Investment Workshop 11: Understanding Your ETFs

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.

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Hi everyone, and happy Wednesday!

Now normally we’d be doing another buy this week but this happens to be one of those weirdo months where a bi-weekly buy schedule starts to drift away from the typical semi-annual paycheck schedule. So rather than buy on Jan 11th, we’re going to take a break and do our next buy next week on the 18th to get re-synced a little bit closer to people’s paychecks.

So what are we going to talk about today?

ETFs.

You know, those things you own (if you’ve been following our workshop).

ETFs, which of course stands for Exchange Traded Funds, are the single best way for Joe-Shmoe investors like you and me to build a low-cost Indexing Portfolio.

But they aren’t without their confusing quirks.

Our email gets blasted every day with people asking us how to understand these things we own. Specifically,

  1. How do I figure out what my fees are?
  2. How do I know this ETF is actually owning the index like it claims it does?
  3. How do I figure out my ETF’s yield, and how will it be taxed?

Let’s go over these one by one.

How do I figure out what my fees are?

I have written before, and will write again, about the toxic, degenerative, and corrosive effect of investment fees on a portfolio. The average Management Expense Ratio (or MER) of an equity mutual fund in Canada in north of 2%, and as proud as I am of the North, I’m not THAT proud. The average cost of an equity ETF is less than 0.2%.

That is one TENTH of the big banks! While owning the same companies!

Why people continue to buy the crap banks sell continues to elude me.

But don’t take my word for it. Figure it out for yourself. An ETF’s MER is easily discoverable. All you have to do find it.

And in case you’re too lazy, we’ve gone ahead and done it for you.

If you’ve been following our Investment Workshop, you will have noticed that we’re using two ETF providers: Blackrock (formerly iShares) and Vanguard.

Both are fine, and both are great. Now let’s see how to see how their fees look.

Let’s start with iShares/Blackrock. If we were to take an ETF that we owned, like XEF, we would just go to the Blackrock site, search for XEF, and get taken to the fund’s website, where we would find this:

In the bottom left corner, you can see the important figure, the MER, sitting at an impressively low 0.22%. Note that the typical Canadian equity fund has an MER of around 2%, or 10X higher while giving you NO extra performance!

So now let’s see what the Vanguard site looks like for our All-American ETF, VTI.

There, on the right, is the Expense Ratio of…0.05%?!?

GODDAMMIT!

Wow. Once again you Americans have managed to beat our Canadian asses in terms of investment options.

Here’s where your much higher population density helps you. One ETF like this has a potentially 10x higher market than ours because your population is around 10x ours. Our entire country has less people than the state of California! So the costs of running an ETF can be spread over more people, hence the much lower MER. Good for y’all! We’re not jealous at all.

*grumble grumble grudgingly sips maple latte*

How do I know my ETF is owning the index?

Now let’s talk about what those ETFs actually hold. Remember, ETFs are just baskets of other stocks (or bonds), and the value of the basket is simply a sum of the value of the whole.

But how do you know what your ETF is holding?

Well, if you’re holding some random actively-traded ETF (or mutual fund), I’ve got bad news for you: You have no idea!

Your holdings are basically just made up by whoever your fund manager is, and that manager is free to change their mind at any time.

But with an Index ETF, it’s far easier to figure out whether the fund is doing what it’s supposed to. While actively traded mutual funds have a generously ambiguous mandate of “make money,” passive ETFs like the ones we own have a much more concrete mandate of “track this specific index.”

Funds that have the former, ambiguous mandate are very difficult you evaluate. You can pour over their prospectus, look over their top 10 holdings, and then…what? What have you learned? Nabisco and Pepsi are your top two holdings? What does that tell you?

But on the other hand, Index ETFs have a very clear mandate: Track their index. That is a clear, unambiguous goal. And more importantly, that can be measured very very easily. For example, here is SPY, the oldest and largest S&P 500 ETF brought up on Google Finance.

And here is the actual S&P 500 overlaid on top by typing in the ticker symbol .INX into the “Compare” field.

Nice. The fact that the two lines overlay each other so tightly tells us that the ETF is doing what it’s supposed to. It’s mandate is to track the S&P 500, and it’s price history has indicated that it has done exactly that.

Here’s VTI, the Vanguard Total Stock Market ETF overlaid with the S&P 500:

Again, the two lines are following themselves pretty tightly. In this case, VTI does diverge on occasion because it’s actually a TOTAL stock market fund, rather than just the top 500, so on occasion it will under-perform if small/midcap stocks are dropping faster than the top 500, and on occasion it will out-perform if small/midcap stocks are rampaging ahead, like right now, which is why the blue line is slightly above the index.

You can do this with all of the ETFs we own to see how closely they track their respective index, and before we picked these ETFs for our workshop, this is exactly what we did to make sure they were good Index ETFs. Try it yourself! It’s fun!

What’s my yield, and how is it taxed?

