Canada's New Evidence-Based ETFs

Canada just got a new suite of ETFs that could change how a lot of Canadian investors build their portfolios. They have all the good aspects of index funds, low fees, low turnover, and broad diversification while making some evidence-based tweaks to improve expected returns. If you've been watching this channel, you've heard me talk about ETF slop. These ETFs are not slop, and I'm going to tell you why. I'm Ben Felix, chief investment officer at PWL Capital, and I'm going to tell you about the new Avantis ETFs from CIBC.

This video is not meant to make you drop your index fund strategy and go allin on these new ETFs. These funds won't be for everyone, and lowcost index funds are still a sensible option for most people. All I'm aiming to do in this video is tell you what these new funds are, the theory and evidence supporting them, and why they are an interesting development for Canadian investors. That said, if you're currently holding VEQT or XEQT or any of the other EQTs in your RSP, TFSA, or whatever, you'll want to pay attention. I want to note this video is not sponsored. I have no financial relationship with CIBC or Avantis and have no conflicts of interest to disclose. Before we can get into the funds themselves, we have to talk about why they're worth talking about. A lot of Canadians still invest in old school actively managed funds, which represent over 80% of the Canadian fund market based on year-end 2024 data. Active management is, broadly speaking, a losing game. Active managers rarely outperform the market, especially over longer time horizons. That means the vast majority of Canadian investors are still paying well over 1% in fund fees, probably to one of the big five Canadian banks, to probably underperform the market. Not a great situation, but there are better alternatives increasingly gaining traction today, like lowcost index funds. Lowcost index funds have been consistently gaining market share since they were first launched by Vanguard in 1976. An index fund simply replicates the holding of an index, which is a list of stocks designed to represent a stock market. Index funds make sense because they keep costs low and capture the returns of the broad market rather than unsuccessfully trying to beat it like act like actively managed funds do. This works as long as markets are efficient. And active managers, to their credit, actually keep markets efficient through all the analysis, trading, and stock selection they do in their effort to outperform, even though that effort doesn't usually deliver excess returns after fees to investors. Active investors effectively pay for the cost of keeping markets efficient in exchange for a tiny chance of outperformance, while index funds reap the benefits. Index funds are the investing equivalent of never interrupt your enemy when they're making a mistake. All that said, index funds, well, in my view, a huge upgrade from traditional active management for most investors most of the time, are not perfect. Many index funds track an index that weights its holdings by their market capitalization. They are cap weighted. This means that index funds will hold more weight in the biggest stocks and less weight in the smallest stocks. There's nothing inherently wrong with market capitalization waiting. Owning the market gives you exposure to the equity risk premium, which has historically delivered solid long-term returns for investors. But since index funds were first created in the 1970s, financial economics has identified other return premiums. Premiums the typical index fund Canadians are increasingly investing in do not capture. Basically, we've known for a long time that stocks have higher expected returns than bonds, which makes sense in theory and has worked out in practice. But we also know that certain types of stocks have higher expected returns than others. By tilting your portfolio toward these types of stocks, you can capture higher expected returns. The same theoretical principles that explain why stocks should outperform bonds also tell us that some types of stocks should outperform others. I did a deep dive on this in a recent video about the famous 1993 FMAN French paper on the common risk factors in stocks and bonds. In short, theory supports different expected returns across stock types and the empirical data backs it up. The other issue is that index funds also by their nature of tracking an index trade when the composition of the index changes. For example, if there is an initial public offering, shares of the newly listed company will be added to many indices and index funds will then buy them to match the index. There are other examples too like existing companies issuing more stock and companies buying back stock. These are all changes in market composition. Research on this suggests that the systematic trading done by index funds to match changes in market composition results in an implicit cost of somewhere around 0. 5% per year. I did a whole video on this too if you want to learn more. Between there being multiple known drivers of expected returns that go beyond what cap weighted index funds capture and index funds having their own implementation quirks with implied costs that far exceed their fees. Constructing a portfolio that improves on indexing is an interesting premise that might sound like active management which I just finished telling you does not work. But

unlike trying to pick stocks or time the market, this approach is like a slightly more advanced version of the principles behind market cap weighted index funds. Investing this way still results in lowcost, broadly diversified portfolios, but rather than just trying to capture the equity risk premium while mechanically following an index. It aims to capture multiple return premiums while being intentional about implementation. Dimensional Fund Advisors has been a leader in this space since 1981, but their funds are not super accessible to Canadians. Their products are mostly limited to financial advisors. My firm PW Capital does make extensive use of Dimensional funds, and I invest in them personally. As always, Dimensional did not pay me to say any of this. Dimensional did launch publicly available ETFs in the US in 2020, but not in Canada. As a result, Canadian investors without a financial adviser had been left out in the cold. With respect to this investment strategy, I put together a model portfolio for Canadian investors back in 2020, consisting of Canadian listed ETFs and two US listed ETFs. I'll be the first to admit that the model portfolio was a bit clunky. I think a lot of people might have tried to implement it and then abandoned it. It did mean buying and rebalancing multiple ETFs, dealing with currency conversion to purchase US-listed ETFs and considering the foreign withholding tax implications of US listed ETFs of foreign stocks in some Canadian account types. Blogger Rob Enen, who's a friend of mine, predicted that there would be thousands of Ben Felix investing refugees who tried to implement my model and then realized it was too much work, later abandoning it in favor of easytouse asset allocation ETFs. That's the good news is that a direct competitor to Dimensional Fund Advisors, Avantis Investors, has now launched Canadian listed ETFs, including a single ticker asset allocation ETF like the EQT ETFs through CIBC. Avantis has been around since 2019 when they were launched by a group of former Dimensional employees, including their former co-CEO and CIO, Eduardo Rapedto. Avantis is sort of a new fund company, but they exist inside of American Century Investments, which has been around since 1958 and manages more than $300 billion today. Avantis is cut from the same cloth as Dimensional and is backed by a long-standing and a large asset manager. Like, I think they're not going to disappear is the point there. Dimensional and Avantis do each have their own flavor of the approach, but the underlying principles are fundamentally similar. This CIBC ETF launch is a big deal for a few reasons. The Canadian listed products mean that Canadian investors don't need to convert currency to buy them, which is great. The Canadian listed ETFs hold securities directly, which eliminates the double withholding tax concern for foreign stocks in TFSA, RSP, and taxable accounts. And the Canadian listed international funds carve out the Canadian allocation while Canada is included in Aventus' US listed international funds. Small detail, but it does matter. What this means is that Canadian investors get a hassle-free way to invest in this type of strategy without needing to use USlisted funds. In the remainder of this video, I want to walk through what some of these funds look like and how they compare to market cap weighted index funds. Then I'll get properly nerdy and explain the underlying principles behind this approach in more detail, which is important to understand for anyone who wants to pursue this investment strategy. One thing to note is that as I have mentioned, these are not index funds since they don't track an index. They do address one of the current concerns that many investors have. They do not mechanically invest in the shares of newly listed IPOs just because an index told them to. I talked to Avantis about their approach here. They don't have a blanket exclusion for newly listed companies, which Dimensional Fund Advisors does, and they will include them if they have enough information on their full set of financials and the company trades at an attractive price relative to those financials. They are well aware of the issues around index inclusion that I mentioned in my last video on IPOs, and they're careful not to get caught up in the mechanical price increases following index inclusion. Before I walk through each fund, here's the mental model. Every one of these funds does the same basic thing. They tilt toward smaller, cheaper, and more profitable stocks relative to their benchmarks. The difference is how aggressively each one tilts and which part of the market it covers. The more aggressive the tilt, the higher the expected return, but also the bigger the tracking error. That's like performance that's different from the index. Keep that trade-off in mind as I go through each one because it does matter for investor psychology. Okay, let's dig

into what these funds look like under the hood. Starting with CACE, the Avantis CIBC Canadian Equity ETF. It has a management fee of 0. 19%. Note that the management fee is not the MER, which can't be calculated until the fund has been operating for a while. The ME will be slightly higher, but not too much, roughly just by the amount of sales tax on the management fee. This is a Canadian total market fund that tilts moderately toward higher expected return stocks. The way that this shows up in the fund's characteristics is that it has a lower average market capitalization than the market cap weighted index, meaning that it underweights larger stocks and overweights smaller stocks. It has a higher average booktomarket ratio, meaning that it overweights lowpriced stocks and underweights highric stocks. and it has a higher average profitsto book ratio which means that it is underweight less profitable stocks and overweight more profitable stocks. Overall you can see that the portfolio tilts smaller, cheaper and more profitable than the Canadian market. The biggest underweight is in mega cap stocks with high prices and low profitability and the biggest overweight is in small cap stocks with low prices and high profitability. This reflects the underlying principles of Avantis. As I described earlier, this ETF's sector mix is generally pretty close to the Canadian market with some overweights and underweights. Before I continue, I do want to reiterate one of the big trade-offs of setting portfolios up this way. Being different from the market means you will perform differently from it. Obviously, and increasingly so, the more different you are. In the long run, we expect that difference to be positive from the tilts that Avantis supplies. But the reality is that there can be long periods where tilting a portfolio towards smaller, cheaper, and more profitable stocks leads to underperformance. The US market has been a recent example of this where the largest companies in the market, often companies with high prices, have delivered exceptional returns. Tilting away from those stocks and towards smaller and cheaper stocks, has been painful for many years now in the US market. