Rob Carricks' Guide to ETFs

NOTE: This eBook has been designed to be viewed on a device with an internet connection. If you are reading on a device without internet capabilities, we recommend you download the offline optimized PDF version at tgam.ca/ebooks

Copyright © 2014 The Globe and Mail. All Rights Reserved

This book may not be reproduced, transmitted, or stored in whole or in part by any means,

including graphic, electronic, or mechanical without the express written consent of the

publisher except in the case of brief quotations embodied in critical articles and reviews.

Follow us: @rcarrick facebook.com/RobCarrickFinance

Introduction

Exchange-traded funds are a good idea gone crazy.

There are hundreds of ETFs listed on the Toronto Stock Exchange. Three to six are all you need for a nicely diversified portfolio.

Recognizing that investors need help finding the right ETFs for their portfolios, we have created The Globe and Mail ETF Buyer’s Guide. Covered here are five types of ETFs – Canadian, U.S. and international equity funds, dividend and income diversified income funds and bond funds. Use this guide to narrow down the choices in these categories. Then, continue your research using the resources that ETF companies make available on their websites.

ETFs have been around for close to 25 years, so there’s nothing new or trendy about them. And yet, many investors are still getting to know them. A few basic facts:

- ETFs are a sort of mutual fund that trades like a stock.

-You need a brokerage account to invest in them, or an adviser who is able to access them.

-Most brokers charge commissions to trade ETFs, but a few waive some or all of these costs.

-The traditional ETF tracks major stock and bond indexes; today, many funds follow more niche-oriented indexes or have a manager who picks stocks.

Why own ETFs? They’re much cheaper to own than mutual funds, yet they provide all the same diversification benefits. Portfolios built on ETFs can take you through your saving years right through to retirement and beyond. ETFs are suitable for your registered retirement savings plan, your tax-free savings account and your registered educations savings plan.

A caveat for ETF investors: Because they trade like a stock, ETFs can be bought and sold much easier than mutual funds. In trying to reach your long-term financial goals, excessive ETF trading can very easily make you poorer.

Rob Carrick,

The Globe and Mail

The Lessons

Where to learn about ETFs

For a complete list of links to the websites mentioned below, click here.

1. What the heck is an ETF, anyway?

Basic, unbiased information about ETFs is available on the GetSmarterAboutMoney.ca website, which was established by the Ontario Securities Commission and, unlike many other financial sites, accepts no advertising from financial firms. Note: The Investor Education Fund, the group behind the website, is a co-sponsor of The Globe’s Let’s Talk Investing online video series.

Morningstar, an independent analysis firm, offers ETF basics in slide show form on its website. Newbies should check out the presentations titled “Are ETFs Right for You?” and “Mutual Funds or ETFs – Which to Choose?”

- Investor Education Fund ETF page

- Morningstar ETF page

2. Who are the ETF companies in the Canadian market?

TMX Money, an investor website run by the company that owns and operates the Toronto Stock Exchange, has an ETF section that includes profiles of the nine companies offering exchange-traded products in the Canadian market. Included is the newest entrant, First Trust Portfolios Canada.

- TMX Money ETF company profiles

3. Where can I find a master list of all ETFs listed on Canadian and U.S. exchanges?

Use the stock filter on Globeinvestor.com. Choose your exchange from the drop-down menu, then select ETFs from the menu labelled Security. A total of 343 TSX-listed ETFs were listed as of mid-week, along with 1,132 on the New York Stock Exchange.

- Globeinvestor stock filter

4. How can I narrow my search?

TMX Money has a basic screener that lets you isolate funds by asset class, region, style, size, sector and issuer. The results are displayed in a way that lets you instantly see which funds are the cheapest, most diversified, most liquid, most tax efficient and have the least tracking error (that’s where an ETF’s returns deviate from its underlying index). There’s a lack of precision in this screener that will give you oddball results at times, but it’s still worth trying.

ETF Insight’s screener lets you search using such criteria as asset class, strategy (examples: dividend income, covered call, equal weight, fundamental), management expense ratio, performance, distribution frequency and yield. For bond ETFs, you can search by yield to maturity and duration. Yield to maturity is the best indicator of your future returns from a bond ETF (remember to subtract a fund’s MER for a net number), while duration is a key measure of sensitivity to moves in interest rates.

- TMX Money ETF screener

- ETF Insight screener

5. How can I quickly compare the particulars of a few ETFs at once?

The Vanguard family of ETFs offers a comparison tool that lets you compare up to four funds from Vanguard and most other Canadian mutual fund and ETF companies. For ETFs tracking stock market indexes, you’ll find such data as MER, Price-Earnings Ratio, Price-Book Ratio, dividend yield, portfolio turnover, sector breakdowns and Top 10 holdings. The data for bond ETFs are spotty, however.

- Vanguard ETF comparison tool

6. What’s the best source of information on individual ETFs?

Transparency, along with low costs and incredible utility as portfolio-building tools, are the main attributes of ETFs. So don’t be surprised that ETF companies offer detailed online profiles of their funds with data on fees, yields, distribution history, top holdings in both stock and sectors and performance of both funds and their underlying indexes. Some firms are better at disclosure than others – maybe I’ll write a column on that some day.

The ETF profiles on Google Finance include one of the best charting tools around. Just type the ETF ticker into the search box, which seems to recognize TSX-listed ETFs. If you run into trouble, try typing “TSE:” in front of the symbol, as in TSE:XIU.

- BMO ETFs

- FirstAsset ETFs

- First Trust Portfolios Canada

- Horizons

- iShares

- PowerShares

- RBC ETFs

- Vanguard

- Google Finance

7. Where can I find ETF prospectuses?

A central clearing house for all ETF prospectuses and other regulatory documents is the online System for Electronic Document Analysis and Retrieval, or Sedar (check here for documents issued by mutual funds, closed end funds and publicly traded companies as well).

- Sedar

8. How can I keep track of new or upcoming ETFs?

The ETF News area on the Morningstar.ca website lists new ETFs on the Canadian market.