And finally, let’s figure out yields.

Each fund distributes, or pays out, a certain amount of sweet sweet cash over a set schedule. This happens because either the underlying bonds pay interest (for a bond ETF) or the underlying companies pay dividends to their shareholders (for an equity ETF).

But how much can you be expected to get? Well for that, let’s go back to the fund summary pages and look for the fund’s yield.

On Blackrock/iShares’ site, just scroll down a bit to the fund’s Portfolio Characteristics section

And you can see that for XEF, we can expect a nice juicy 3.3% distribution yield going forward.

On Vanguard’s site, this info is listed in the fund’s summary under “SEC Yield”

Here we can see that VTI has a projected yield going forward of 1.96%.

But how do we know when these distributions happen, and more importantly, how do we know what TYPE of distribution they are for tax purposes?

Well for iShares/Blackrock, we scroll up to the top of the fund’s info page and find that cute little “Distributions” chart in the left sidebar.

Click on that and a window pops up showing you exactly when each distribution got paid.

Here, we can see that XEF pays semi-annually. Once in December and once in June.

Now, click over to the Calendar Year tab and you’ll see this:

And if you scroll over to the right…

You can see exactly how each distribution is classified for tax purposes. For XEF, we can see that most of the distribution is classified as “Foreign Income,” which is treated as regular income for tax purposes. That’s why we want to hold these in an RRSP or TFSA, if possible.

For Vanguard, just click the “Distributions” tab on the fund’s main page and you’ll see this.

And here, we can see how VTI distributes and how those distributions are classified. VTI paid out quarterly (March, June, September, and December) and those distributions are dividends.

And We’re Done

And that is it for this week. Thanks for tuning in everyone, and hope that answers some of your questions. We will see you back next week, same Bat Time, same Bat Channel!

WORKSHOP TOOLS:


How much does it cost to participate in this investment workshop? NOTHING. Because that's how we roll. All we ask is that you sign-up using the following affiliate links to keep it free forever:


For Canadians:
Questrade
Personal Capital


For Americans:
TD Ameritrade
Personal Capital


Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.

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30 thoughts on “Investment Workshop 11: Understanding Your ETFs”

  1. “How do I figure out what my fees are?”

    And related to that question is this:

    How *exactly* are those fees deducted from your account?
    Do they take it out of your dividend distributions (let’s say for VTI)?

    Logging into my account, I see that I have received my dividends ( $0.72700 share) for the last quarter but no where do I see where they’ve made the deduction.

    1. The MERs are deducted invisibly behind the scenes. You can normally only see this if you pull up the ETF and overlay its underlying index. The tiny spread between the two is the MER being deducted.

      That’s why actively traded funds go all out and charge such high fees. Because you can’t compare it against an index, there’s no easy way to see the effect that fee has on your investment. You just get suckier performance and you don’t know why.

  2. Daaang, those investment fees are crazy; that’s good to know. Oh Canada! I just stumbled upon this series, but it’s exactly what I was looking for–explanations on the big, wonderful world of investing. So thanks. 🙂

    1. Management Fee + Operating Fee = MER

      So no you don’t exactly add MER and management as management is a portion of the MER.

  3. I am brand new to investing, despite being in my early 40s. Can you please explain the difference between VTSAX and VTI? It looks like VTSAX isn’t an ETF. AM I right? How do I pick which one is a better long term investment?

    1. You are correct that VTSAX is not an ETF it is an index fund. To determine which would be better for long term investment we would need to know if it is in a tax advantaged account and how you plan to fund it.

      This link should provide some helpful info on ETF vs Index Fund which is essentially what you’re asking.

      http://www.fool.com/investing/2016/08/26/etf-vs-index-fund-which-is-best-for-you.aspx

      For what it’s worth though… VTSAX and VTI are essentially identical performance wise and fee wise and picking either of them are absolutely amazing decisions.

  4. Thanks guys for a great series. I have (yet another) question about ETFs v. proper Index Funds. As you show above Vanguard’s Total Market Index ETF ‘VTI’ has an expense ratio of 0.05%. However I also see via the interwebs that Vanguard’s 500 Index Fund itself VFIAX also has an expense ratio of 0.05% (granted, for Admiral class). If the expense ratios are the same are there any other reasons to prefer an ETF vs. a proper fund? Tax reasons maybe? Cheers from London

    1. I believe VTSAX has a minimum initial investment requirement of $10000, so if you have less than that you have to use the ETF.

      That being said, usually the decision of mutual fund-vs-ETF is usually based on how often you trade because ETFs usually cost money per trade. But if you’re using Questrade like this Workshop suggests, buying ETFs is free, so I think ETF always wins now.

      1. VTSAX is 10,000 however VTSMX is identical and requires only 3,000 minimum. Only difference is the expense fee which is has such a minimal impact when you are talking about less than $10,000 that it isn’t even worth discussing really. Once you get over 3K in VTSMX they automatically convert it for you and give you the better expense feee. IF you are doing the transactions with a vanguard account then both the ETF and the index fund would be free transaction so the cost per trade is eliminated and you’re back to it basically not mattering which route you go.

