If you are new to investing and don’t have the time to do proper due diligence, or if you simply want a passive investment strategy, there is perhaps nothing better than index investing.
What is Index investing, and why should we be buying Canadian index funds?
Simply put, index investing is a passive strategy that attempts to replicate the returns of a particular index. This is done through the purchase of Canadian exchange-traded funds (ETFs), or mutual funds that are built to closely track the underlying index. It is also one of the most effective ways to diversify your holdings.
For this particular article, we will be speaking on index ETFs only, as we believe they are more beneficial than mutual funds
Index investing is one of the simplest investing strategies, and one that is recommended by financial gurus.
Here is what some of the most well-respected gurus have had to say when it comes to index funds:
"By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb." – Warren Buffet
"The word passive does a disservice to investors considering their options. Indexing provides an effective means of owning the market and allows investors to participate in the returns of a basket of stocks. The basket of stocks changes over time as stocks are added or removed based on its rules." - Charles R. Schwab
Canadian index funds can remove emotions from investing
Research has shown that retail investors consistently underperform the markets. In fact, most hedge funds do as well. At the heart of the issue for retail investors – is emotions.
Index funds take the emotion right out of the equation, as investors don’t get emotionally attached to any particular stock or company.
With this in mind, let’s take a look at the top Canadian ETF Index funds that provide a low-cost and passive investment solution for investors.
Canada's best index funds to be looking at moving forward
BMO S&P/TSX Capped Composite Index ETF (TSX:ZCN) & iShares Core S&P/TSX Capped Composite Index ETF (TSX:XIC)
|2||Royal Bank of Canada (RY)||6.01|
|3||Toronto Dominion Bank (TD)||5|
|4||Canadian National Railway (CNR)||3.91|
|6||Bank of Nova Scotia (BNS)||3.12|
|7||Barrick Gold (ABX)||2.98|
|8||Brookfield Asset Management (BAM.A)||2.87|
|9||TC Energy Corp (TRP)||2.50|
Let’s start with the ETFs that cover the broadest collection of Canadian stocks, the S&P/TSX Capped Composite Index. I’ve listed two - the BMO and iShares versions. In essence, both are pretty much identical and have very similar compositions.
Both track the performance of the S&P/TSX Capped Composite Index which covers approximately 95% of the Canadian equities market, and has been the primary gauge for Canadian-based, Toronto Stock Exchange-listed companies since 1977.
The ETFs have identical MER fees (0.06%) and have similar holdings. The iShares fund is slightly larger with $6.44 billion in assets as compared to the $3.88 billion held by the BMO fund. Performance wise, the iShares fund during the turmoil of 2020 has outperformed as well.
Since this is a capped index intended to represent the broader TSX, the sector weightings are largely inline with the broader market. As such, Financials, Energy, Industrials and Basic Materials dominate the portfolio holdings. A recent surge in tech however has popular Canadian stock Shopify actually at the top in terms of holdings.
The Top 10 of each ETF accounts for approximately 37% of the assets and features several of the big banks including...
- Royal Bank of Canada (TSX:RY)
- Toronto-Dominion Bank (TSX:TD)
- Bank of Nova Scotia (TSX:BNS)
Other notable names include...
- Enbridge (TSX:ENB)
- BCE (TSX:BCE)
- Shopify (TSX:SHOP)
Interestingly enough, prior to the March crash, Suncor (TSX:SU) and Bank of Montreal (TSX:BMO) were in the top 10 holdings.
They've now been replaced by Companies like Shopify and Brookfield Asset Management (TSX:BAM.A).
If you are looking to closely track the TSX Index, these two ETFs are your best options. However, if you're looking for an ETF that is laser focused on the banks, check out our post on Canadian banking ETFs.
As we can see with its performance chart below, XIC mimics the returns of the index with extreme precision.