- Morningstar.ca ETF page

9. What’s a good source of Canadian ETF investing ideas?

Globeinvestor.com’s ETFs page packages our extensive ongoing coverage of exchange-traded funds. Recent articles you’ll find here cover such topics as ETFs for exploiting a turnaround in gold prices, how ETFs would be affected by the Loblaw-Shoppers Drug Mart deal and assessing the risk of rising interest rates in bond ETFs. Also try Morningstar.ca’s webpage and ETF Insight.

- Globeinvestor ETF page

10. What about U.S. ETFs?

A basic but effective screener for ETFs listed on exchanges in the United States and elsewhere is offered by the Bloomberg business news service. You’ll find a more advanced screener on the ETF Database website. Worried you’ll miss out on good ETFs because the U.S. market is so vast? If you call up a profile of a fund on the Wikinvest website, you’ll find a list of all comparable products listed on U.S. exchanges. For investing ideas, try IndexUniverse and ETF Trends. The ETF page on Yahoo Finance is worth looking at because it aggregates content from a variety of other sites.

- Bloomberg ETF screener

- ETF Database screener

- Wikinvest

- Index Universe

- ETF Trends

- Yahoo Finance ETF page

11. Where can I find model ETF portfolios?

ETF Insight offers a variety of model portfolios under the following categories: Traditional, low cost, fundamental and alternative (the latter includes a rising interest rate portfolio). Data on portfolio fees, yield and, where applicable, duration, are included. The ETF Trends website offers a U.S. perspective on model ETF portfolios.

- ETF Trends model portfolios

12. Which online brokers are best for ETFs?

The Globe and Mail’s annual review of online broker puts a big emphasis on costs, including the availability of low- or zero-cost ETF trading.

- 14th annual Globe brokerage ranking

13. Which investing bloggers cover ETFs?

The Canadian Couch Potato blog is all index investing, and ETFs get a lot of coverage because they’re an ideal way to invest in the world’s major stock and bond indexes. The Canadian Capitalist blog maintains a “Sleepy Portfolio” of ETFs that is designed to be easy to run and ultra cheap.

- Canadian Couch Potato blog

- Canadian Capitalist

Read more from Portfolio Strategy.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).

About Bonds

There are so many ins and outs to putting bonds in your portfolio. Bond funds are expensive to own, but convenient to buy. Bond exchange-traded funds look good by comparison, but they lack the singular advantage of owning individual bonds. On maturity, the government or company that issued a bond will hand investors their money back. Bond funds and ETFs never mature.

Which bond investing vehicle is best for you? Here is The Globe and Mail’s definitive guide to bond investing choices. Bond funds, bond ETFs and individual bonds are examined here in 10 different categories and rated on a scale of one to five for their utility. First, a quick look at how the choices available work:

Click here for a printable PDF of Rob Carrick's definitive guide to bond investing choices.

Reading between the lines: The nitty-gritty on ETF payouts

Even the most useful and sensible of investing products can turn out to be more complex than you thought.

Exchange-traded funds that pay monthly income are a good example. Put them on your short list if you need a well-diversified, low-cost way to squeeze income from your investment dollars, but mind the details. Two areas to focus on: yield, and the extent to which a return of capital is present in the monthly payouts.

Comments I’ve received from investors suggest some people are not getting the yields they expected from their monthly income ETFs. Others have received their 2011 tax documents and found that, in addition to bond interest and dividends, the income they’re receiving in their non-registered accounts includes a significant return of capital. That’s a turnoff to investors who want the simplicity of being paid with interest and dividends only.

Naturally, investors bear some responsibility for understanding what they buy. But the investment industry has obligations as well to disclose in simple terms how their products work. In a recent publication for the broad investment fund industry, the Ontario Securities Commission suggested some firms are falling short.

Following a review of income funds of all types, the commission said it would ask for greater clarity in how yields are calculated and more detail on whether a return of capital is part of the distributions made to investors. ETFs are often praised for providing a higher level of disclosure than other types of investment funds, so there’s some reason to hope for better labelling of monthly income funds. In the meantime, let’s look at some things investors need to know when evaluating these products.

Monthly income ETFs generally hold stocks and bonds, or a basket of other ETFs that focus on various income-producing sectors. A key point of comparison in choosing a monthly income fund is the yield, which is calculated as the annualized total income payout divided by share price.

Finding a real-world yield for an income ETF can be a challenge. One reader said he had issues with a fund that was described on the website of the company offering it as having a “portfolio yield” of 5.4 per cent. When this investor checked the yield online at Globeinvestor.com, he found the yield was 4.8 per cent.

The lesson here is that portfolio yield refers to the income paid out by the investments in an ETF, before fees. Distribution yield, which you’ll see in online quotes and on some ETF company websites, is more useful because it’s an after-fee number based on the actual income payments made by a fund.

Unfortunately, distribution yield isn’t a perfect number if you’re looking at monthly income funds that happen to hold some bond ETFs. As you’ll know if you read my Portfolio Strategy column from last year (tgam.ca/DLXB), looking at the distribution yield for bond ETFs can give you a distortedly high picture of your yield. The better indicator of what yield to expect from a bond ETF going forward is yield to maturity minus a fund’s management expense ratio. You can find yield to maturity data on ETF company websites.

If you’re evaluating a monthly income fund that holds bond ETFs in its portfolio, it’s worth looking at those bond funds individually to monitor the gap between their distribution yields and their after-fee yields to maturity. The bigger the gap, the more you should mentally discount the distribution yield for your monthly income fund.

Income payments are one variable in calculating yield; the other is price. But what price? Some ETF companies use the market price and some use the net asset value, which can at times can differ from the market price.

This shouldn’t be a major problem with ETFs because the gap between market prices and NAVs is supposed to be inconsequential. Yves Rebetez, a chartered financial analyst and managing director and editor at ETF Insight (etfinsight.ca), said that of the two, he prefers NAV in the yield calculation because it gives a truer picture of the income produced by an ETF’s portfolio.

The presence of a return of capital in ETF monthly income distributions is something investors just have to live with if they want a monthly income ETF. Return of capital refers to cash over and above the taxable income generated by the investments in a fund.

