With Q3 earnings for the Canadian banks behind us, you might be considering investing in the banks using BMO Equal Weight Banks Index ETF (ZEB). This ETF exclusively holds an equal weight of each of the big 6 Canadian banks. While the convenience of this one-ticket solution is enticing, I believe using this ETF is a bad financial decision for long-term buy-and-hold investors.
I wouldn’t blame you for wanting to invest in the Canadian banks. I believe the banks have provisioned adequately for significant loan losses and are well prepared for the current economic disaster. Furthermore, Royal Bank, TD, CIBC, Scotia and Bank of Montreal respectively pay a 4.2%, 4.8%, 5.6%, 6.3% and 5.1% dividend yield (as at August 28, 2020). Many investors view these companies as interesting long-term holdings.
While ZEB can simplify the investment into Canadian banks into a single transaction, investing in a highly concentrated ETF like ZEB can be a bad idea. Anyone interested in buying-and-holding the Canadian banks for a long time might be better off simply buying the individual stocks.
Forget BMO Equal Weight Banks Index ETF (ZEB)…Buy the Stocks Instead
For example, let’s say you have $20,000 you want to invest. With an MER of 0.61%, ZEB ETF will cost you $122 per year to own plus any trading commissions. That cost (excluding the trading commission) is repeated each year in perpetuity and will rise as your holdings appreciate in value.
In contrast, you can buy 5 of the banks for a total one-time trading commission of between $0 and $50 (depending on your online broker). Let’s be generous and say you could pay $100 in commissions for the round trip. If you plan to hold your investment for a decade ZEB would cost you at least $1220 while owning the individual stocks would cost a maximum of $100.
While it’s true that ZEB rebalances between its holdings, one could easily replicate this at minimal cost annually using the dividend income spit off from these stocks.
Overall, the value proposition for ZEB is fairly weak for long-term investors. Of course, the story is different for people using ZEB for short term trading or hedging purposes. But I would guess that a significant number of people who hold ZEB don’t realize this.
If you’re a buy-and-hold investor I just saved you $1120. Don’t spend it all in one place.
2020 has been a tough year, but the investment funds industry has remained resilient. Net Sales are positive and AUM has grown over last year. The crash in Feb/March will affect fee revenue for the year but overall the industry keeps moving forward. As banks report Q3 earnings, we can see that the wealth segment is holding it together. Today (August 25th) BMO beat street estimates based on wealth and trading activity. We’ll see how RBC, CIBC and TD do, as they report later this week.
In line with the entrenched trend over the past several years, ETF flows and ETF asset growth surpassed those of traditional funds by a wide margin. This trend is driven by price-sensitive investors aggressively switching to lower-fee ETFs.
While the flows into ETFs are more evenly spread across asset classes, flows into mutual funds are clearly overweight to bonds. This is likely because investors/advisors are more inclined to pay higher fees for active management in the fixed income space. The religion of low-cost passive indexing has not yet permeated the bond portion of the portfolio.
Flows into balanced funds – previously the bread and butter of the mutual funds industry (particularly the banks) – remain conspicuously absent. This is detrimental to bank wealth management divisions, which push managed solutions through their retail distribution channels.
As you can see below, dollar flows into ETFs was more than double that into mutual funds. This is a powerful trend that will likely continue.
A reader recently asked me about the TSX-listed iShares S&P/TSX Composite High Dividend ETF (XEI). XEI invests in a range of dividend paying Canadian companies and features a 6.26% distribution yield (June 30, 2020). The ETF pays roughly $0.075 to $0.091 per share on a monthly basis providing an attractive income stream. XEI’s management fee is 20bps.
Is XEI too good to be true? Or is it a great income provider?
Currently, XEI remains about 26% below its February 20, 2020 peak before the Covid-19 market crash. In comparison, the S&P/TSX Composite Index only remains about 13% below it’s February 20th level. This divergence can mainly be explained by differences in the holdings. The S&P/TSX Composite Index, for example, holds gold miners and Shopify which have been performing very well since the March 23rd bottom. In contrast, XEI is heavy into financials and energy, both of which have lagged. As a dividend fund this makes sense.
XEI seeks to replicate the S&P/TSX Composite High Dividend Index. For this reason, the growth and momentum names that don’t pay dividends are excluded from the portfolio.
Effective June 13 2017, the fund’s name was changed from iShares Core S&P/TSX Composite High Dividend Index ETF to iShares S&P/TSX Composite High Dividend Index ETF.
