Reduce Your Volatility By Adding XEQT:CA (TSX:XEQT:CA)

Who is this Fund for?

This fund is a simple and low-cost way to gain broad exposure to global equity markets. iShares Core Equity ETF Portfolio (TSX:XEQT:CA) holds over 9,000 equities from across the globe, with exposure to all major stock markets. All-in-one exchange-traded funds (“ETFs”) are often billed as ideal products for beginner investors, those with small portfolios, and investors who don’t have the interest, skill or inclination to manage a stock portfolio. I disagree with this premise. Even experienced stock pickers can use a backstop.

All investors need to be properly diversified across sectors, geographies and asset classes. Achieving proper diversification while still allocating sufficient capital to build up overweight positions in high-confidence ideas can be a challenge.

Using broad index ETFs to ensure proper diversification can allow an investor to focus their time, research and capital to their best ideas. I don’t have the time or expertise to have an edge in all markets and sectors. The best use of my research time and capital is to focus on investments in industries and markets where I am more knowledgeable and experienced. For example, at any given time, I might hold 15 high-conviction positions, not enough to maintain proper diversification across sectors and markets.

For this reason, I think that the best way I can add alpha to my portfolio is to have a portion of my portfolio tracking a broad index of stocks and a portion dedicated to my highest conviction ideas. These ratios may vary by investor based on confidence and portfolio size. This iteration of a “core and explore” strategy is my preferred portfolio construction.

About XEQT:CA

iShares Core Equity ETF Portfolio fund is comprised of four underlying BlackRock iShares ETFs that contain a total of 9,448 individual equity holdings. These four constituent funds are:

• iShares Core S&P Total U.S. Stock Market ETF
• iShares Core S&P/TSX Capped Composite Index ETF
• iShares Core MSCI EAFE IMI Index ETF
• iShares Core MSCI Emerging Markets ETF.

XEQT:CA trades on the Toronto Stock Exchange with average daily volume of 218,524 units. The fund began trading on August 7, 2019 and has since accumulated $1.34B in net asset value.

The fund has a management fee of 0.18% with a total MER of 0.20%. This fee is inclusive of all funds represented in XEQT:CAs underlying holdings. This fee is 0.04% lower than its closest competitor from Vanguard, Vanguard All-Equity ETF Portfolio (VEQT:CA), which has an MER of 0.24%. XEQT:CA’s trailing 12-month yield is 2.05%, higher than the current yield of the S&P 500 at 1.64%.

The fund’s stated investment objective is to:

“[P]rovide long-term capital growth by investing primarily in one or more exchange-traded funds managed by BlackRock Canada or an affiliate that provide exposure to equity securities.”

Over the past three calendar years, the fund has returned 11.7%, 19.6% and -13.4% respectively.

XEQT:CA is part of the iShares Core ETF Portfolios. This suite of products offers a range of portfolio solutions with various fixed income/equity allocations. I am focusing on the 100% equity iteration for this analysis.

Diversification

XEQT:CA’s exposure to over 9,000 companies is more than double the number of listed firms in the U.S. The developed North American markets account for less than 5% of global population. For proper geographic diversification, it’s important to ensure broad exposure to developed markets outside of North America as well as emerging economies. While developed markets are well represented in this fund, emerging markets exposure is light, at only 5.3%.

In addition to geography, the fund is well balanced across sectors. No one sector has a greater than 20% weighting, and only Financial Services has a weighting of more than 15%.

Reducing Volatility

For any portfolio comprised of 100% equity, there is going to be volatility. Both Vanguard and iShares offer related products with varying mixes of fixed income and equities based on investor needs. Even with a 100% equity allocation, XEQT:CA is designed to reduce volatility without adding fixed income.

One obvious question investors would have about XEQT:CA’s geographic allocation, is why is it so overweight Canadian equities? Canadian equities account for around 2.7% of the global equity market, however, XEQT:CA has a 24% weighting. The answer to this is volatility dampening.

A 2021 research paper from Vanguard found that including international equities in a portfolio tends to decrease volatility risk and increase expected returns to a point. Ben Felix of PWL Capital notes that specifically for Canadian investors:

Vanguard found that the maximum expected volatility reduction was achieved when a Canadian investor allocated 50%–60% of their equity portfolio to non-Canadian stocks. Allocating more than that actually increased volatility.

The graph above identifies the optimal weighting of Canadian stocks in an all-in-one asset allocation ETF to reduce overall volatility. The sweet spot is a weighting of approximately 20-30% Canadian stocks. The Vanguard research on diversification and volatility concluded:

In each market we examined, our analysis indicated that volatility was reduced most with an allocation to international equities of between 35% and 55%. While this observation may help investors determine the appropriate mix of domestic and international equities, volatility reduction is not the only factor to consider.

Fees and Taxes

While the diversification and automatic rebalancing are the advantages of this product, it is not perfectly efficient. The 0.20% MER is relatively low cost, however individual investors can find savings by replicating XEQT:CA and holding the underlying ETFs directly. While this strategy could more than halve the MER to 0.09%, investors would need to consider the cost and effort to monitor and rebalance.

Using XEQT:CA comes with a tax drag in withholding taxes for Canadian investors that will vary by account type. For example, the iShares tax calculator suggests that the tax drag for holding this all-in-one fund is 0.22% for RRSPs. This drag is the result of owning U.S. securities through a Canadian listed fund, this is less efficient than holding a U.S. listed ETF in an registered account.

Similar Products

The closest competitor to XEQT:CA is Vanguard’s VEQT:CA. This fund launched a few months before the iShares XEQT:CA in 2019 has amassed $2.2B in assets under management (“AUM”) compared to XEQT:CA’s $1.4B. Vanguard’s version has even greater diversification, with over 13,000 stocks in the portfolio. While this covers a broader swathe of the investable universe, there are diminishing returns on adding securities held in such small fractions.

Two notable differences between Vanguard’s VEQT:CA and the iShares XEQT:CA are fees and geographic allocations. VEQT:CA has an MER of 0.24%, compared to XEQT:CA’s 0.20%, a difference of about $40 on every $100,000 invested. Vanguard’s fund has approximately 30% Canadian equity compared to the XEQT:CA allocation of 24%. VEQT:CA also has a little more exposure to emerging markets and a slightly lighter U.S. equity weighting.

For broad exposure to global equities without the overweighting on Canadian shares, one could use the Vanguard Total World Stock Index Fund (VT) or iShares MSCI All Country World Index Fund (ACWI). The biggest difference is XEQT:CA and VEQT:CA are overweight Canada between 24-30%, whereas VT and ACWI hold Canada around its global market cap of around 3%. While these funds lose the volatility advantage of overweighting Canadian equities, holding a globally diversified basket of equities is already less volatile than any single national market.

Investor Takeaways

Holding XEQT:CA is my preferred way of ensuring that I stay well diversified. This allows me to focus on a smaller number of direct holdings where I see the greatest opportunity. This low cost all-in-one ETF is designed to reduce overall volatility. This overweighting of Canadian equities and exposure to international markets results in XEQT:CA yielding approximately 40 bp more than an S&P 500 index.