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Discussion Starter #1
Hi,

I've held ZCN, VUN, XEF/XEC, and VAB for pretty much a decade now, and I'm thinking maybe it's time to ditch ZCN and VUN in favour of something like XIU and VFV.

I was initially sold on the thousands of stocks in ZCN and VUN, but I've come to think that such a level of diversification is probably not doing anything, and they're dragged down poor performers at the bottom end.

It seems like the more focused-on-large-company ETFs consistently outperform by about 0.5-0.7% annually. And during downturns, they don't do any worse than the whole market variants.

I'd have to switch several accounts over between RRSPs, TFSAs, and RESP, but it could be an investment. I'm not really into just leaving as is, and making new contributions to XIU and VFV because I figure I think the only negative here is the selling commission and Questrade allows ETF purchases for free. And I want to hold the minimum number of funds possible to stay organized.

Anyone have thoughts about this? Obviously no one has a crystal ball, but do some of you agree or disagree with this line of thinking? The way the world is going, with big companies becoming more powerful than some governments, I also feel like sticking with big companies is a reasonable strategy.

Thanks
 

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I've held ZCN, VUN, XEF/XEC, and VAB for pretty much a decade now, and I'm thinking maybe it's time to ditch ZCN and VUN in favour of something like XIU and VFV.

I was initially sold on the thousands of stocks in ZCN and VUN, but I've come to think that such a level of diversification is probably not doing anything, and they're dragged down poor performers at the bottom end.

It seems like the more focused-on-large-company ETFs consistently outperform by about 0.5-0.7% annually. And during downturns, they don't do any worse than the whole market variants.
The recent market environment we've been in, ever since about 2000, has favoured large cap companies, giving a performance boost to the TSX 60 and S&P 500 versus broader indexes.

That could be just the current mood of the day/decade rather than some fundamental or permanent thing. I don't think that necessarily means that the large cap focused ones are the best choices going forward. They happen to be the best performers right now, just like tech stocks happen to be the best performers.

Think of it this way. If you're less diversified, you're more highly concentrated into something. Any time you're more concentrated into something, it could turn out that this "thing" happens to perform very well. It could also perform terribly.

Going with more diversification (ZCN and VUN) is probably the better long term position because by holding a wide spread of stocks, you are more likely to pick up the intrinsic upward direction of stocks in general over the long term. It does not matter that they have had lower performance over the last decade or two.

And you are right that in the last few years, the broader indexes have been 'dragged down' by some poorer performing stocks. But, the reverse is also possible. At some point, some stock(s) that nobody would guess today will become the best performers. The broader indexes include those stocks, and are more likely to benefit from that eventual situation. For example, if a crazy strong rally in small caps begins, only the most broad ETFs will get that benefit.

Some videos that I think will be useful, especially the first one:
Ben Felix on over-diversification
Ben Felix on the S&P 500 index
 

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I should add that I think a lot about this problem, because I invest a significant amount of my Canadian equity into just 5 stocks (my 5-pack): RY, ENB, CNR, BCE, FTS.

This is the issue you describe on steroids. I am even more highly concentrated into some of the largest cap stocks; in fact these stocks are the largest weights in XIU. In recent years, this has given outperformance.

But over the years I have started seeing that this is mostly just a fluke of very large caps being the hot area right now. That could change, eventually. And if that reverses (which it could) then these very large caps would do worse than the broader index.
 

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Discussion Starter #4
Yeah, that's an age old debate about diversification and the possibility that, as you said, if some small/med caps do really well, only the broad etf would benefit. But while that's possible, I'm thinking it's less probable as time goes on. And if they do really well, it seems to me like the small/med cap's goal is to become a large cap, no? Whether through acquisition, merger, or being bought out.

Also, I think ZCN has lagged behind even other whole market Canadian ETFs like VCN and XIC.....must be some kind of drag it's experiencing....I think ZCN needs to get kicked to the curb. VCN tracks FTSE, but both VCN and XIC track SP/TSX..I dunno.

Also, volumes are way higher for XIU/XIC than ZCN. I'm having trouble unloading this stuff today! I don't wan this to be a bigger problem in the future. Even VFV has double the volume of VUN.
 

