% | 0.00% | FTSE excludes Limited Partnerships (LPs) |
Sources: BlackRock Asset Management Canada Limited, Vanguard Investments Canada Inc., as of September 28, 2018
However, these and other stock exclusions are unlikely to have a material impact on the future return differences between VCN and XIC. In fact, since 2003, both of the ETF’s underlying indices have returned an identical 8.7% on an annualized basis.
A kick at the RCAN
RBC was a little late to the game, but in 2017 they launched the RBC Canadian Equity Index ETF (RCAN), which tracks the FTSE Canada All Cap Domestic Index.
The term “Domestic” in the name indicates that this particular index methodology does not apply any foreign ownership restrictions when calculating each individual company’s weight in the index (whereas the FTSE Canada All Cap Index does adjust the company weights for foreign ownership restrictions). It’s interesting to note that the S&P/TSX Capped Composite Index does not adjust their company weights either with regards to foreign ownership restrictions.
For example, Bell Canada (BCE) is subject to the Telecommunications Act, which governs the Canadian ownership and control of Canadian telecommunications carriers. The Act restricts foreign investment in voting shares of BCE to a maximum of 33 1/3%. If we view the weight of BCE in each of the broad-market ETFs we have just discussed, we find that all of them have a 2.1% weight to BCE, with the exception of VCN, which has a lower weight of 0.7%. If we divide 0.7% by 2.1%, we end up with 33.33%, the maximum foreign ownership of the company allowed.
| Security | Symbol | Weight of BCE |
|---|---|---|
| iShares Core S&P/TSX Capped Composite Index ETF | XIC | 2.1% |
| BMO S&P/TSX Capped Composite Index ETF | ZCN | 2.1% |
| RBC Canadian Equity Index ETF | RCAN | 2.1% |
| Vanguard FTSE Canada All Cap Index ETF | VCN | 0.7% |
Sources: BlackRock Asset Management Canada Limited, BMO Asset Management Inc., RBC Global Asset Management Inc., Vanguard Investments Canada Inc., as of September 28, 2018
At the beginning of 2019, RBC and BlackRock Canada announced an ETF partnership under the brand RBC iShares. On or around April 5th, 2019, they will be merging RCAN into XIC (which may have tax consequences for the current unitholders of RCAN). Due to this upcoming taxable disposition, it would be prudent to avoid RCAN as a core Canadian equity ETF holding going forward.
Going Global for Effective Diversification
So there you have it: a collection of ETF solutions to consider for creating broad-market Canadian equity exposure. Don’t obsess over which one is the best. Any of them should get the job done, and all of them are strongly preferred over expending time and energy trying to pick individual stocks on your own.
Before we wrap, I’ve got one more point to make. It’s well known that our Canadian stock market is over-exposed to four sectors: financials, energy, industrials and materials. No matter which Canadian broad-market ETFs you choose, these four sectors will end up representing approximately three-fourths of the value of your holdings. The best way to easily diversify away from this sector risk is to include a healthy dose of global stocks in your overall equity allocation.
Fortunately, that gives me plenty more to discuss in future installments of my “Understanding ETFs” series. Next up, I’ll take a closer look at broad-market U.S. equity ETFs.
| Tracking ETF | Symbol | MER (%) | Underlying Index | Number of Stocks | Dividend Yield (%) |
|---|---|---|---|---|---|
| iShares Core S&P/TSX Capped Composite Index ETF | XIC | 0.06% | S&P/TSX Capped Composite Index | 248 | 3.0% |
| BMO S&P/TSX Capped Composite Index ETF | ZCN | 0.06% | S&P/TSX Capped Composite Index | 248 | 3.0% |
| Vanguard FTSE Canada All Cap Index ETF | VCN | 0.06% | FTSE Canada All Cap Index ETF | 212 | 3.0% |
Sources: BlackRock Canada, BMO Asset Management Inc., Vanguard Investments Canada Inc., as of September 28, 2018
Hi Justin,Having read your posts about understanding equity ETFs (this one and the US and foreign equity posts) I really liked the way you explained equity ETFs in a methodical, progressive manner. Reading through those articles really helped me grasp what’s available for such ETFs and their attributes.Have you ever thought about doing something similar but for fixed income ETFs?
