An inexpensive way to diversify globally

The largest is the $1.1-billion iShares Core MSCI All Country World ex Canada Index ETF, one of three passively managed global equity index offerings managed by BlackRock. “The big-picture investment thesis behind each of those products is ultimately incorporating the benefits of breadth of diversification in a portfolio,” says Steven Leong, BlackRock’s head of ETF product. “You’re diversifying single-security, single-stock, single-sector, single-country risk as much as you can.”

Scott Johnston, head of product for Vanguard Canada, says that while there’s a case for both active and passive funds in anyone’s portfolio, index strategies are a great choice for people who may be worried about picking an active manager who then underperforms. Secondly, he adds, indexing can come at a significantly lower price for the investor than active management. “That can leave more of the value with the end client.”

Past performance of the trio of ETFs with at least three years of history bears out that contention. Within the global equity category, iShares World ex Canada, iShares MSCI World Index ETF and Vanguard FTSE Global All Cap ex Canada Index ETF all have above-average Morningstar Ratings for risk-adjusted past returns.

Always a formidable competitor on fees, Vanguard has lowered the management fee by five basis points on its already modestly priced Vanguard FTSE Global ETF. Effective Nov. 1, the new fee is 0.20%, matching what its main iShares rival charges. “This is an example of an area where we have significant scale with this product and we’re able to give more of the benefit back to investors,” says Johnston. The Vanguard ETF has about $835 million in assets, second to its largest iShares rival.

The fee sensitivity of investor demand for index funds is illustrated by the fact that the oldest of the global ETFs — the 10-year-old iShares MSCI World with assets of about $640 million — has been leapfrogged in size by its cheaper iShares sibling and by Vanguard. The management expense ratio (MER) of iShares MSCI World is 0.47%, virtually the same as when it became Canada’s first global equity ETF in June 2009.

iShare MSCI World’s fee is roughly double that of the lower-cost providers. These include the three new entrants this year, all of which are structured as ETF-of-ETFs portfolios. They are Vanguard All-Equity ETF Portfolio, launched in January, iShares Core Equity ETF Portfolio, launched in August, and Horizons Growth TRI ETF Portfolio, launched in September.

Though it lacks the global economies of scale that BlackRock and Vanguard can draw on, Horizons is able to compete effectively on fees. To keep costs down, the underlying holdings of its portfolio ETF are exclusively index-futures based Horizons ETFs. Secondly, Horizons charges no management fee other than the weighted-average fees of the underlying ETFs. The result: an MER of approximately 0.17% that’s capped at 0.19%.

“It’s essentially providing advice and not charging for it,” says Horizons president Steve Hawkins. “It’s really directed at the Mom and Pop investors now who are waking up to the costs of mutual funds and balanced funds, and getting balanced exposure and not wanting to do the underlying or not ever having done the underlying work with respect to where to allocate their money. We can do it for them for free.”

The most distinguishing characteristic of the Horizons portfolio ETF is tax deferral. Because the four underlying ETFs employ total-return swaps and are structured as corporate-class funds, they pay no dividends or other income. So there are no withholding taxes for foreign income. This enables investors in non-registered accounts to avoid tax liabilities until they sell the ETF for a profit, which is taxed as a capital gain.

Four of the six low-fee global equity ETFs include Canadian stocks, though the proportions vary. At the low end is the 3.4% weighting in iShares MSCI World, reflecting Canada’s share of market capitalization in the developed markets.

The highest Canada weighting is 30%, in Vanguard All-Equity ETF Portfolio. The remaining countries, including emerging markets, are weighted according to their market capitalization. This ETF, says Johnston, provides total world equity exposure but with a Canadian home bias.

In a variation on this theme, iShares Core Equity Portfolio employs for four geographic blocs: 25% for Canadian equity, 45% for U.S. equity, 25% for international developed markets and 5% for emerging markets. The underlying ETFs are rebalanced periodically to these target weights, which are specified in the prospectus.

The fixed weightings, says Leong, simplify the task of portfolio construction for advisors and investors who want to maintain precise geographic weightings. One of the various applications of index-style global ETFs is to serve as core holdings, around which other portfolio components can be added.

Horizons Growth TRI ETF Portfolio maintains a 15%-20% weight in Canada to satisfy what Hawkins calls the “home-centric bias” of Canadian investors. The bulk of the remaining exposure, a target weight of 55%, is devoted to U.S. equities, with the rest allocated to the developed markets of Europe and Asia.

Unlike its competitors, Horizons hedges its U.S. currency exposure back to the Canadian dollar. “We took the currency equation out of it,” says Hawkins, “so that the unitholders could really get the underlying return of a large-cap global equity portfolio without having to worry about currency.”

The most diversified global equity ETFs have exposure to emerging markets. The Horizons ETF and iShares MSCI World do not. These two ETFs have the fewest underlying holdings — about 1,400 and 1,500, respectively — and are essentially large-cap in nature.

The most widely diversified by name, and with the most exposure to small and mid-cap stocks, are the two Vanguard ETFs. Vanguard All-Equity has exposure to more than 12,600 holdings, followed by the Vanguard FTSE Global ETF with about 10,700 holdings.

Similarly, two of the three iShares ETFs, including iShares MSCI All Country World ex Canada, have more than 8,500 holdings. Many of these are small and mid-cap names. “The academic research would demonstrate that over the very long term there is a return premium through small caps,” says Leong, adding that this has not been the case in recent years. “It’s not a tactical bet. It’s really about incorporating that source of return over the long run.”