Hone in on the important features of an ETF and ignore the rest
When you buy something on Amazon, it’s really important to look at the product details. Have you ever made the mistake of ordering something that wasn’t quite what you expected? Like a desk lamp that is half the size you thought it was? Or the string of LED lights you assumed would make it all the way around your son’s bedroom but actually only covers one wall? Amazon makes it easy to check the details before buying: all the information is there, such as dimensions, what it’s made of, and its special features.
Buying an investment fund is no different – the product specs are available and are easily accessible. Every mutual fund and ETF comes with a fact sheet, the equivalent of the Amazon product descriptions. In fact, it’s a regulatory requirement for companies offering mutual funds and ETFs to publish certain documents on a regular basis that outline the main elements of the investment. The purpose of these documents is to explain what you’re investing in using plain language, without the mind-numbing lingo.
Although it’s true that the language in these documents isn’t difficult to understand, it can still be hard to know what to look for. What elements are important? What do they actually mean? In the Amazon description, there’s information I skip over and things I hone in on. If I don’t know what's important to me, I might feel overwhelmed by the information. “Is this a good or bad thing?” “Should I care about this?" Information overload can lead to analysis paralysis. A document that looks too long and is overwhelming won’t be read. (This seems to be the primary philosophy for any Terms and Conditions disclosure.) On the other hand, zeroing in on just a few items is a lot easier and more manageable – and therefore more likely to be done.
Using the ETF Fact Sheet
An ETF Fact Sheet is required for every exchange-traded fund on offer. The Canadian Securities Administrator (the body that oversees investment product regulation in Canada) describes it as follows: “The ETF Facts is a four-page document that summarizes key information about an ETF in a simple, accessible and easily comparable format.” If you’re only going to look at one document when choosing an ETF, this should be the one.
Before you start looking at specific ETFs, though, you should have already learned a few things: the difference between passive and active investing, how much of your money you want to allocate to the stock market, and how you want to divide your investments by geographic location (Canada, U.S. and international). These are the building blocks. Only then should you start looking at individual funds and their Fact Sheets.
With that said, let’s look at what’s important and what you can pass over using the iShares Core S&P/TSX Capped Composite Index ETF (XIC) Fact Sheet as an example.
1. The name of the company offering the fund is, in my opinion, important. Well-established, large fund companies that have been around for a while have a track record when it comes to managing products. They know what they are doing. With investing, the trust factor is important.
2. The description of the fund is important for two reasons: it tells you whether it is following an index (passively-invested) and it tells you which index it tracks. The key here is words like “replicate”, which tells you this is a passively-managed fund that follows an index. The description also tells you what index it replicates, in this case the S&P/TSX Composite Index.
3. This “Why XIC?” isn’t a standard component of every fact sheet and it’s really not that important. Why? Because by the time you’ve gotten to this stage of the game, you should have already decided why you want to buy an equity ETF: you want broad exposure to the stock market and you want to pay low fees. And you should also know that when you’re investing in the stock market, it’s for the long-term. You don’t need a marketing team to tell you that.
4. Although the “Key Facts” here are interesting for some people, for the purposes of choosing an ETF there isn’t much here that’s important.
5. Performance isn’t important? Really? No, in this case it isn’t. This fund is mirroring a market index so the performance isn’t a reflection of how “good” the fund is - it’s just doing what the market does. If you believe in passive investing and understand that the stock market goes up and down, it doesn’t matter how it has performed in the past.
6. The management expense ratio is your cost – how much you will pay every year to own this investment. Skip right past the management fee and go straight to the MER. The MER is the “all-in” cost of running this fund and it’s the number you should care about. The MER is expressed as a percentage; in this case, if you invest $20,000 in the fund, you will pay $12 a year in fees ($20,000 times 0.06%).
7. Although it’s interesting (to some) to see what stocks the ETF holds, it’s not important. When you buy a broad-market ETF, you’re owning the market index. The holdings are not hand-picked by the fund manager and they aren’t an indication of how what “bets” are being taken. So even though it’s nice to know what’s in the fund, you don’t really need to pay any attention to this.
8. Ok wait….this is performance again, so why does it matter now when it didn’t in the last section? This table shows the performance of the ETF versus the benchmark and it’s important because it shows you how well the manager of the fund has been able to track the market’s performance. You’ll notice that the fund performs slightly differently than the benchmark. This is due partly to the fee that is deducted and partly due to some technical factors. You want the fund to track the index very closely, so if the difference between these two numbers is high, you might want to look at another ETF that replicates the same index and see how that fund manager has done.
9. This is my favourite “not important” component because back when I was a stock market analyst, we lived and breathed this stuff. The first two numbers, the “Price to earnings” and “Price to book value” make my heart feel warm, but in fact they are not important in this situation. These are measures of valuation, how “expensive” the holdings in the fund are. But when you’re buying an ETF, who cares how much you are paying per unit of earnings or per unit of a company’s book value? You’re here to invest for the long term in the broad market – whether the market is “cheap” or “expensive” right now is irrelevant because you’re not into trying time the market – right? The distribution yield also isn’t important unless you specifically want to have income from dividends. The trailing 12-month yield tells you how much the fund paid out in dividends over the last year - not relevant.
10. We all know how important diversification is when investing in the stock market and this table tells you how diversified the fund is. Surely this is important, right? Yes, except that as an ETF investor, you’ve decided how much of your portfolio you want to invest in Canadian stocks, US stocks and international stocks. When you invest in all of these geographies, you’re going to get adequate diversification. The Canadian market is hugely overweight financials (it’s 30% of our stock market as you can see) and has only a tiny position in health care but don’t worry – your U.S. ETF will help to balance out this exposure. So don’t sweat the sector exposure in this fund – but do make sure you own other countries too.
So to recap: as an ETF investor who understands and believes in index investing and who has allocated their money to a variety of countries, the only things you really need to pay attention to when choosing your ETFs are:
1) The provider, for the trust factor
2) The description, which will confirm whether it is passively-managed and what market it tracks
3) The cost, or MER, and
4) How well the performance of the fund matches the index it is tracking.
Stay focussed on these and you'll find choosing ETFs to be pretty simple.