Each return of capital payment has the effect of lowering the cost that you will use at some point in the future to calculate your capital gain (or loss) when you sell your ETF. Given that only 50 per cent of a capital gain is taxable, you might conclude a return of capital is not a bad thing.

Some investors don’t agree. They like the transparency of living off dividends and interest and leaving their capital alone. But after checking a wide variety of income-focused ETFs (including bond, dividend, diversified income and covered call funds), it seems virtually impossible to avoid at least some return of capital component in distributions.

One explanation lies in the fact that ETF firms must occasionally create new units to satisfy investor demand. Investors who own the newly created units expect a full distribution, even if these units haven’t been around long enough to have generated sufficient dividends and interest.

Morningstar ETF analyst John Gabriel said there’s a cash component that goes into the creation of new ETF units to top up the distributions payable. “From an accounting point of view, that cash component isn’t really a dividend paid by the underlying companies,” he wrote in an e-mail. “So that portion of the distribution is classified as a return of capital.”

Mr. Gabriel said the return of capital is reported only on an annual basis. “It’s an accounting matter typically handled at year end after all the dust settles.”

A return of capital also plays a role in income ETFs with level monthly payments designed to give investors a predictable flow of cash. These funds face a challenge in that quarterly dividends and semi-annual bond interest don’t arrive in an orderly way that easily lends itself to a steady monthly payout. By using a return of capital, ETF companies can smooth the payouts.

“If investors want steady income from investing in sectors that don’t pay out a predictable income stream, there will need to be return of capital from time to time,” said Oliver McMahon, head of product for the iShares ETF lineup, said in an e-mail.

Before buying income ETFs for your non-registered accounts, familiarize yourself with the composition of the distributions. All ETF firms have fund profiles on their websites with a tab dedicated to distributions. Check out this year's view for the most recent full-year tally and save yourself from a surprise when your tax slips arrive.

For more personal finance coverage, follow me on Twitter (rcarrick) and Facebook (Rob Carrick).

The best, and cheapest, online brokers in Canada

The best reason to be a do-it-yourself investor is to cut costs, and the online broker that helps you do that best is Virtual Brokers.

Cost is a huge category in the 15th annual Globe and Mail ranking of online brokers, and VB aces it. Now you understand why this tiny firm that hardly anyone knows about has, for the second year in a row, taken top spot in the annual Globe and Mail ranking of online brokers.

VB is no one-trick broker. It ticks off several other key boxes in this ranking, including personalized account reporting to show clients how their portfolios are performing and the availability of U.S.-dollar registered accounts.

As a relatively new player in the online brokerage business, VB is still a bit rough around the edges. But over all, it emerges ahead of Qtrade Investor, long a dominant player in this ranking, and other strong options like BMO InvestorLine, RBC Direct Investing and Scotia iTrade. For the first time, the independent firm Questrade has been included with the higher-scoring brokers.

This ranking is designed for mainstream investors, not active traders, so firms are only considered if they offer all types of registered accounts, and a wide variety of investment choices and tools for research, planning and screening. All brokers included here are members of the Canadian Investor Protection Fund (CPIF), which protects account assets of up to $1-million if a broker goes under.

Brokers are evaluated on their online services, not those available by telephone.

Here’s an outline of how brokers are scored

Cost:

Brokers who do well in this category have a low hurdle for clients to qualify for sub-$10 stock trades. Commissions on bonds and mutual funds are also considered, as are administration fees for registered accounts and the availability of commission-free exchange-traded funds.

Account information:

In this category, brokers live or die by the job they do in helping clients gauge how their portfolios are performing over time.

Trading:

Brokers are graded here on the availability of registered accounts that can hold U.S. dollars (many brokers force a conversion into Canadian dollars when clients sell U.S. stocks or receive dividends from such stocks), as well as the trading experience for clients when buying or selling stocks, the range of investment products available online and the number of stocks available for dividend reinvestment plans.

Tools:

This category covers the variety and exclusivity of a broker’s research, financial planning and stock/ETF/mutual fund screening tools.

Innovation:

Shows which firms are leaders in terms of cutting prices and introducing new services, and which are followers.

BMO InvestorLine

Overall letter grade: B

- Costs: Not a strength, C

- Account info:Among the best B+

- Trading: U.S.-dollar RRSPs are available B

- Tools: Good B

- Innovation: A strong record in this area B

The best of the bank-owned firms right now over all, InvestorLine subtly tries to raise itself above the small-account riffraff with a $5,000 account minimum (TFSAs and RESPs excepted), the highest of any firm in this ranking. Administration fees for registered accounts are also on the high side for small accounts. Aside from costs, InvestorLine does pretty much everything well. Through its AdviceDirect channel, InvestorLine even offers an advice option. Clients pay 1 per cent of their account assets annually (less for large accounts) in exchange for investing guidance delivered online and through a staff of eight investment specialists. That’s pricey, but possibly a value for DIY investors who would flounder without assistance.

CIBC Investor’s Edge

Overall letter grade: C

- Costs: Not bad C+

- Account info: Nobody home D

- Trading: U.S.-dollar registered accounts unavailable C+

- Tools: Tons of research from CIBC World Markets and other sources A

- Innovation: Not a strong suit D

If you have $100,000 in total household business with Canadian Imperial Bank of Commerce (mortgages included), you qualify for a flat rate of $6.95 for online stock trades. For a bank-owned firm, that’s a pretty nifty value. Not a CIBC client? Then there’s little here of interest beyond the excellent library of stock research and one of the few fee-free registered education savings plan accounts in the online brokerage world.

Credential Direct

Overall letter grade: C

- Costs: Not a leader C+

- Account info: Good job B+

- Trading: U.S.-dollar registered accounts unavailable C

- Tools: A good package B

- Innovation: None to speak of D

Welcome to Credential Direct’s bizarro world. Credential charges a minimum $19 per stock trade for small accounts, compared with $29 at the bank-owned firms. But while the banks cut your commissions to a flat $10 or so if you have at least $50,000 in your account, Credential gets you down to that price level only if you trade actively. What’s weird here is that Credential is part of a credit union movement that is supposed to represent the interests of Main Street, not Bay Street. So why does it promote the sort of active trading that generates wealth for brokers at the expense of clients? At least Credential has lowered the qualifying threshold for $9.95 commissions to 10 trades within three months from 25 trades.

