The iShares S&P/TSX 60 Index ETF (XIU) has nearly $10.9 billion in assets, making it by far the largest ETF in Canada according to the Canadian ETF Association January report. It is also the oldest, and not just in Canada. In fact, its roots go back to 1990 and it is considered the oldest ETF in the world. The Globe & Mail tells the story in “The Canadian investment idea that busted a mutual-fund monopoly“.
Despite these impressive accolades, the S&P/TSX 60 Index it tracks is not ideal as a broad based passive representation of the Canadian equity market. Two major reasons make it inferior to the S&P/TSX Capped Composite Index, which is tracked by both the iShares Core S&P/TSX Capped Composite Index ETF (XIC) and the BMO S&P/TSX Capped Composite Index ETF (ZCN). These are:
Both of these contribute to higher concentration risk for XIU, a foundational theme for this analysis.
XIU invests in the 60 largest publicly traded Canadian companies, while XIC and ZCN invest in the 250 largest and cover 95% of the Canadian equities market, according to S&P Dow Jones Indices. This fact alone suggests that the 190 extra companies accessed through XIC and ZCN do a better job of providing investors with broad Canadian equity exposure in a single ETF. By owning only the largest 60 companies, XIU places extra emphasis on the biggest companies. The following table of the top 10 holdings in each of XIU and XIC shows the concentration in the largest companies.
|ROYAL BANK OF CANADA||RY||9.01||6.84||2.17|
|BANK OF NOVA SCOTIA||BNS||5.72||4.35||1.37|
|CANADIAN NATIONAL RAILWAY||CNR||4.53||3.44||1.09|
|SUNCOR ENERGY INC||SU||4.42||3.35||1.07|
|BANK OF MONTREAL||BMO||3.91||2.97||0.94|
|CANADIAN IMPERIAL BANK OF COMMERCE||CM||3.18||2.42||0.76|
Source: BlackRock.com on 2/27/2018
-West Fraser Timber
Smaller names such as WestJet, Maple Leaf Foods, Cineplex, and Canfor do not constitute a large part of the S&P/TSX Capped Composite Index, but at least they are present. Their inclusion would be expected in any index tracking the Canadian market at large.
The sector makeup of XIU is also more lopsided than XIC/ZCN. As the following table shows, XIU holds a whopping 40.62% in financials compared to 34.93% for XIC. The next two largest sectors are mixed. Energy is larger in XIU, but materials is smaller. The three largest sectors sum up to over 70% for XIU and about 65% for XIC.
Source: BlackRock.com on 2/27/2018; sorted by largest XIU sectors; may not add to 100% due to small cash and/or derivatives positions
Turning to the smaller sectors, it is clear that Canada’s market lacks a meaningful health care and information technology presence, and XIU barely has any exposure in these sectors. XIC/ZCN are a bit better. Real estate is entirely absent in XIU but makes up 2.96% of XIC. Together, the three smallest XIU sectors make up only a 2.10% weight, while those same sectors are 7.49% of XIC.
The S&P/TSX Capped Composite Index has a limit of 10% for any individual issuer. This is an important feature of a core passive fund, because it prevents things from getting out of hand. Although the largest weight in either XIU or XIC/ZCN is under 10% now, a history lesson will serve to highlight the importance of capping.
During the tech bubble, Nortel stock reached tremendous heights, peaking at around 35% of the S&P/TSX Composite in August 2000 before eventually filing for bankruptcy in 2009. The Bloomberg article Valeant’s Slide a Reminder of Canada’s BlackBerry, Nortel Legacy addresses Nortel and other past high fliers.
The surge in Nortel caused the capped the S&P/TSX Composite Index to underperform the uncapped modestly in 1999, but the capped outperformed the uncapped significantly in 2000 and 2001. In 2002, Nortel was below a 10% weight and returns converged. The chart below shows how performance differed in this period and the uncapped index suffered a more significant drawdown in the aftermath of the tech bubble.
It is possible that a stock could get massive and continue to outperform for a lengthy period, but a more prudent approach is to limit any single company to 10%.
Valid as the above points may be, the fact that the S&P/TSX 60 Index has outperformed the S&P/TSX Capped Composite Index means that investors would have been better off in XIU, especially in the last 5 years. Looking 10 years out, the difference is immaterial.
|Performance (ending 1/31/2018)||1 Year||3 Year||5 Year||10 Year|
|S&P/TSX 60 Index||6.94%||6.41%||8.56%||5.04%|
|S&P/TSX Capped Composite Index||6.67%||5.90%||7.85%||5.01%|
The sector differences explain much of the outperformance. Over the past 5 years, the financials sector (which the S&P/TSX 60 Index is overweight relative to the S&P/TSX Capped Composite Index) outperformed, while the materials sector (which the S&P/TSX 60 Index is underweight relative to the S&P/TSX Capped Composite Index) underperformed. Past outperformance does not guarantee future outperformance, but investors with a strong bias to financials and away from materials may prefer XIU. On the other hand, materials outperformance of financials is a potential tailwind for XIC/ZCN. The materials sector is unlikely to underperform the broad market by double digits over the next 5 years like it has over the past 5.
|Performance (ending 1/31/2018)||1 Year||3 Year||5 Year||10 Year|
|S&P/TSX Capped Financials TR||11.59%||14.23%||13.61%||8.86%|
|S&P/TSX Capped Materials TR||-2.11%||1.04%||-3.11%||-2.33%|
XIC or ZCN?
If the above arguments were sufficient to declare XIU inferior, which of XIC or ZCN is best? Both follow the S&P/TSX Capped Composite Index, both charge a tiny management fee of 0.05% and show a management expense ratio (MER) of 0.06%. Both are large, with over $4 and $3 billion in assets, respectively.
One point in favour of ZCN is that it has tracked the index better, with a 7 basis point lag over 5 years compared to 11 basis points for XIC (keep in mind ZCN tracked the Dow Jones Canada Titans 60 Index prior to September 21, 2012, so performance comparisons before this period are unreliable), but all in all it is a wash between these two ETFs.
|Performance (ending 1/31/2018)||1 Year||3 Year||5 Year|
|ZCN - NAV||6.65%||5.88%||7.78%|
|XIC - NAV||6.63%||5.85%||7.74%|
|S&P/TSX Capped Composite Index||6.67%||5.90%||7.85%|
Source: BlackRock.com and BMO.com
Where XIU Excels
XIU does not have the assets it does without good reason. This analysis was done through the lens of a long term passive investor seeking broad Canadian equity exposure. Not all market actors have this goal in mind. For short term trading and institutions requiring sizable liquidity, XIU offers a fast and efficient way to access to Canadian market.
XIC and ZCN are best in class passive Canadian equity ETFs. They offer broad exposure to 250 companies, cap holdings at 10%, charge low fees, and boast large asset bases with narrow bid-ask spreads.
On the other hand, XIU is limited to the 60 largest Canadian companies, does not cap holdings, and charges a higher management fee of 0.15% with an MER of 0.18%. But XIU is even more liquid and the fact that it has more in financials and less in materials may appeal to some.
This post is not meant to be taken as investment advice. Please conduct due diligence on any ETF investment you are considering, including but not limited to a review of the prospectus, underlying benchmark methodology (if applicable), portfolio characteristics, holdings, performance since inception, role in your existing portfolio, and outlook for future performance.