The many benefits of ETFs: What’s not to love about them?

The availability of exchange-traded funds (ETFs) is one of the best things to happen to investors in the last twenty years. What’s not to love about ETFs?

Investors can get broad diversification on the cheap with just two or three funds. This simplicity is what tipped the scales for me nearly three years ago when I switched from a portfolio of 25 Canadian dividend stocks to my two-ETF solution (the four-minute portfolio).

But not all Canadian investors are as enamoured as I am with ETFs. While Canadian ETF assets climbed to a record $133.8 billion in assets under management (Canadian ETF Association – Aug 31 2017), the Canadian mutual fund industry claims a whopping $1.41 trillion in assets (Investment Funds Institute of Canada – Aug 31 3017).

That 10:1 ratio needs to change in a hurry, but there are still headwinds facing the average investor.

First of all, mutual funds have been around a lot longer than ETFs and their sales channels are more widely available. In plain language that means any Joe or Jane investor can go to an advisor and choose from a menu of in-house mutual funds, whereas if an investor wanted to build a portfolio of ETFs, his or her advisor might not have the right license to sell them, might not have access to an exchange to trade them, or might simply balk at the idea that a couple of low cost ETFs could outperform an actively managed portfolio of mutual funds.

Many investors are forced to go the do-it-yourself route like I did, learning on the fly from financial blogs, forums, and sometimes even the financial media about the benefits of investing in low cost ETFs.

Despite these challenges, Pat Chiefalo, the new head of iShares Canada, sees a bright future for the ETF industry in Canada as investors seek lower price points and broader exposure to different markets.

“ETFs offer a simpler and cleaner approach to building a diversified portfolio and we see that diversification makes up the vast majority of investment returns,” said Chiefalo.

Indeed, fans of this blog and of the Canadian Couch Potato’s model portfolios will recognize products like iShares Core MSCI All Country World ex Canada Index ETF: also known as XAW. This ETF gives investors one-stop-shop access to U.S., international, and emerging markets — nearly 8,000 holdings in total — for just 22 basis points (0.22% MER).

It’s hard to believe a company can make money charging $22 for every $10,000 invested, but you won’t hear Canadian investors complain. That’s because a similar global mutual fund might cost $220 for every $10,000 invested (there’s that 10:1 ratio again).

How low will ETF costs go?

Chiefalo says it’s tough for companies to compete on price, and with 14 new entrants to the ETF market in Canada in the last year alone (bringing up the total number of players to 24 firms) something has to give.

“iShares’ BlackRock is the largest ETF provider in Canada, our global scale allows us to deliver cost efficiencies to Canadian investors,” says Chiefalo.

Building a better Dividend ETF

One question I often get from readers is about finding a good-quality dividend ETF, a product that has traditionally been expensive, poorly selected, and lacking high enough yield to appeal to hard-core income-seeking investors.

Dividends are becoming an increasingly important to a lot of investors, said Chiefalo, and earlier this year iShares launched a suite of passive dividend ETFs that the company hopes will appeal to investors looking for exposure to high-quality dividend stocks at a reasonable price.

The Canadian version — XDIV — boasts an impressive 3.89% yield and costs just 10 basis points (0.10% MER). Only 23 stocks make the grade. Chiefalo explains the methodology below:

The first screen looks for companies with above-average dividend yields that have also maintained or increased their dividends over the past five years. Then, those companies are further screened based on measures of financial quality such as return-on-equity, earnings variability and debt-to-equity. This helps identify companies that have a greater potential to sustain dividend payments over time. Finally, to avoid value traps, the methodology screens out the worst performers by excluding the bottom 5% of securities with negative one-year price performance.

There’s also a U.S. version, called XDU, which holds 126 stocks, yields 2.96%, and costs just 14 basis points (0.14% MER).

Finally, the Global version, XDG, holds 268 stocks, yields 3.13%, and costs just 20 basis points (0.20% MER).

Final thoughts

While ETFs start to catch on in Canada (though not as quickly as they have with investors south of the border), I’ll continue to beat readers over the head with the idea that building a simple, broadly diversified portfolio with low-cost ETFs will lead to better outcomes.

What’s not to love about ETFs? Let me know in the comments what you’d like to see from the ETF industry.

In addition to running the Boomer & Echo website, Robb Engen is a fee-only financial planner. This article originally ran on his site on October 5  and is republished here with his permission.