Disnat Classic

Overall letter grade: C

- Costs: A higher cost broker C

- Account info: Good job B+

- Trading: U.S.-dollar registered accounts unavailable, but they say they’re working on it C

- Tools: A good package B

- Innovation: Not much to speak of C

Three things stand out – personalized account reporting, a good collection of research on stocks and ETFs, and a feature called GPS, which offers clients model stock and ETF portfolios run by a Desjardins Securities portfolio strategist.

HSBC InvestDirect

Overall letter grade: D

- Costs: A typical bank-owned firm C

- Account info: Nil D

- Trading: Online trading in global markets, but no U.S.-dollar registered accounts D

- Tools: Laggards C

- Innovation: Kidding, right? F

Hard to see why they bother.

National Bank Direct Brokerage

Overall letter grade: C

- Costs: On the high side, but kudos for recently giving commission-free ETF trading a test drive C-

- Account info: A bright spot B

- Trading: U.S.-dollar registered accounts are targeted for June – they’ll improve this firm’s ranking. D

- Tools: Strong B

- Innovation: Signs of improvement C

These guys nailed top spot in the latest J.D. Power discount brokerage investor satisfaction survey, so their customers like them a lot. NBDB has never been a star in this ranking, but there are some signs of fresh thinking at work. Example: The firm recently concluded a six-month promotion allowing clients to trade Canadian-listed ETFs for nothing. Commission-free ETFs are a significant win for investors, so how about making this permanent?

Qtrade Investor

Overall letter grade: B+

- Costs: Very reasonable B

- Account Info: They were early adopters of personalized account reporting A

- Trading: Well done A

- Tools: Middling B

- Innovation: Quick to adopt everyone else’s breakthroughs B

Qtrade’s second-place ranking here is mainly explained by the fact that it was elbowed aside by Virtual Brokers on cost. Qtrade remains a great choice for the mainstream investor who wants state-of-the-art service in virtually all respects. Still, we’ll have to keep an eye on Qtrade, now that Desjardins Group owns a 40-per-cent stake. Desjardins is the parent of Disnat, which has been looking up – way up – at Qtrade for years in this ranking. Qtrade says it has assurances from Desjardins that it will continue to operate independently, but you have to wonder about the economics of one firm running two separate online brokers.

Questrade

Overall letter grade: B

- Costs: A friend to the frugal mainstream investor, thanks to a $4.95 minimum stock-trading commission B

- Account info: Lame now, but they say personalized reporting is coming early in 2014 B

- Trading: They have U.S.-dollar registered accounts nailed, but the lack of online bond and GIC investing is a negative. B

- Tools: Not their strong suit C

- Innovation: The quintessential nimble independent firm B

Questrade exemplifies the latest thinking in the online brokerage business about how you can’t build a business catering mainly to active traders. Year by year, Questrade has been making itself more appealing to the investing mainstream, especially the newbies who get their bones picked clean by bank-owned firms through high trading costs and annual account administration fees. Questrade has zero account admin fees, the second-lowest trading commissions behind Virtual Brokers and a program that allows investors to buy any ETF commission-free (you pay to sell). With personalized account reporting, this firm will be even better.

RBC Direct Investing

Overall letter grade: B

- Costs: Not a draw for this broker C

- Account info: First rate A

- Trading: Strong B

- Research: Good B

- Innovation: Ebbs and flows C

Big blue is a strong overall broker that was ahead of the curve in offering personalized account reporting and U.S.-dollar RRSPs. Research tools are quite good, but it’s an irritation that RBC Dominion Securities stock research is reserved for active traders and high-net-worth clients. On mutual funds, RBC is both hero and villain. Clients can now buy low-fee, D-class versions of RBC mutual funds with a minimum of $500, down from $10,000. But funds from Mawer Investment Management, among the finest out there for DIY investors, are not sold because they pay no commission to the seller.

Scotia iTrade

Overall letter grade: B

- Costs: Not bad for a bank-owned firm B

- Account info: A black hole C-

- Trading: Good B

- Tools: Love their research centre A

- Innovation: Once strong, but fading B+

Scotia iTrade has one of the sharpest websites of any firm listed here, and its research tools stand out for not relying on the Morningstar data that so many other firms trundle out for clients. In fact, everything hums along for clients until they try to find the tools that show them how their portfolios have performed over the long term. There aren’t any, and Scotia hasn’t provided any indication of when they might be added.

TD Direct Investing

Overall letter grade: C

- Costs: One of the most expensive brokers C-

- Account info: Not in the game C-

- Trading: The lack of U.S.-dollar registered accounts hurts them C+

- Tools: Arguably the best A+

- Innovation: Lost their way C-

The former TD Waterhouse has made zero progress in filling in two gaping holes in its service – personalized account reporting and the lack of U.S.-dollar registered accounts. Are these guys on a technology strike? They don’t even allow clients to send secure e-mails to get administrative questions about their accounts answered. Add high costs to the analysis and you end up with what could be the weakest showing TD has ever had in this ranking. TD still rules in two areas – research and service, thanks to a call centre that operates 24/7 in English, French, Cantonese and Mandarin. Also, TD has really improved its visual presentation of client account holdings. Footnote: TD suckered me last year in saying U.S.-dollar registered accounts were “coming soon in 2013.” Now, they say they’re on track for a 2014 delivery.

