Indexing

Welcome to my popular Indexing page. 

If you think my dividend investing approach is boring you haven’t seen anything yet! 

Beyond dividend growth stocks, we also invest in low-cost indexed ETFs for growth. 

When in doubt, most investors should consider indexed ETFs.

 

Q&A with Mark – Indexing, what is that?

The premise behind index investing is simple:

  • You can achieve market performance less minuscule money management fees.
  • You can obtain great diversification from companies and countries from around the world.
  • You can largely “set and forget” (to some degree) the portfolio and achieve long-term growth.

Indexing or index investing is a passive strategy that attempts to generate similar returns as a broad market index.

Investors use index funds to replicate the performance of a specific index – generally an equity or fixed-income index – by purchasing exchange-traded funds (ETFs) that closely track the underlying index. There are numerous advantages of index investing. For one thing, empirical research finds index investing tends to outperform active management over a long time frame. Why?  You’re not cherry-picking stocks.  By taking a hands off approach to investing eliminates many of the biases and uncertainties that arise in any stock picking strategy.  Two, since index investing takes a passive approach, index funds including indexed ETFs usually have lower management fees and expense ratios than actively managed funds. The simplicity of tracking the market without a portfolio manager (to cherry-pick stocks) allows providers to maintain modest fees. Index funds also tend to be more tax efficient than active funds because they make less frequent trades.  Third and likely most importantly, index investing is an effective method of diversifying against risks. In other words, an index fund consists of a broad basket of assets instead of a few investments. This serves to minimize unsystematic risk related to a specific company or industry without decreasing expected returns.

I think indexing inside your tax-deferred (RRSP) and/or tax-free (TFSA) accounts using low-cost, diversified ETFs that track a broad market index can work very well for the majority of investors. 

The main reason for that? 

Like you read above most investors have no hope in beating the index consistently over time although it can be done!

Check out the Beat the TSX (BTSX) strategy here.

Check out how Ross Grant Beats the TSX here. 

That said, instead of trying to beat the market, be the market. 

With indexing you’ll ride market returns less puny money management fees to any fund provider.

Even the greatest investor of our time believes in indexing…

Even the greatest investor we know says you should index (Warren Buffett).  Here’s a quote, from page 20 of his annual letter to Berkshire shareholders, dated February 28, 2013.  After all of his Berkshire shares are distributed to charity, take the cash, Buffett says, and just buy index funds:

My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.

He goes on to say:

Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.

So, be boring, like owning a farm.

What could your “farm” look like?

Although I invest in a few individual stocks, I firmly believe most Canadian investors would do well to own any combination of up to three (3) equity ETFs in their portfolio or less. 

In fact, maybe just one ETF will do and you can fire your money manager in the process.

 

Q&A with Mark – what your your favourite ETFs?

I’ve got an entire page dedicated to low-cost ETFs.

If I had to pick just two funds I might go with these: XIU for Canadian stock exposure and XAW to own the rest of the world:

ETF SymbolMER# of holdings5-Year Return*10-Year Return*Since Inception*
XIU0.18%60 Canadian stocks7.98%8.89%7.34%
XAW0.22%Over 9,500 beyond Canadian stocks7.86%N/A8.59%

*Data current to summer 2023. 

Check out my comprehensive ETFs page for more details about what you should consider and why including all-in-one ETFs.

My ETFs

 

Q&A with Mark – if you suggest indexing, why do you own any individual stocks?

Great question. My simple answer is and has always been:

  • I feel I get the best of “both worlds” through my hybrid investing approach (a mix of individual stocks and low-cost ETFs). That approach delivers both income and growth. 
  • This is a plan/approach I strongly believe in – which helps me stay motivated and remain invested.

Read on for more related FAQs about how I invest here.

Ultimately, when it doubt, I have and continue to believe low-cost, diversified ETFs can work for most over time. 

 

Q&A with Mark – what about asset location with indexing?

Diversification is great but it comes at a cost unless you put your low-cost ETFs in the right location.  

Asset location is important because many countries levy taxes on ETF distributions paid to foreign investors.

This is what I’ve learned and how I try and manage my own portfolio. Your mileage may vary. 

What about currency hedging – to hedge or not to hedge? 

I try to avoid currency hedging with my ETFs. Why?  While hedging eliminates currency risks from your portfolio (meaning, you only own assets in Canadian dollars only) you’ll pay higher fees because of this avoidance. Hedging is not free. 

Personally, I think you want currency exposure. So, consider owning unhedged ETFs.  

What about Foreign Withholding Taxes (FWT)? – what should I put where?

Let’s look at a couple of examples.

Example 1 – Canadian ETF that holds international stocks: Vanguard VEE. VEE is a Canadian-listed ETF.  If you look up VEE it is the Canadian version of U.S. version VWO.

Using VEE in a non-registered account withholding taxes will apply (15%) but they are recoverable when investors file their tax returns.  

Using VEE in a RRSP or TFSA withholding taxes will apply.

Why? A Canadian-listed ETF that holds international stocks with have withholding taxes applies. Those international withholding taxes may double the cost of some ETFs inside a RRSP or TFSA.

Example 2 – Canadian ETF that holds U.S. stocks: Vanguard VFV.  VFV is a Canadian-listed ETF. VFV is the Canadian version of U.S. VOO.  

Using VFV in a non-registered account withholding taxes will apply (15%) but they are recoverable when investors file their tax returns.  

Using VFV in a RRSP or TFSA withholding taxes will apply.

Example 3 – VUS that trades in Canadian dollars and uses currency hedging.

Using VUS in a non-registered account withholding taxes will apply (15%) but they are recoverable.

With the currency hedging AND the withholding taxes applied the MER for this ETF is really closer to 0.50% (instead of the posted MER of about 0.15%). 

 

Indexed Canadian ETFs vs. U.S. ETFs summary:

  1. If you don’t have much money to invest (<$25,000) it’s probably best to invest with a Canadian ETF. No currency conversions. 
  2. If you have more money to invest (say >$25,000 or much more) AND you have a long-term plan to own U.S. assets directly then consider owning U.S. ETFs.

Otherwise, don’t let the tax tail wag the investing dog. 

At the end of the day owning low-cost diversified Canadian ETFs is an excellent long-term investing strategy to save hundreds if not thousands of your own money that could have been lost to money management fees.

You can learn more about Foreign Withholding Taxes in these great articles here:

Justin Bender, Portfolio Manager, PWL Capital Inc. and Dan Bortolotti, Associate Portfolio Manager, PWL Capital Inc., “Foreign Withholding Taxes:  How to estimate the hidden tax drag on US and international equity ETFs”

Finally, check out my Archives page for some of my past ETF products and posts.

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