indexing – Money Smarts Blog

Comparing Market Cap ETF vs Dividend ETF – How Much Duplication?

I had a reader question the other day where they mentioned buying both XIU (iShares Cdn Large Cap 60 ETF) and XDV (iShares Cdn Dividend Index Fund ETF) for their portfolio. I had responded that although I wasn’t sure, I suspected that might be a lot of duplication in the two funds since XIU has all the biggest public Canadian companies – a lot of which are good dividend stocks and would probably also be in XDV.

Duplicate holdings is a common problem in mutual funds – especially in a market like Canada where there are not a lot of different companies to buy for the larger funds.

I decided to do a bit research and find out if there was as much duplication as I suspected in the two funds. The question I want to answer is if it is worthwhile to own both funds for diversification purposes or will just one do.

Number of companies in common

The first and simplest criteria was how many companies are in both ETFs. This isn’t necessarily all that meaningful since one ETF might have a lot of XYZ company whereas the other might only have a small holding.

XIU 60 has 61 holdings (can’t they count?), XDV dividend has 31 holdings, there are 15 companies that they have in common. This seems like quite a bit since it means that half of the companies in the dividend ETF are also in the XIU ETF.

Amount of market cap in common

What I did here is take the companies that are in both ETFs and compare the percentage holdings and add up the smaller number. For example if CIBC was 9% of the dividend fund and 5% of the XIU then I counted that as 5% in common (by market cap). This totalled up to 31%. This was a smaller number than I expected which means that a good portion of the dividend ETF is not represented in the XIU 60.

Measuring correlation between the ETFs

The next test I did, which should have been the first and only test since it is the only one that has any real meaning is to measure the amount of correlation between the two ETFs. Correlation is a measure of the relationship between the prices of the two ETFs.

A measure of 1 means that they always move in price exactly the same way, a measure of 0 means they are completely uncorrelated and a measure of -1 means they always move in price in exactly the opposite direction. One of the main concepts behind building a portfolio is to try to find different assets that are not correlated with each other.

To accomplish this I needed some historical price data which I managed to find at Yahoo Finance. To figure out the correlation I used the Excel correl function (is there anything Excel can’t do?). XDV dividend has only been around since the end of 2005 so the data is only for a bit less than 4 years. Not being a stats guy I’m not sure if this is a long enough period to be meaningful but it’s all I’ve got. Regardless, the correlation “r” number was 0.72 which implies some benefit for diversification but not a whole lot.

Performance

The last thing I looked at was performance. Since the time period is fairly short I’m not looking to see which ETF did better but rather to look at the difference in performance. Ishares.ca website has a handy calculator just for this purpose. I choose the last 3 years since the next category was 5 years which wouldn’t work for XDV dividend.

3 year total return

XIU Large Cap 60 = -12.98%
XDV Dividend = -18.19%

From what I’ve read the XDV dividend has a higher ratio of financials than the XIU 60 which is probably one of the reasons for the big performance difference. The XDV dividend has a higher mer (0.5%) than XIU 60 (0.17%) which would account for about 1% of the 5% difference.

Conclusion

I looked at 4 categories to see how different XIU and XDV are:

Similar companies – half of the XDV dividend companies are in XIU.
Similar companies by stock market capitalization – 31% of the companies market cap are in both ETFs.
Correlation – over the last 4 years the correlation is 0.72.
Performance – the two ETFs were about 5% off in terms of total performance over 3 years.

What does it all mean? Hard to say – there are much better ways to diversify your portfolio – REITs, small cap, foreign holdings would likely all have correlations that are less than 0.72. I’m also not crazy about the higher mer of the dividend ETF.

I think if you want to have most of your equity in Canada then buying partially overlapping ETFs might be the only way to diversify without getting into individual stocks. Personally I like to be diversified over the whole world so for me, the XIU Large Cap 60 by itself is good enough – in my case adding XDV would not increase my diversification enough to make the higher mer worthwhile. XIC (TSX 300) is also a good choice.

The Death Of Index Investing And Other Silly Stats

I recently came across yet another post on investing which goes something along the lines of “If you invested 10 years ago in the Dow then you would have earned exactly nothing in that time”. I hate to pick on any one blogger since I’ve read these articles all across the blogosphere but this one is the latest and he also had the temerity to tie in poor index performance with the death of index investing. Of course all the stock pickers out there ALWAYS beat the index so poor market are no concern to them…! I want to emphasise that Jacob at Extreme Early Retirement does a great job with his blog and I don’t want to sound like I don’t like the blog – just that one post! 🙂

What about the dividends?

Usually these posts look at the point value of an index at a previous time, say 10 years ago and compare it to the present index point value. This is incorrect because they are missing dividends. Published index returns always included reinvested dividends and any type of analysis on index performance should always include the same. Admittedly, if you are looking at a 10 year period where the index point value hasn’t changed, the addition of dividends isn’t going to change the argument very much but it should be there.

Selectivity of stats

Why is it that all the articles always pick the worst peak to trough period to illustrate their rather suspect point that maybe equity investing or even index investing is evil? Have you ever heard of such a person who invests all their money on the same day the markets peak and then doesn’t invest any more? Doesn’t seem all that likely to me. Most people invest their money over time because that’s how they earn it, then save it, then invest it. Picking one particular time period to prove or disprove a theory is like measuring your gas mileage one mile at a time and then using the best or worst mile to prove your point.

Investment performance

And what about active stock pickers – did they all do better than the indexers over that period? Or did some of them do better, some of them the same, and some of them didn’t do as well? I’ve asked many bloggers and non-bloggers who claim they can beat the index by picking their own stocks to prove it – measure their performance and let me know if they did better than the market or not. You know what? Not one of them has ever shown that they can beat the market – oddly enough, most of them don’t even bother to measure their performance. How can someone who doesn’t even know how their own investment method measures up criticize someone else’s?

What is average?

One of the criticisms of indexing is that you will only achieve “average” results – again – will I do better by randomly picking stocks or paying someone lots of money to pick them for me? One thing about indexing is that you will get the index return minus a very small fee – you will never beat the index but more importantly you won’t underperform the index (except for the small fee) either. Active pickers can certainly outperform the market but they can also underperform as well – sometimes by a huge margin. I like making money – if I thought it was possible for me to beat the market then you can rest assured that I would give it my best effort.

Dividends, smividends

Ok – one more rant… I like getting dividends just as much as the next investor but I really think there is an over-weighting on the importance of dividends in the blogosphere. Yes, the idea of living off your dividends is nice but investment performance measures total return which is capital gains plus any reinvested dividends and interest payments. That’s it. I don’t care in what form the company pays out in the end – if the total return is higher, then its a better investment. If that includes dividends, fine – if not, that’s fine too.