Virtual Brokers

Overall letter grade: A

- Costs: The lowest-cost broker in this ranking, period A

- Account info: Coming along nicely B

- Trading: Everything you need A

- Tools: Meh C

- Innovation: The most innovative broker in this ranking, period A

VB was last year’s winner, and some Globe readers tried it on that basis. For a while, the feedback was worrying. People said the account-opening process was abysmally slow and the firm was sluggish to respond to queries by phone or e-mail. VB says it had its hands full with two initiatives that stretched its resources temporarily. The upside of being a VB client is a mix of the lowest costs in this ranking (including a new minimum commission of a penny a share and no-cost buying of ETFs) and amenities that quite a few industry giants don’t have, including U.S.-dollar registered accounts (RESPs included) and personalized account reporting. Most important, there’s constant innovation. Just introduced is the Kickstart Investment Program, an automated program (with no trading fees) for young investors, and a new twist on DRIPs that provides a commission-free way for clients to reinvest their dividends in any eligible stock or ETF.

Globe app users click here for online broker tables comparing commissions, foreign exchange and interest rates on margin debt.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).

To view the Rankings, click the links below.

Single page

- 1

- 2

- 3

How to keep more of your ETF nest egg

ETF investors, be careful not to overpay your taxes.

You can easily do this if you hold your exchange-traded funds in a non-registered account. It’s not unusual for ETFs to make what’s called a reinvested distribution at year’s end. Even though you don’t actually receive any money, these distributions are documented as capital gains on the T3 slips mailed by investment firms at this time of year, and you have to pay tax on them.

There’s nothing you can do about these distributions – they’re an annoying fact of life with investment funds of all types. But you can address the taxes payable when you sell an ETF.

Here’s how: Find the amount of reinvested distributions you received from an ETF over the years you owned it and then combine that amount with your purchase price plus brokerage commission. This is an important part of calculating your adjusted cost base, which you’ll use to determine your ultimate capital gain or loss when selling your ETF.

The net effect of adding reinvested distributions to your purchase price is to lower the amount of your capital gain (or increase the loss, if your ETF fell in value) when you sell. Imagine you take an ETF investment that cost you $50 per share (including commission) many years ago and adjust the cost base to $52.50 after considering your reinvested distributions and another variable called return of capital that we’ll look at shortly. If you sell for $60, the amount of capital gain per share is $7.50.

You’ll need a record of what you paid to buy an ETF for this calculation (including commission), and the cumulative amount of reinvested distributions, if any, for the years you owned it. This latter information should be available under the “distributions” tab on the fund profiles provided online by ETF companies. Look under the column heading that says “reinvested distribution per unit.”

In the case of BMO ETFs, you’ll find a footnote to the information on reinvested distributions that states: “Distributions by the BMO ETF that are not paid in cash should be accounted for by investors for tax purposes by adding the distribution amount to the adjusted cost base of the units held.” The website for BlackRock’s iShares family has the same message, and it’s in the same tiny type, way down at the bottom of the page.

“This information is all publicly available, but you have to mine for it,” said Kathy Hill, co-owner of a website that offers an adjusted cost base calculation service called ACB Tracking Inc. For a modest fee, ACB will produce a personalized adjusted cost base for any TSX-listed closed-end fund, exchange-traded fund or income trust. You just need the buy and sell details for the security you own.

ACB started out as a way to help investors keep track of return of capital payments from income trusts and other investments. Return of capital is another major component of the adjust cost base calculation, and it has the opposite effect of a reinvested distribution. Return of capital payments should be subtracted from your cost base, which means they will either increase your ultimate capital gain or reduce your loss.

The income-focused ETFs that have been especially popular in recent years almost always have a return of capital component to their regular monthly distributions. As a result, investors should have at least a passing acquaintance with this particular tax issue (read more: Reading between the lines: The nitty-gritty on ETF payouts).

Reinvested distributions are less well understood, in part because ETFs don’t expose investors to them on a regular basis. A reinvested distribution generally occurs when a fund sells securities in its portfolio and locks in a capital gain that isn’t offset by capital losses. Unitholders must pay tax on the gain, even as the money is reinvested back in the fund in a way that leaves the value of your investment unchanged. Now you understand why ACB Tracking uses the term “phantom” to describe those reinvested distributions.

Phantom distributions used to be a sideline to ACB’s main job of tracking return of capital. But the proliferation of ETFs in recent years has made these distributions more of an issue.

Let’s not overstate the matter, though. As an index-tracking investment, an ETF typically offers less risk of reinvested distributions than a conventional mutual fund. A fund manager may, for any number of reasons, sell stocks and thereby lock in a capital gain. A traditional ETF tracks a stock index and thus makes changes in its holdings only when the index is rebalanced. Often, there will be no reinvested capital gains distributions at all.

There are roughly 320 ETFs listed on the Toronto Stock Exchange. ACB says 74 of them made phantom distributions last year, and they ranged from a few cents to almost $1 per unit. In 2011, 45 funds made this kind of distribution.

Phantom distributions shouldn’t have a massive impact on your adjusted cost base, but they may still add up to a significant amount if you’re a long-term investor. ACB says the largest ETF in the country, the iShares S&P/TSX 60 Index Fund (XIU), has made a total of 11 phantom distributions totalling $1.66 per unit since 1999 (adjusted for a 4:1 stock split in 2008).

ACB charges as much as $8.50 and as little as $3 per calculation, depending on which data package you buy. Each calculation allows you to input multiple purchases and sales of a particular ETF to get an adjusted cost base that reflects both return of capital and phantom distributions over the period you owned the fund.

ACB’s database is loaded with return of capital and non-cash distribution data, which saves you the trouble of gathering this information yourself. Note: If you use a dividend reinvestment plan, you’ll have to enter reinvested dividends manually.

Investors who don’t mind keeping their own records should take a look at a free website called AdjustedCostBase.ca. Input all your buy and sell transactions, your return of capital payments, your capital gains distributions and any reinvested dividends and it will keep a running tally of your adjusted cost base.

Ms. Hill said 40 per cent of the people using her website are accountants, 40 per cent are investment advisers and 20 per cent are individual investors who understand how to calculate their adjusted cost base. “We’re seeing the savvy investors. There are lots out there who don’t know.”

Read more from Portfolio Strategy.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).

Rob Carrick's ultimate investing guide for Gen Y

The more money you have, the more attention you get from the investing industry.