  5. Thanks for all the great info and practical examples. Much appreciated! I am curious why you prefer to use TD Ameritrade rather than purchase VTI or VTSAX directly from Vanguard’s website, besides the issue of a minimum amount of $10,000 USD for VTSAX? Thanks again!

    1. Hey Frank, may be worthwhile going back and reading from the beginning (the comments sections are pretty useful as well). It looks like while the ETFs being purchased now are all from Vanguard that may not always be the case. From week 1:

      “And now onto the Americans. For you, we’ll be using TD Ameritrade. Why? TD Ameritrade offers commission-free trading on certain ETFs, and somehow all the ETFs we plan on using are in that list, including all the cool ones run by Vanguard!

      If you don’t currently have an account, you can open one up using the link below. We’re going to be only using ETFs on their commission-free list so the advertised “commission-free trades for 60 days” doesn’t really matter. YAY! free shit!”

  6. This article was so enlightening!! I knew pretty much what you discussed, but it’s good to have those knowledge confirmed! It’s cool the Blackrock fund shows so much detail regarding their distributions!

    I have some hypothetical questions on the nature of the distributions from Blackrock. For the portion of the distribution that is capital gains, on your tax form, do you treat those as capital gains? vs just dividend income? How do you know of those capital gains are long or short-term, since it makes a difference on the US tax return?

    Also, for the foreign taxes paid part of the distribution, would this be a foreign tax credit on the tax return? Just curious. I understand you might not know since Canada tax is probably different than US.

    Thanks!

    1. The Vanguard site actually lists it explicitly as “LT Capital Gains” or “ST Capital Gains” for US ETFs.

      And yes, the foreign taxes paid is a withholding tax. You list it on your tax return as a foreign tax credit so you don’t get double-taxed, and if your tax bracket is low enough (like mine) you do get that money back.

    1. Return of Capital is the fund distributing back your own cash back to you. Basically, if an ETF has too much cash lying around that they don’t want to invest, the manager may shrug and just give it back to the shareholders. These distributions are completely tax-free.

  7. I’ve been signed up with personal capital for a total of 5 minutes and received the below msg.

    “A globally diversified portfolio can be an effective way to reach your investment goals. Because your portfolio is conservative, we anticipate you could be missing out on powerful growth opportunities. Based on historical results, your current portfolio is expected to return 3.4% compared to 8.9% you could expect with a globally diversified Target Allocation. By retirement, this difference in returns could cost you up to $7,800.”

    I thought I had a globally diversified portfolio…
    Or is this the trade off, they occasionally try to sell you their services for the use of their free platform?

    1. Ouch. DSCs have the WORST possible fee structure because it prevents you from getting out. And the +5% return last year isn’t a shocker considering how much the markets rallied (our investments were up 8% and this is AFTER management fees). But even with that return 2% or more gets eaten up by your horrible MERs every year.

      So in that case, since the $3000 penalty is only 3% of your 90K investment, that’s just slightly higher than what you’re losing EVERY YEAR on the shitty MER. If I were you, I’d sell it and invest in low cost index ETFs.

      Luckily the 70K is can be liquidated with no penalty. So pick an allocation and move it to low cost index ETFs. I don’t see the point of DCAing in this case since you’re already invested. If you liquidate and then gradually move back in with DCA, you’re actually timing the market even though you’re not intending to.

      1. Just saw your response in this post! Funny, my original question was in another post. Thanks for your response, FireCracker. It gives me the clarity and confidence to move forward. You’re right. It’s only slightly better than the absolute shitty MER that I’m being charged. I am also certain I can do better following the advice of the workshop over the long term than to leave the current portfolio the way it is.

        By the way, please keep posting your travel adventures. They are inspiring! I have recently made the move to become a digital nomad myself and starting a business. I am looking to travel more and in a different way: slower and longer in different places, spread between Europe and Asia. I love hearing about where you guys travel and what you’re up to! Cheers.

        1. Will do! And welcome aboard, fellow digital nomad! One of the best things we ever did was get out of our comfort zone and do slow travelling. It has been absolutely life changing (and surprisingly inexpensive) and I think it will be for you too.

  8. Does anyone want to share their Questrade “refer a friend” code? You get $25, and I get $25-$75 depending on how much I deposit! I’d rather that then $50 in free trades, since buys are all free anyway ;-).

    1. Hey Jamie,
      If FIRECracker and Wanderer want to share their code, they should go first, but I’ll throw mine in, too: 645620873407690

      Please feel free to delete if you don’t want it posted.
      All best,
      Melissa

  9. Hi! I can’t find the company ‘Questrade’ on the PersonalCapital web sites list, am I misunderstanding something?

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