Exposure to Canada has been conspicuously missing from broad-based international exchange-traded funds, including the $37 billion iShares MSCI EAFE Index Fund ( EFA), which excludes all North American companies. Vanguard plans to remedy that. It's launching an ETF later this quarter that provides similar exposure to international stocks as the iShares MSCI EAFE but allocates 5% of its assets to Canada. The FTSE All-World ex-USA Index Fund will provide exposure to more than 2,000 large-cap and mid-cap stocks from 48 different countries in the developed and emerging markets. It will have an expense ratio of 25 basis points. Vanguard will also be rolling out two mutual fund versions of the product: an investor share class that will have an expense ratio of 40 basis points and an institutional share class that will charge just 15 basis points for shareholders with $5 million to invest. (Unlike exchange-traded funds, which trade throughout the day like stocks, mutual funds can only be purchased or sold once a day.) "If you look at the opportunity for investors outside the U.S., it does include Canada," says Paul Lohrey, Vanguard principal. "For that reason, we think it is important to include Canada in a broad-based index that is essentially a global index ex-the U.S." Lohrey adds that in the past, many investors who wanted truly global exposure paired the iShares MSCI EAFE with an ETF that tracks the S&P 500 (a broad representation of the U.S. market). That worked when the S&P 500 still included a fair number of Canadian stocks. But Canadian stocks were removed from the S&P 500 a few years ago, making the index more of a pure U.S. play. This left some people with a hole in their portfolio.
It's no wonder that investor interest in Canada has been piqued, given the strong performance of the Canadian stock market over the past three years. Since January 2003, the S&P/TSX Composite Index, which includes the largest companies on the Toronto Stock Exchange, has risen about 90%. The Canadian market isn't without its risks, however. If you look at the prior three years, from January 2000 to January 2003, the S&P/TSX Composite Index was down 23%. Greg Newton, who runs the Naked Shorts blog, says that investors who include Canada in their portfolios are basically making a play on commodities. And given the way the commodity markets have blow up this week, he says, Canadian equities likely won't be far behind. While 5% may seem like a relatively small allocation, it can make a huge difference in the performance of an index, according to Matthew Hougan, senior editor of the Journal of Indexing and Web site IndexUniverse.com. He notes that Exxon ( XOM), the largest component in the S&P 500, only has a weighting of 3.4%. Even actively managed funds rarely allocate more than 5% to a single stock. "It's larger than the largest stock position in just about any sensible mutual fund," Hougan says. "No portfolio manager would forfeit a 5% position on a whim, and neither should index investors."
Hougan notes that over the past five years, iShares Canada ( EWC) has returned around 125% cumulatively, while iShares MSCI EAFE has returned just 83% cumulatively. And, he adds, "a back-of-the-envelope calculation shows that adding a 5% exposure to Canada would have boosted cumulative returns of the EAFE index by about 2.5% over the past five years, or somewhere in the range of 40-50 basis points per year. That's more than the expense ratio on many ETFs, including both EFA (35 basis points) and the new Vanguard international fund (25 basis points)." Naked Shorts' Newton takes a more skeptical view, however. "Anything that
represents 5% of a portfolio would have to go up or down 20% to make a 1% difference to the overall deal," he says. Vanguard's Lohrey concedes the FTSE All-World ex-USA Index Fund's allocation to Canada is "not huge." For investors who are already invested in the firm's Total International ETF, which excludes Canada, he says, "I don't know I would be motivated to sell the holdings to get Canada." However, he says investors who don't already own Total International should "seriously consider" using the FTSE All-World ex-USA Index Fund. Lohrey says that for investors who want total global exposure, buying a total market U.S. ETF (such as an S&P 500 ETF) and the new Vanguard product is a better option than buying a U.S. ETF and an international ETF that excludes Canada and tacking on a Canada-only ETF. (Currently the only Canada ETF is the iShares MSCI Canada Index Fund ( EWC).) He says buying just two ETFs, as opposed to three, is more convenient and will generally mean lower trading commissions. Hougan agrees that the new ETF is a good bet for investors who want global exposure, and believes that future ETFs are likely to follow in these footsteps. "This is probably just the first such product," he says, adding that including Canada in broad-based international ETFs "might even become a new best practice."