Young investors are pretty much invisible to Bay Street, then. Bank branches will sell mutual funds to anyone with a pulse and $500 to spend, and investment advisers will often take their clients’ kids on as a courtesy. But no one is reaching out to people who are starting out in the work force and looking for ways to start investing.

That’s where the Globe and Mail Gen Y Investing Guide comes in. It’s designed to help 20- and 30-somethings get situated as investors without being mauled by fees and commissions. Parents, pass this guide along to your kids.

1. Especially for students and recent grads

Virtual Brokers, which ranked first in the 15th annual edition of The Globe and Mail’s online brokerage ranking (published this week), has created what could very well be the only investment plan aimed at young investors. It’s called the Kick Start Investment Program and it allows clients to set up an automated purchase plan where money goes into exchange-traded funds or individual stocks in the S&P/TSX 60 and S&P 500 indexes with zero commission costs.

The minimum monthly contribution is $100 and you can invest in as many as five stocks or ETFs. Contributions are drawn from a linked bank account and then used to buy as many full shares as possible, with any remaining money left to sit in your account as cash. Kick Start has zero cost for students and people who have graduated within the past two years. Everyone else pays a $50 annual fee, but no commissions when buying shares (normal sell commissions apply).

2. When you’re starting from nothing and have only small change to invest

Check out the ING Streetwise Balanced Growth Portfolio, which is sold by the online bank ING Direct (changing its name to Tangerine in the new year). You can invest any amount in this ready-made portfolio, which is based on index funds tracking Canadian bonds and cash (about 24 per cent) and Canadian, U.S. and international stocks (76 per cent). That’s an appropriately aggressive mix that will reward you well in up markets for stocks and offer a modest cushion in down markets.

The fee associated with owning this fund is 1.07 per cent, which is acceptable for a turnkey portfolio that allows you to contribute any amount and any time without paying any commissions.

With as little as $100 to start, you can buy the e-series of index funds from Toronto-Dominion Bank. Set up an account at TD’s online brokerage firm, TD Direct Investing, and use it to build a portfolio based on the funds in the e-series lineup. There’s no fee to buy or sell and the cost of owning these funds is very close to exchange-traded funds, which we’ll cover shortly. Note: If you’re opening a registered retirement savings plan account with TDDI to buy an e-series fund, tell them you want a basic RRSP with a low annual administration fee of $25 that applies to accounts of under $25,000.

3. If you want ETFs

Exchange-traded funds are low-cost index funds that trade like a stock, which means you’ll pay commissions of up to $29 to buy and sell them at an online broker. However, a few firms now waive some or all ETF commissions. Qtrade Investor, Scotia iTrade and Virtual Brokers have a limited list of ETFs that can be traded at no cost. Questrade and VB let you buy ETFs at no cost, but charge you a sell commission (VB has two ETF offers). Zero-cost ETFs are perfect for people who want to make monthly or quarterly investments.

4. If you want individual stocks

When starting with a small amount of money, you’re best served by owning a diversified ETF or mutual fund. But for those infatuated with stock picking, you’ll find the lowest commissions at Virtual Brokers, where the cost is basically a penny per share with a $9.99 cap, and Questrade, where trades start at $4.95. Avoid the big bank firms – they charge as much as $29 to clients with less than $50,000 in their accounts.

5. Be smart with registered account fees

Young investors often ask whether it’s better to contribute to a registered retirement savings plan or a tax-free savings account. TFSAs are more versatile as an all-purpose investing vehicle, and young adults may find they have certain tax advantages over RRSPs (more on that online). There’s also a fee-related reason to use TFSAs if you’re the customer of many of the big online brokers.

The practice at many online firms is to offer TFSAs without annual administration fees, while charging up to $100 for RRSPs with assets of less than $15,000 to $25,000. Another advantage with TFSAs is that they may not be subject to a broker’s minimum size requirements for new accounts. At BMO InvestorLine, for example, the $5,000 minimum is waived for TFSAs.

6. If you want to practise your skills as an investor

Online brokers are increasingly offering practice accounts, which look like the real thing and use virtual money. They’re a great way to familiarize yourself with online trading of ETFs and stocks, and test your investing acumen before committing real money.

Most practice accounts are available to clients of a firm only. Suggestion: Open an account and then explore the practice accounts before doing any actual investing. Or, check out the new stock trading simulator created by TMX Group Inc., the company that owns the Toronto and Montreal Stock Exchanges. It’s set up very much like the trading screens at online brokerage firms and it’s available to anyone.

Read more from Portfolio Strategy.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).

The Guide

Vol. 1: Canadian Equity ETFs

One of the most basic jobs you have as an investor is to get some exposure to the Canadian stock market in your portfolio.

But if you use exchange-traded funds, you’ll find upwards of a dozen and a half different ways to do this. Welcome to ETF-land, investors. For every job, there are many tools.

In the first instalment of the ETF Buyer’s Guide, you’ll find a list of ETFs suitable for consideration as core Canadian equity funds in a portfolio. There are lots of choices for buying the well-known S&P/TSX composite and S&P/TSX 60 indexes, plus many new indexes with less of a track record.

A quick word about diversification. The Canadian market is made up of heavy hitting sectors like financials and energy, and pipsqueaks like technology and technology. Some ETFs listed here exaggerate this skew with weightings in financials of 40 to 50 per cent or more. Be cautious about having that much of your Canadian market ETF tied up in a single sector.

Here are some explanation of the terms you’ll find in this ETF Buyer’s Guide:

Assets: Shown to give you a sense of how interested other investors are in a fund; the smallest funds may be candidates for delisting.

Management expense ratio (MER): The main cost of owning an ETF; on an ongoing basis; as with virtually all funds, published returns are shown on an after-fee basis.

Trading expense ratio (TER): The cost of trading commissions racked up by the managers of an ETF as they shuffle the portfolio to keep it in line with a target index; add the TER to the MER for a fuller picture of a fund’s cost. Note many ETFs do so little trading that their TERs round down to zero.

Dividend yield: Mainstream indexes can be a good source of dividend income.

Average daily trading volume: Trading of less than 10,000 shares per day on average tells you an ETF isn’t generating much interest from investors.