@Jim – I’ve certainly thought about it, but it would be much more complicated than the equity videos.
When I look at the holdings for VCN on their website, it definitely lists SHOP as one of the top holdings. Was this a recent addition?
@Nicholas: It sure was – Vanguard added it sometime after I released the video/blog.
Glad I saw this clarification. I can rest easy now!
Hi Justin. Thanks for such wonderful well organized info! I’m just starting to learn about ETF investing and this is very helpful. I have a question. Is VCN capped like the XIC and ZCN to prevent things like Nortel situation?
@Jenny: Great question! The FTSE Canada All Cap Index (which VCN follows) is not capped, so a Nortel-like situation could be possible in the future (hopefully Vanguard would speak with FTSE Russell about implementing an index change if this became a reality).
Hi Justin,
I have a stupid question
I was using Modified Dietz Rate of Return Calculator for my TD e-series where all the dividends were automatically reinvested.
I switched recently to ETF (VCN&XAW) where the dividends have to be manually reinvested.
Just wondering how am I treating the entry when I’m buying new units with the dividend paid. Is that treated as a “+ cash” (in this case the interest on return for an ETF might be different vs an E-series due to DRIp
Thanks
@Ale: If you’re calculating the Modified Dietz return for an individual ETF, you would have to add any cash to the month-end market value that wasn’t reinvested into the ETF (because it couldn’t purchase a full share). The reinvested dividend will increase the market value of the ETF holding, so this will already be accounted for.
Thank you Justin for another excellent post!
What is your thought about combining XAW/VCN in a 95%/5% ratio in the CCP model to reflect the real relative sizes of the equity markets.
I have always wondered why all the CCP models have 2/3 vs /1/3 split (over-representing Canada). What is the benefit of this strategy compared to the one above. Please educate me on this point.
Thank you for all your amazing teaching
@Ahmed: I’ve written about this topic here:
https://canadianportfoliomanagerblog.com/ask-bender-canadian-stocks-vs-global-stocks/
https://canadianportfoliomanagerblog.com/ask-bender-canadian-stocks-vs-global-stocks-part-ii/
Thank you Justin! Appreciate the quick answer.
Ahmed
Hi Justin,
After reading this blog post, some people holding significant amounts of VCN in their registered accounts might be inclined to sell it all to buy XIC instead (despite a historically similar performance for both ETFs). However I am not so sure.
What are your thoughts? Would there be any significant disadvantages to be aware of? I am thinking that the difference between the NAV of each ETF and the bid/ask prices might have a negative effect on one’s portfolio, but perhaps that is not significant?
Thanks,
@Mark: I’m not certain selling VCN to buy XIC (even if there are no tax consequences) would be prudent, as we don’t know whether the index methodology differences will lead to outperformance of either ETF going forward. If this is something you’re concerned about, you could consider adding new contributions to XIC instead of VCN.
Hi. Justin
Just came across this video on DIY building ETF portfolio with TD…you made this video 2 years ago, would still recommend investing in TV these ETFs in 2019?
https://youtu.be/S5LmyozD4d4
@Jay: I have updated model ETF portfolios available here (but they’re very similar to the ones in the videos):
https://canadianportfoliomanagerblog.com/model-etf-portfolios/
There are also new asset allocation ETFs from Vanguard/iShares/BMO that would be worth considering.
Thanks for another great post, Justin – I have learned so much from your blog and website.
I am confused as to why VCN’s allocation to BCE is 0.7% and not 1.4%.
Are BCE shares held by VCN considered to be held by a foreign investor?
Thanks,
Steve
@Steve: In the video, I show that XIC, ZCN and RCAN each allocate 2.1% to BCE (which is BCE’s float-adjusted market weight in the S&P/TSX Capped Composite Index and the FTSE Canada All Cap Domestic Index). There are no foreign ownership restrictions in the indices that these ETFs follow.
VCN only allocates 0.7% to BCE (which is 1/3 or 33.33% of the 2.1% weight to BCE in XIC, ZCN and RCAN). This is because the FTSE Canada All Cap Index restricts the weight of BCE to the amount of shares foreign investors are allowed to own (which is 33.33%). So it’s kind of like another float-adjustment. Unfortunately, since we’re Canadian investors buying VCN, it doesn’t make a lot of sense to have this restriction (perhaps Vanguard Canada will adjust their index after watching this video).
