Investing in Canada
Canada accounts for only 2-3% of the world's security markets, based on stock market capitalization. The Canadian stock market suffers both from a lack of breadth (insufficient variety of companies) and a lack of depth (rapid drop-off of capitalization) in comparison to the American stock market. For these reasons, some investors prefer not to invest in Canadian stocks at all, but use the American indexes. For others, the exchange-traded funds or index funds discussed below offer inexpensive and tax-efficient Canadian equity exposure without the effort needed to select individual securities.
As retirement approaches, dividend-paying Canadian investments (discussed in later sections on Canadian stocks and preferred shares) become an attractive alternative. Although the tax payable on dividends represents undesirable friction during asset accumulation, upon retirement dividend-paying Canadian stocks form a particularly useful source of income for many retirees. The reason is the dividend tax credit, which allows dividend income from Canadian companies to be taxed at a lower rate. If a retiree can stay in the lowest federal tax bracket - about $35000 - the marginal tax rate on dividends is quite low, a few percent (depending on the province). The major drawback of dividend income is the "gross-up", which moves a retiree into the next bracket sooner. Therefore, upper-income retirees may prefer capital gains to dividend income.
The marginal rates can be obtained here.
As mentioned earlier, exchange-traded funds (ETFs) are baskets of stocks which can be bought and sold as a single entity on a stock exchange. They differ from closed-end mutual funds in that large buyers such as pension funds can purchase or redeem the ETFs in exchange for the underlying stocks. This creation and redemption mechanism ensures that the ETF valuations never stray far from the Net Asset Value (NAV) of the underlying stocks. In contrast, closed-end mutual funds may trade at a significant premium or discount to NAV.
For those who wish to use exchange-traded funds for their Canadian content, a list of such funds is maintained by Bylo Selhi and can be found on the link below:
Investors in Canadian ETFs should also consider reading "The New Investment Frontier", by Howard J. Atkinson and Donna Green.
The most popular ETF is the Barclay's i60 (stock symbol: XIU) available from Barclay's Investments Canada. This fund is based on the Standard and Poor's S&P/TSX60 index of large-capitalization stocks. Other notable ETFs available from Barclay's include one based on the TSX/S&P Capped Composite Index (stock symbol: XIC); several sector ETFs that concentrate on individual TSX sectors, including one based on the financial services sector (stock symbol: XFN); ETFs based on short-term (stock symbol: XSB) and universe (stock symbol: XBB) bond indexes; a 'mid-capitalization' ETF (stock symbol: XMD) based on the mid-cap and small-cap companies that make up the S&P/TSX Canadian Completion Index; an ETF based on Real Estate Investment Trusts (stock symbol: XRE); and two ETFs based on non-Canadian content (stock symbols: XSP and XIN) that will be discussed later.
All the ETFs based on the Canadian stock market offer inadequate equity diversification by themselves. Nevertheless, for those seeking capital gains rather than dividend income, several ETFs should be considered as part of the equity portion of a diversified portfolio. These are: the ETF tracking the S&P/TSX60 (XIU); the capped ETF tracking the S&P/TSX Composite (XIC); the financial services sector ETF (XFN); and the new dividend ETF (XDV). Most of the sector ETFs are too concentrated in one or two stocks; if one wants sector exposure, either buy the stocks directly or use the broader US sector ETFs. The financial services sector ETF is dominated by the five big banks and the two largest insurance companies; although these can be held directly in a sufficiently large portfolio (see Example 3 in the Payback Time subsection in the Cost Control section), investors with smaller portfolios will save commissions by a single purchase.
The dividend income provided by some Canadian ETFs may be inadequate for some investors, particularly retirees. The income can be increased by purchasing higher-yielding but more narrowly based ETFs, or by investing directly in Canadian dividend-paying stocks, in preferred shares, or in trusts. The non-ETF approaches are discussed in later sections. For those who wish to avoid buying individual securities and remain with broadly-based indexes, income can be increased by selling a few percent of the holdings each year. This approach gives capital gains (or losses), rather than dividends; these are taxed less favourably in the lowest tax bracket but more favourably in the top tax bracket. A constant percentage, rather than a constant dollar amount, should be sold to avoid depleting the portfolio if equities are at a low price. Therefore, the income will be variable.
Index Funds or ETFs?
The decision whether to use index funds or ETFs is dependent upon portfolio size, portfolio makeup, and portfolio stability. The advantages and disadvantages are summarized below:
Comparison of Index Funds and Exchange-Traded Funds
Index funds have higher Management Expense Ratios (MERs) than do broadly-based ETFs, but do not incur transaction costs or foreign exchange costs when changes are made. Some index funds have exorbitant MERs, and should be avoided by cost-conscious investors. ETFs are available in greater variety, and include size, style, and sector variants.
In general, index funds are more suited to investors with changing portfolios, such as those accumulating assets. ETFs are more suited to large, stable portfolios. A portfolio MER reduction of 0.15% is only $150 per year on a $100,000 portfolio but is $1500 on a $1,000,000 portfolio.
For investors who wish to use index mutual funds rather than ETFs for their portfolio, Bylo maintains a list of low-cost index funds here.