Top three sector weightings: Most Canadian market ETFs reflect the fact that financials, energy and materials account for about 70 per cent of the market; a few ETFs attack the market differently.

Top three stocks: Another view on which ETFs take a different approach to tracking the Canadian market.

Click here for a printable excel table.

Vol. 2: U.S. Equity ETFs

The second instalment of The Globe and Mail ETF Buyer’s Guide covers what could be the most confusing category of them all for investors.

All the usual selection criteria apply when researching TSX-listed exchange-traded funds covering the U.S. stock market – including fees, the index being used and the diversification being offered. The extra step with U.S. equity funds concerns currency hedging. Many ETFs have it, a growing number don’t and a few others give you a choice of hedged or unhedged exposure to U.S. stocks.

A quick primer on hedging: It eliminates distortions to index returns caused by fluctuations in the Canadian dollar against the U.S. buck, while also adding a bit to an ETF’s fees in some cases, and contributing to tracking error. That’s where an ETF’s returns wander off the ideal path of index returns minus fees. Hedging means your U.S. returns won’t be undermined when our dollar rises, nor will they be enhanced when the dollar falls. If you forgo the hedge, you lose out when our dollar rises and benefit when it falls. The purpose of this guide isn’t to recommend hedging or not – that’s your call. Rather, it’s to round up your ETF options for investing in the broad U.S. market and help you make an informed choice.

ETFs are a low-fee version of mutual funds that trade like a stock. Traditionally, ETFs tracked major stock and bond indexes; today, many funds follow more obscure indexes or have a manager who picks stocks. To invest in ETFs, you need a brokerage account. For help on that, consult my latest ranking of online brokers (read it here).

The Globe and Mail ETF Buyer’s Guide will cover a variety of asset class, including Canadian, U.S. and international equity, dividend funds and bond funds. The first instalment appeared Nov. 9 and you can read it here). Look for further chapters in this space in the weeks and months to come.

Here is an explanation of the terms you’ll find in the ETF Buyer’s Guide:

Assets: Shown to give you a sense of how interested other investors are in a fund; the smallest funds may be candidates for delisting.

Management expense ratio (MER): The main cost of owning an ETF on an ongoing basis; as with virtually all funds, published returns are shown on an after-fee basis.

Trading expense ratio (TER): The cost of trading commission racked up by the managers of an ETF as they shuffle the portfolio to keep it in line with a target index; add the TER to the MER for a fuller picture of a fund’s cost. Note: Most U.S.-market ETFs do so little trading that their TERs round down to zero. Full year 2012 numbers are presented here.

Dividend yield: Mainstream indexes can be a source of dividend income

Average daily trading volume: Trading of less than 10,000 shares per day on average tells you an ETF isn’t generating much interest from investors.

Distribution frequency: How often are dividends paid out?

Top three sector weightings: U.S. market ETF are typically dominated by sectors that are under-represented in the Canadian market, notably technology and health care.

Top three stocks: Another view on what’s inside an ETF.

Launch date: Shows you how long an ETF has been around.

A final note about hedging: ETF that are hedged typically have the term “CAD hedged” in their name, with CAD being an investment industry short-form for the Canadian dollar.

Click here for a printable excel table.

Vol. 3: Global ETFs

Canadian investors have long and justifiably been criticized for not having enough exposure to global stock markets.

It turns out the exchange-traded fund companies are guilty of exactly the same thing. The third instalment of The Globe and Mail ETF Buyer’s Guide was initially meant to cover international funds, or those covering developed stock markets outside North America. But the small number of funds in this category left room for more.

As a result, you’ll find emerging markets covered here, as well as global dividend funds. Country-specific funds were left out on the basis that they’re more for speculation and not a core investment.

One thing you won’t find in this list is a wide selection of global funds, which are an all-in-one way to get exposure to broad stock market indexes in the United States and elsewhere. The mutual fund industry has lots to offer in global funds, but ETF companies have almost ignored the category. As a result, you’ll likely need to partner an international ETF with a U.S. fund to complement your Canadian stock holdings.

And now for a quick word about currency hedging, which cuts the distortion in returns caused by our dollar’s ups and downs versus global currencies. Hedging adds to your investing costs in some cases, and it can undermine returns a bit by causing what’s known as tracking error. It’s useful to have hedging when the Canadian dollar is rising, but you’ll find it a drag on returns when our currency is falling. ETFs that are hedged typically have the term “CAD hedged” in their name, with CAD being an investment industry short-form for the Canadian dollar.

ETFs are a low-fee version of mutual funds that trade like a stock. Traditionally, ETFs tracked major stock and bond indexes; today, many funds follow more obscure indexes or have a manager who picks stocks. To invest in ETFs, you need a brokerage account. For help on that, consult my latest ranking of online brokers.

The ETF Buyer’s Guide has already covered Canadian equity ETFs and U.S. equity ETFs. To come in the weeks ahead are bond ETFs and Canadian dividend and diversified income ETFs. Here are some explanations of the terms you’ll find in the guide.

Assets: Shown to give you a sense of how interested other investors are in a fund; unless they’re new, the smallest funds may be candidates for delisting.

Management expense ratio (MER): The main cost of owning an ETF on an ongoing basis; as with virtually all funds, published returns are shown on an after-fee basis.

Trading expense ratio (TER): The cost of trading commission racked up by the managers of an ETF as they shuffle the portfolio to keep it in line with a target index; add the TER to the MER for a fuller picture of a fund’s cost. Note many ETFs do so little trading that their TERs round down to zero. Full year 2012 numbers are presented here.

Dividend yield: Mainstream indexes can be a good source of dividend income

Average 30-day daily trading volume: Trading of less than 10,000 shares per day on average tells you an ETF isn’t generating much interest from investors.

Top-three country and sector weightings: International ETFs vary a fair bit in terms of which countries and sectors they emphasize.

Top three stocks: Another view on what’s inside an ETF.

Click here for a printable excel table.

Vol. 4: Income Paying ETFs

Give us dividends. Give us bond interest. Give us distributions from real estate investment trusts.