XEI Construction
To understand how XEI operates, one must look at the methodology of the underlying index. The S&P/TSX Composite High Dividend Index consists of 50 to 75 stocks selected from the S&P/TSX Composite focusing on dividend income. The index is market-capitalization weighted, with stocks capped at 5% and each sector capped at 30%. The index rebalances quarterly.
To be included in the index, a stock must be a member of the S&P/TSX Composite and have a non-zero indicated annual dividend yield. Selection is done step by step, as follows:
As of the reference date for the Composite rebalancing, S&P Dow Jones Indices determines the median indicated annual dividend yield of all stocks in the S&P/TSX Composite with non-zero indicated annual dividend yields.
The 75 stocks with the largest indicated annual dividend yield, from those stocks which have indicated annual dividend yields above the median calculated in step 1, are selected to form the index. Current index constituents are not removed unless their indicated annual dividend yield falls below the 85th position. Stocks that are not current index constituents with an indicated annual dividend yield ranking above the 65th position are automatically added to the index.
If step 2 yields fewer than 75 stocks but more than 50, stocks with indicated annual dividend yields greater than or equal to the median form the index. The buffer thresholds given in step 2 continue to be 10 ranking positions above and below the number of constituents.
If there are fewer than 50 stocks with indicated annual dividend yields above the median, stocks are added in descending order of indicated annual dividend yield below the median until a total of 50 stocks are included.
The index is market-capitalization weighted subject to a maximum weight of 5% for each stock and 30% for each GICS Sector. The caps are established at the quarterly rebalancing and are not revised until the next quarterly rebalancing.
Based on this methodology, the portfolio will provide exposure to the highest-yielding dividend stocks in the S&P/TSX Composite Index, regardless of quality. Unlike some other dividend ETFs, XEI doesn’t factor in dividend growth or longevity.
Performance
Since its April 2011 inception, on an annualized basis XEI has returned 3.09% (ending June 30, 2020). If you held until January 31, 2020 (thus avoiding the Covid-19 mess), you would have received an annualized 6.27%.
Looking back 5 years (ending June 30, 2020), XEI returned 1.23% annualized vs. S&P/TSX Capped Composite Index’s 4.45%.
For the 5 years ending January 31, 2020, XEI returned 5.62% annualized vs. S&P/TSX Capped Composite Index’s 6.53%.
While fees can explain some of the difference vs the broad benchmark, it is clear that the lack of growth names has caused total returns to lag somewhat – especially recently.
Why is the distribution yield so high?
XEI sports a 6.26% distribution yield. While total returns matter, many investors are attracted to this yield. The yield is based on the underlying components of the ETF, 49.08% of which is concentrated in the top 10 holdings.
The top 10 stocks held by XEI have dividend yields ranging between 4.74% and 8% (as of June 26, 2020). These ten holdings contribute to about half of XEI’s overall distribution.
Many funds top up their distributions by returning capital to investors. In contrast, XEI is mostly distributing dividends the fund receives from underlying holdings. In 2019 about 8% of the distribution was considered return of capital, whereas in 2018 and 2017 there was none. Most of XEI’s distribution is organic as opposed to manufactured.
Exposure
While XEI imposes a 30% cap on sector weights the fund is still quite concentrated. I would expect this, given the nature of how the ETF is constructed (essentially a sort and rank of dividend paying stocks). Naturally, XEI will have higher exposure to areas of the market that have higher dividend yields – financials, energy, utilities. 73% of the ETF is concentrated in these three sectors.
Bonus concern
It is interesting to note XEI’s high portfolio turnover. Clearly this has to do with the construction and rebalancing methodology.
Compare XEI’s 2018 turnover of 49.86% to that of the FTSE Canadian High Dividend Yield Index ETF (VDY), which is just 22.90%. This may be a nothingburger, but higher turnover strategies tend to be indicative of higher costs. However, with XEI’s management fee of just 20bps this doesn’t appear to be much of a concern.
My verdict
XEI will never hold high-flyers like Shopify or junior gold miners. So investors need to recognize that it might underperform the broad market during periods in which momentum or growth are favoured.
Given the construction methodology, it is expected that many names within XEI might have historically been poor performers. (Dividend yields rise as stock prices fall.) There is no discretion applied to what names are in XEI, so there inevitably will be a mix that could includes dogs at risk of dividend cuts. Luckily exposure to any single company is limited to 5% at the time of rebalancing.
There may also be companies with well-supported dividends that have simply underperformed (driving up the yield) for other reasons.
Conclusion: don’t buy XEI for the yield. Buy it because you like most of the companies it holds. If you think most of the underlying holdings will continue to pay their dividends and are good long-term holdings, then XEI is a convenient way to invest in those companies.