Thanks Justin – I get it now!
@Steve: I should also add that BCE is not the only company subject to this foreign ownership restriction in the FTSE Canada All Cap Index – Telus, Air Canada and West Jet are some other notable companies with noticeable underweights, relative to the S&P/TSX Capped Composite Index, or the FTSE Canada All Cap Domestic Index.
Hi Justin
A question re moving equity funds such as VCN FTSE from a taxable account to TFSA vs RRSP. Is there a preference to move equity funds such as this to a TFSA first, even though there’d be tax sheltering and income reduction if it was placed in an RRSP? Thanks for helping sort this stuff out! Beverley
@Beverley Cassidy: Most Canadians in relatively high tax brackets should generally be maxing out their TFSAs and RRSPs if they have taxable investments available (usually the RRSP first, then the TFSA).
Thanks for this excellent summary Justin! Slowly but surely getting a grip on this stuff! Really appreciate that you write these series. Beverley
Could you also please write about Global index EFTs that includes Canada and the US? I really like the idea of having 1 global ETF like VT ( but I don’t think this fund is available for Canadians as I was only able to find it on the US vanguard site and not the Canadian one. ) Thanks!
@Darlene: I can certainly include VT in my Global Equity ETF video (along with VXC and XAW).
As always, great stuff Justin, thanks.
@Bob Clark: Thank you, Bob – I appreciate the feedback :)
Awesome Presentation. This is the first time i really understand the ETF landscape in Canada.
@Guy Cossette: Excellent to hear – there’s still a lot of information to follow, so stay tuned!
Keep up the great work Justin, another outstanding piece of work, quite frankly I wasn’t aware of the float adjusted aspect of these ETFs or the completion ETF.One point you should have compared the long term performance of XIC vs XIU, I think there very similar, though I could be wrong.please use that comparison in your next blog-S&P 500 vs Broad market US returns
Thanks
Lyndon
@Lyndon: Thanks, Lyndon! Over the past 10 years, the S&P 60 Index and the S&P Composite Index both returned 7.9% annualized. Over the past 20 years, they returned 6.8% and 6.6%, respectively.
Since 2005 (the inception date of the S&P TMI), the S&P 500 Index and the S&P Total Market Index have each returned 8.6% annualized (in CAD).
Thank you for all the valuable info! I currently hold VCN, but going forward, I’m considering buying ZCN or XIC because of the 10% cap. Seems like a prudent feature.
@GMMT: After watching this video, I’m sure there will be more investors thinking of doing the same thing. Perhaps Vanguard Canada will change the underlying index of VCN to the “FTSE Canada All Cap Domestic Index”, and speak to FTSE about including a 10% cap as well. And maybe ask FTSE to include Shopify where it should be…in the Canadian equity indices ;)
How do the e series at TD compare? Specifically, the Canadian index – e? I know the mer is higher, but with frequent purchases, it seems a better choice for me. How do the weights compare to the others you listed?
Thanks in advance.
@Heather: The TD Canadian Index Fund – e-Series follow the S&P/TSX Composite Index (so it is very similar in composition to XIC and ZCN, except that it will not cap the individual stock weights at 10%).
I use your explanations with my students. Thanks for posting!
@Dr. vdB: So glad to hear this information is useful to your students as well (best to get them on the right track at an early age).
Thank you Justin! I could really not have invested in these products without you and Dan’s blogs.
Your help has been invaluable.
@Dr. MB: Glad we could help! :)
Hey,
So my question is, If we hold any of these etfs in a Tfsa will we have to pay any tax on the dividends? Or are they completely tax free because the funds hold the underlying Canadian stocks directly?
@Mike: If you hold these Canadian equity ETFs in a TFSA, you never pay any tax on the dividends, income or capital gains.
Holding the underlying Canadian stocks directly is not a requirement for avoiding taxes in a TFSA for Canadian equity ETFs – they could technically hold another Canadian-listed Canadian equity ETF, and all dividends/income/capital gains would still be tax-free.