Tuesday, 2 February 2010

ETF Comparison: USA Total Market Equity

The United States is the world's largest equity market and it merits a place in every Canadian investor's portfolio.

The S&P500 is NOT the US Stock Market
The US stock market benchmark is usually taken to be the S&P 500 and that is basically the contents of funds available in Canada on the TSX to the Canadian investor. The S&P 500 is however, a group of large, dominant US companies and does not truly represent the whole of the US equity market - about 4500 smaller companies are missing, which comprise about 20% of the total US equity market value. Smaller company stocks (small capitalization or small cap) behave differently and often outperform those of large companies - e.g. see the Google Finance chart image below which shows US-traded ETFs for small cap (Vanguard's offering , symbol: VV), S&P 500 (symbol: SPY) and total market (symbol: VTI). As VTI's performance suggests, owning a total market fund can be a worthwhile ETF to own.

US Total Market ETFs - the Contenders

  1. Vanguard Total Stock Market Index Fund (Symbol: VTI) - the ETF that has attracted the most investor money by far, more than all other entrants combined. Has the largest number of holdings at 3420 and simply buys every company in the index in its market cap proportion, the so-called replication technique.
  2. iShares Russell 3000 Index Fund (IWV) - another well-established fund, it is the second largest and also replicates its index, which is different and smaller than VTI's.
  3. iShares Dow Jones U.S. Total Market Index Fund (IYY) - another offering by iShares, it uses a different index containing the most companies; instead of replication, it uses the sampling technique, in which they take a representative sample of companies, to track the index
  4. SPDR Dow Jones Total Market ETF (TMW) - despite being the oldest total market ETF by a few months and being offered by ETF leader State Street Global Advisors, and seemingly doing its index-tracking job well, it has not caught on to the extent of the top three funds and has attracted low net assets.
  5. Schwab U.S. Broad Market ETF (SCHB) - the baby of the class with a November 2009 launch, it has built a low but reasonable asset base, perhaps because it has the lowest expense ratio of all at a tiny 0.08%
Key Comparison Factors (click on table below for details):

Similarities abound amongst these funds:
  • passive index tracking - they all seek only to mimic the results of the overall market, not to outsmart and outperform and they thus limit trading only to times when the index changes, which in turn keeps trading commission costs down and realizes fewer capital gains that an investor would have to pay taxes on (see previous post on the Mystery of Fund Capital Gains in 2008 Explained)
  • low expense ratios - every ETF has an expense ratio of 0.2% or less, which is outstandingly good, keeping investor costs down and net results higher
  • low variation of market price from Net Asset Value (NAV) - all the ETFs have a very tight link between the price of the ETF on the market and the sum of the company shares held, which is exactly what should happen - you can be assured of buying or selling the ETF for what it is worth
  • low bid-ask spread - the difference for all these ETFs is typically a cent or so, which equates to 0.1% or less a cost to the investor (see The Bid/Ask Spread and Market Making at InvestorHome for an explanation of how this is a cost to the investor)
  • holdings concentration and by sector - their main holdings are more or less the same companies and in the same proportions by industry sector, which is no surprise since they aim to mimic the same thing; the number of holdings does vary a lot, ranging from only about 1000 in TMW to over 3400 in VTI. The sampling technique of the smaller funds to reproduce the overall index with fewer total holdings seems to work very well.
  • returns - the same to a fraction of a percent annualized, again not surprising considering their common aim
  • distribution frequency - all give out cash on a quarterly basis
  • taxes - all distributions from these US ETFs, including any capital gains, will be taxed in a Canadian investor's hands as ordinary income. The good news is that such passive index ETFs will generate almost no capital gains from their internal trading, which is the reason they are described as being extremely tax efficient (see the excellent PriceWaterhouseCoopers Understanding the Tax Implications of Exchange Traded Funds report found on the ByloSelhi website).

Management Expenses (MER) - SCHB's is lowest by a hair at a phenomenal 0.08%, over Vanguard's 0.09%. The others are very low at 0.2%

Performance - the market performance results are so similar that one cannot tell the ETFs apart over the past five years on this Yahoo Finance chart of the first four ETFs. Despite using different indexes, they seem to be very good substitutes for one another.

Which ETF is Best?
It is only by getting out the fine tooth comb that one can detect an advantage by VTI. Its five-year compound annualized total return, which includes distributions, edges out the others at 1.98% compared to 1.81% for the next best IYY. It's hard to tell for sure but the lower expense ratio is likely the reason. The comparison table highlights in green the boxes where VTI is slightly ahead of the others.

Whatever your preference, all these ETFs are very good choices in my view.

Caveats: Morningstar discusses a few considerations Canadians should take into account when investing in US-traded ETFs.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation and that past performance may not continue, costs may change and other comparative factors like taxes may alter their value to you. Do your homework before making any decisions.


Patrick said...

Be careful when you compare MERs. When you say Schwab's MER is 0.08%, bear in mind that they engage in securities lending (as do others), and that funds engaging in aggressive enough lending practices can achieve a nominal 0% MER. The trouble is, all the securities lending risk is borne by the fund investor, while often much of the profit goes to the managers. This is an arrangement that makes me pretty uneasy.

My point is not that securities lending is necessarily dangerous; just that it allows funds to report MERs as low as they want.

CanadianInvestor said...

Good point, Patrick. It's hard to tell in the case of Schwab. The prospectus says it does securities lending as all the ETFs do, but further details are sparse. The only clue I could find is the sentence in the Strategy section that says the fund ... 'may lend its securities to minimize the difference in performance that naturally exists between an index
fund and its corresponding index.' If that were their only driver, it might be ok but we cannot tell what they do behind the scenes.

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