Canada’s aging population naturally gravitates toward income investments, but that doesn’t fully explain the proliferation of income-paying exchange-traded funds. All ETF firms now offer dividend and diversified income funds that in most cases make monthly payments of cash. In the fourth instalment of The Globe and Mail ETF Buyer’s Guide, these products go under the microscope.

There are so many income ETFs that some rules had to be set for inclusion here. Funds must focus on the Canadian market and be core investments rather than specialty products like covered call ETFs (they use financial tools called derivatives to generate investment income). Bond ETFs are also excluded, but they’ll be covered in depth in a fifth volume of the Buyer’s Guide that will appear in the coming weeks. The Guide has already covered Canadian equity ETFs, U.S. equity ETFs and international equity ETFs.

One of the most important variables in choosing income ETFs is the yield, which can be measured a few different ways. Here, you’ll find the distribution yield, also sometimes known as portfolio yield. It’s calculated using recent monthly or quarterly payouts and the latest share price. ETFs are a low-fee version of mutual funds that trade like a stock. Traditionally, ETFs tracked major stock and bond indexes; today, many funds follow more obscure indexes or have a manager who picks stocks. To invest in ETFs, you need a brokerage account. For help on that, consult my latest ranking of online brokers. Here’s some explanation of the terms you’ll find in ETF Buyer’s Guide:

Assets: Shown to give you a sense of how interested other investors are in a fund; unless they’re new, the smallest funds may be candidates for de-listing.

Management expense ratio (MER): The MER is the main cost of owning an ETF on an ongoing basis; as with virtually all funds, published returns are shown on an after-fee basis.

Trading expense ratio (TER): The TER is the cost of trading commission racked up by the managers of an ETF as they shuffle the portfolio to keep it in line with a target index; add the TER to the MER for a fuller picture of a fund’s cost. Note many ETFs do so little trading that their TERs round down to zero. The most recently reported full year numbers are presented here.

Average daily trading volume: Trading of less than 10,000 shares per day on average tells you an ETF isn’t generating much interest from investors.

Top sector weightings: Financial stocks dominate dividend and income ETFs, so be cautious if you already have a lot of exposure to the sector. ETF company websites will show you the latest percentage weightings for sectors and individual stock or bond holdings.

Top three stocks: Another view on what’s inside an ETF.

Returns: ETF companies typically disclose total returns, or share price change plus dividends or distributions.

Follow me on Twitter:

@rcarrick

Click here for a printable excel table.

Vol. 5: Bond ETFs

No matter what your interest rate outlook, there’s a bond ETF for you.But just try and find it. With its manic slicing and dicing of the bond market and its copycat products, the exchange-traded fund industry is overwhelming investors who just want to pick a nice bond ETF or two for their portfolio.

It’s these investors that the fifth and final instalment of The Globe and Mail ETF Buyer’s Guide is aimed at. Here we look at core bond funds that, either alone or combined with a few others, can cover off all your bond needs.

Bond ETFs are a highly efficient, low-cost way to get diversified exposure to government and corporate bonds of all types. The only real hitch is that, whereas an actual bond matures and repays your principal, the typical bond ETF never matures. Instead, it rides interest rate trends over the years, increasing in value when interest rates retreat and falling in value when rates rise.

There are roughly 75 bond ETFs listed on the TSX, far too many to cover here. So we’ll look at some of the largest ETFs by assets – the most popular funds, in other words – along with some others that were hand-picked because they offer an interesting option for investors seeking core bond funds.

Previous instalments of the Buyer’s Guide have covered Canadian equity ETFs, U.S. equity ETFs, international equity ETFs and dividend and diversified income funds.

A key variable in choosing bond ETFs is yield, which can be measured in a few different ways. Used here is yield to maturity after fees, which is the best estimate of what yield you can expect looking forward. Do not use the yield figures shown in stock quotes for bond ETFs. These distribution yields can fool investors into thinking they’ll get higher returns than they actually will. (consult the Portfolio Strategy bond ETF user’s guide for more on this).

Here’s some explanation of other terms you’ll find in the ETF buyer’s guide:

- Assets: Shown to give you a sense of how interested other investors are in a fund; unless they’re new, the smallest funds may be candidates for delisting.

- Management expense ratio (MER): The main cost of owning an ETF on an ongoing basis; as with virtually all funds, published returns are shown on an after-fee basis.

- Average 30-day daily trading volume: Trading of less than 10,000 shares per day on average tells you an ETF isn’t generating much interest from investors.

- Top sector weightings: Federal and provincial government bonds offer the least default risk and the most interest rate risk; corporate bonds offer more default risk and somewhat less rate risk. Note the heavy weighting in the financial sector that many corporate bond ETFs have as it mirrors the heavy financial weighting in many dividend ETFs. Be cautious about overexposure to financials, or any other sector.

- Average duration: Duration, measured in years, is a standard risk metric for bonds; if interest rates rise by one percentage point, the price of an ETF with a duration of five would fall five percentage points (and vice versa if rates fell).

- Returns: ETF companies typically disclose total returns, or share price change plus interest payments, or distributions.

Follow me on Twitter:

@rcarrick

Click here for a printable excel table.

The Globe and Mail's Rob Carrick

Copyright © 2014 The Globe and Mail. All Rights Reserved

This book may not be reproduced, transmitted, or stored in whole or in part by any means,

including graphic, electronic, or mechanical without the express written consent of the

publisher except in the case of brief quotations embodied in critical articles and reviews.

Follow us: @rcarrick facebook.com/RobCarrickFinance

Table of Contents

Rob Carricks' Guide to ETFs

Introduction

The Lessons

Where to learn about ETFs

About Bonds

But yield, return of capital are two areas to monitor in monthly payments

The best, and cheapest, online brokers in Canada

How to keep more of your ETF nest egg

Rob Carrick's ultimate investing guide for Gen Y

The Guide

Vol. 1: Canadian Equity ETFs

Vol. 2: U.S. Equity ETFs

Vol. 3: Global ETFs

Vol. 4: Income Paying ETFs

Vol. 5: Bond ETFs