CapitalTime

Articles on investing and capital management, with a quantitative focus.

#prp - Permanent Risk Parity (how I invest)

Why I chose XIU and ZSP

2021-06-07

Many people have asked why I use XIU and ZSP for the equity components in my portfolio, as opposed to VEQT or XAW (which are popular choices today).

My primary decision factors were my level of comfort and confidence in the index ETFs.

Investing is not just a technical or mathematical game; it's also psychological. It's very important that investors choose vehicles that they can stick with through all kinds of market turmoil.

I should note that these ETFs are in my 'model portfolio'. I track this ideal portfolio for benchmarking purposes. My own investments are very similar, though not identical, to the model portfolio. But yes, I hold all of these ETFs. In one tax sheltered account, I hold exactly the model portfolio.

Choosing my foreign equity ETF

Some people may be surprised to see that my foreign equity component is entirely ZSP, tracking the US S&P 500 index, instead of a globally diversified ETF.

Keep in mind that I formed my portfolio in 2016. VEQT did not exist back then, and XAW was a tiny fund which was barely one year old, so it really wasn't an option.

Here are some things I consider when choosing my foreign equity ETF:

The last point is an important one. In my view, there is a significant difference between theoretical historical performance, and actual, real-world performance of a fund that exists.

I've spent a lot of time analyzing the historical (back-tested) behaviour of potential portfolios. I need to know that I actually could have invested in a vehicle which produced these results. In my view, as an engineer and data analyst, this makes historical results more tangible and more believable.

Would I switch to VEQT or XAW today? No. First of all, I don't have access to several decades of historical performance. It doesn't even exist for VEQT, since this does not track an index. There is a common misconception that VEQT's benchmark is simply the current weights of the ETF's holdings. This is not true. Since VEQT does not define an index benchmark in the Prospectus, there is absolutely no way to tell what it might have held 10 or 20 years ago. In fact, the country weightings are at the discretion of the fund manager!

Perhaps with some digging, I could find historical (theoretical) performance of XAW. But then, I still have the problem described earlier: this vehicle has only existed for 6 years and I could not have invested in it before then.

How about the S&P 500 index? This is an index that I understand, which is important to me. I can easily access historical data for it, which is also great.

Is there an actual S&P 500 vehicle? ZSP has existed since 2013, but I could have also invested in the US-based SPY as far back as 1993. So it's not just a theoretical foreign index. I could have really invested in SPY going back 28 years!

Note, again: I couldn't have really invested in XAW or VEQT.

Because ZSP was somewhat new at the time I started, I watched it very closely to ensure that it tracks the S&P 500. And it does. I think the fund manager (BMO) has done a nice job with ZSP. The management expense ratio (MER) is only 0.09%, it's a huge fund, with $9 billion in assets.

I realize that global diversification is important. Nevertheless, I have to go with what I have confidence in, and I just can't be confident about theoretical index returns when no ETF existed in the past.

How about MSCI EAFE

One way to add international diversification would be to use an MSCI EAFE fund. The US-based EFA has existed since 2001, and there is also a Canadian domiciled version (XEF).

At some point in the future, I might expand my global allocation by combining ZSP and XEF. This seems like a reasonable idea, but I would have to spend a lot of time playing with the historical data to convince myself that I like this modified allocation.

Canada: XIU or XIC?

Two questions might remain: why do I have such a large Canadian equity weight, and why do I use XIU instead of XIC?

Again, this comes down to personal comfort and my desire to use an ETF which I have the most confidence in. I am very familiar with the Canadian market, so I prefer to have a large domestic weight. I actually think that both XIU and XIC are excellent ETFs, and would happily recommend either one to a friend.

I have a long personal history with XIU, going back to when I first started trading it in the early 2000s. XIU was the first ETF in Canada, and probably was the first ETF in the world.

XIU is a remarkably simple ETF, and I love simple and elegant structures. It holds the 60 most liquid large caps in Canada, has great daily liquidity, and is enormous (with $11 billion in assets).

In comparison, XIC holds far more stocks, including many small caps and illiquid stocks which barely have any daily trading volume. This isn't necessarily a bad thing, but the two ETF portfolios are quite different.

I like that XIU holds only the largest and most liquid stocks in Canada. It really is a perfect "plain vanilla" ETF, which isn't surprising considering it was the original ETF. But it's not just the prototype for the modern-day ETF; it has actually proved to be a very well performing fund. It's been through multiple market crashes and has come through them like a champ.

(On the bond side, the same thing can be said about XBB, which I also hold.)

I have tremendous confidence in XIU, and really think it can survive the craziest market conditions. That's why I hold it.

— Jem Berkes