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Also, I think ZCN has lagged behind even other whole market Canadian ETFs like VCN and XIC.....must be some kind of drag it's experiencing....I think ZCN needs to get kicked to the curb. VCN tracks FTSE, but both VCN and XIC track SP/TSX..I dunno.
That's a good observation. The chart below shows a 10% differential in total return over the last 10 years. A bit less than 1% of tracking error per year. I wonder if there is some kink with their methodology or implementation, but that is difficult to explain.

20297


With regard to small caps, the literature suggests that a small cap factor exists meaning they have outperformed large caps in the past, although I believe they have lagged in the past decade. If you forego exposure to the small caps, it is not likely your returns will suffer substantially over the long term, since small caps account for only 20% or so of the market capitalization and a 1% out-performance will result in a 0.2% gain for the index. But as a matter of principle, more diversification is better than less.
 

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Interesting, I did not realize ZCN actually did worse than XIC. Looking at the Morningstar performance table, this appears to purely be due to a single bad year: in 2010, ZCN had about 4% worse performance than the index and XIC! But this was within a few months of the birth of ZCN, so perhaps something strange happened when ZCN was new and had a small asset base. It probably had a small fund size (low assets) at the time and that may have been a factor.

With regard to small caps, the literature suggests that a small cap factor exists
. . .
since small caps account for only 20% or so of the market capitalization and a 1% out-performance will result in a 0.2% gain for the index
This is a good point. You're not going to miss much by skipping the small caps, it seems. In fact, there are additional (hidden) costs when small caps are involved. Poorer liquidity and wider spreads leads to less efficient trades and might eat into that theoretical 0.2% benefit.

Those efficiencies favour liquid large caps, both for the fund's internal trades, and the investor trading the ETF.

I don't think a person can go wrong with XIU. Maybe I was wrong about these theoretical advantages of holding the more broadly diversified ETFs.

The insanely good liquidity of XIU, the insanely good liquidity of all its underlying stocks, the simplicity of managing only 60 stock positions (superior arbitrage and tracking) may all be notable advantages... especially during volatile markets or extreme situations.

For US exposure, I only hold the S&P 500 index.
 

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Maybe I was wrong about these theoretical advantages of holding the more broadly diversified ETFs.
I think you are right about holding a broadly diversified portfolio. But there is an incremental cost to doing it, such that not all of the theoretical benefits accrue to the investor.
 

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I don't think a person can go wrong with XIU. Maybe I was wrong about these theoretical advantages of holding the more broadly diversified ETFs.
Well, you may not go wrong as you have a low risk of losing money, but I could also say that you can't go wrong with all of you money in a HISA. You certainly won't go wrong in the sense that you won't lose money and you'll get returns, but you are also losing the opportunity of higher returns, and losing that opportunity is wrong, in my opinion. (And I'm not saying that XIU is a bad choice, it's a good choice, it all depends on your goals and risk tolerance)

Therefore, there's no such things as "you can't go wrong". If you've invested your money and got 5% CAGR, it didn't go wrong, but if meanwhile most people did 7% CAGR, well, you're on the low side of the mean. It's the same analogy to inflation, keep all your money safely in cash only and yet you are losing purchasing power over time, so you're losing money.

We are either trying to get high returns at the risk of losing money or trying to get safe returns at the risk of losing opportunities. Both methodologies are taking some kind of risk, in my opinion.

About very broad ETF, I'm not in favour of ETF holding 10 000 underlying stocks. At that point, you need a statistical analysis of its distribution. If you find out that for each 5 stocks which are small holdings, you get 4 stocks at -5% return and 1 stock has +40% return, well you are doing only +4%.

At some point, you are losing the opportunity of higher returns for only a negligible decrease of risk.
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It's all about opportunity cost and expected value. Would you rather buy a 3$ lottery ticket with 1/1000 chance to win 1 000 000$ or a 30$ lottery ticket with 1/2 chance to win 500$? Still, that also depends how many tickets you can buy...
 

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Discussion Starter #9
I think I'm going to go with XIU. If I'm going to go with SP500 for US, it's kind of reasonable to take the top 60 companies in Canada since that's about proportional to our population (huge simplification). I agree the incremental increase in diversification doesn't seem worthwhile at some point. At least this is where I'm landing on the risk/benefit curve now at this point in my life. Plus I think the liquidity is beneficial. We'll see what happens.
 
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