XIC 5 year dividend adjusted performance vs the TSX Index
iShares S&P/TSX 60 Index ETF (TSX:XIU)
|2||Royal Bank of Canada (RY)||7.49|
|3||Toronto Dominion Bank (TD)||6.24|
|4||Canadian National Railway (CNR)||4.88|
|6||Bank of Nova Scotia (BNS)||3.89|
|7||Barrick Gold Corp (ABX)||3.71|
|8||Brookfield Asset Management (BAM.A)||3.57|
|9||TC Energy Corp (TRP)||3.11|
The iShares S&P/TSX 60 Index ETF tracks the 60 biggest stocks on the TSX Index. These are defined as the biggest in terms of market cap and are considered the most liquid stocks on the index. This is why you see the emergence of Barrick Gold and Shopify in this index fund, as they've become some of the biggest companies in the country.
This ETF is one of the largest in the country with net assets of $8.23 billion and pays out a quarterly distribution that currently yields 3.29%. XIU has a moderate risk profile and ultra-low MER fees of 0.15%.
The iShares Index ETF has done particularly well over the past number of years. It has outperformed the Canadian Equity fund category over the past one, three, five and ten-year periods. In other words, it has consistently outperformed the broader TSX Index, as we will highlight in its 5 year chart at the bottom of this write up.
In 2019, the Index ETF gained 21.96% outperforming the broader TSX Index (18.33%) and the Canadian Equity fund group (20.05%).
The top 10 stocks account for approximately 48.5% of the portfolio and the industry weightings closely match that of the index weightings as Financials and Energy dominate the portfolio.
However, it is key to note that both the material and tech sectors have emerged as some of the largest sectors in this index fund. This is primarily due to the demand in tech and the rising price of gold. If anything, it makes this index fund a little more balanced, which is a good thing.
In terms of top holdings, if you look closely, they are identical to that of the two previous ETFs which tracked the S&P/TSX Capped Composite Index. The difference being, that the top 10 account for a bigger percentage of assets as there is a smaller number of stocks.
Simply put, XIU is the best blue-chip ETF on the market.
XIU 5 year dividend adjusted performance vs the TSX Index
S&P/TSX Canadian Dividend Aristocrats Index Fund (TSX:CDZ)
|1||Transalta Renewables (RNW)||2.54|
|2||Transcontinental Inc (TCL.A)||2.48|
|3||Fiera Capital (FSZ)||2.46|
|4||The North West Co (NWC)||2.40|
|7||Choice Properties REIT (CHP.UN)||2.12|
|9||Capital Power Corp (CPX)||2.05|
|10||Granite REIT (GRT.UN)||2.03|
There is only one ETF that currently tracks Canada’s Dividend Aristocrats. In comparison, there are almost a dozen funds south of the border that track U.S. dividend growth companies.
Aristocrats are stocks that have a history of raising their dividends for at least five consecutive years.
The index fund seeks to replicate the investment of the S&P/TSX Canadian Dividend Aristocrats Index. To be included in the Index fund, stocks must have a market cap of at least $300 million.
There are currently 82 stocks in the portfolio. It is one of the simplest ways to implement a dividend growth strategy.
The fund has MER fees of 0.60% and pays out a monthly dividend that currently yield’s 5.22%. The management fee on this index fund is quite high, one of the primary reasons a lot of Canadian investors avoid it. That, and it's underperformance which we'll get to later.
From 2014 to 2019, the company raised eligible dividends from $0.76101 to $1.11098 per share.
This is equal to an average of 9.2% annually. In comparison, the Canadian Dividend Aristocrats have collectively raised dividends by approximately 11.8% over the same time frame.
In 2019, it tracked the performance of the broader TSX Index (+19%) and it has outperformed the Canadian Dividend & Income equity category average over the past three, five and ten-year periods.
Over the past 5 years it has averaged a compound annual return of -0.18%. Because so many of these aristocrats are the financial and energy sectors, the performance of this index fund was hit hard by COVID-19.
However, the Aristocrat index fund is a well-balanced ETF with most sectors accounting for no more than 20% of holdings. The lone exception is Financial Services which is the top sector holding at 23.7%.
The Top 10 holdings are quite interesting and outside of the norm. They account for only 22% of holdings and no stock accounts for more than 2.55% of holdings.
As you'll see with its performance, this index fund has struggled as of late to keep up with the TSX Index.
CDZ 5 year dividend adjusted performance vs the TSX Index
iShares S&P/TSX Capped Info Tech ETF (TSX:XIT)
|1||CGI Inc (GIB.A)||16.02|
|6||Constellation Software (CSU)||23.66|
|8||Enghouse Systems (ENGH)||2.37|
|9||Lightspeed POS (LSPD)||1.15|
Over the past decade, the TSX Index has underperformed the U.S. markets in a fairly significant way. The main reason? Exposure to technology.
Information Technology accounts for only 5.2% of the TSX Index.
Although this is up significantly from years past, it pales in comparison to the exposure south of the border. Information Technology is the top weighted sector accounting for 22% of the S&P 500.
As mentioned, Canada is starting to form an impressive collection of IT companies.
XIT has, to put it lightly, soared due to the COVID-19 market crash and the pandemic overall. You'll see in the performance chart below that this index fund has absolutely crushed the overall returns of the TSX Index over the last 5 years. With management fees of 0.6%, it's fairly expensive to own this index fund. However, the returns are well worth the fees.
Given the tech boom, it is not surprising the XIT has been a beast.
In 2019, it returned 51%, crushing both the TSX (18.33%) and the average of other sector equity funds (11.06%). In 2020, the index fund is up yet another 45% while the TSX is losing mid double digits.
If you are bullish on the markets, expect XIT to consistently outperform.
Interestingly, the top four holdings account for 82.27% of the portfolio. These include Constellation Software (TSX:CSU), CGI Group (TSX:GIB.A), Shopify (TSX:SHOP) and Open Text (TSX:OTEX). Combined, the top 10 account for 98.42% of assets.
Although this ETF does contain other tech companies, a purchase of XIT is a big bet on the top four holdings that we list above.
So, why so heavily weighted?
This lack of diversification is a reflection of a young industry. As mentioned, tech hasn’t had a big presence on the TSX and it has only recently begun to expand.
This is a highly concentrated ETF appropriate for those with a higher risk appetite, and for investors looking to capture the best of the best, TSX-listed technology companies.
XIT 5 year dividend adjusted performance vs the TSX Index
iShares Core S&P U.S. Total Market Index ETF (TSX:XUU)
|3||Alphabet Inc A||1.43|
|4||Johnson & Johnson||1.24|
|7||Alphabet Inc C||1.39|
|9||Visa Class A||1.09|
|10||Proctor & Gamble||0.99|
One of the biggest mistakes made by Canadian investors is lack of exposure to markets outside of the country. The TSX Index is heavily weighted towards financials and is highly dependent on resources.
Considering this, investors should add exposure to equities south of the border.
The iShares Core S&P U.S. Total Market Index ETF is the best and most diversified way to accomplish this. It trades in Canadian dollars, and aims to track the performance of the S&P.
It is a relatively young ETF having only been introduced in 2015. Prior to this market crash, it had frequently outperformed the S & P 500.
Outside of significantly increasing diversification, it has ultra-low MER fees of 0.07%. It is worth noting however, that his is slightly misleading (more on that later).
The Top 10 securities account for only 23.15% of assets, and there are 3,436 stocks in the portfolio, a testament to its diversification. Not surprisingly tech dominates the top 10 with Microsoft, Apple and Amazon leading the way. Berkshire Hathaway and Johnson & Johnson also crack the top 10.
There is no better way to increase your exposure to the stock markets south of the border.
A word of caution however, the ETF is subject to withholding taxes.
Since the XUU holds underlying ETFs, it faces a withholding tax of 0.32% regardless if it is held in an RRSP. This has the net effect of bumping its MER to 0.39%. Still cheap, but not as eye-catching as an MER of 0.07%.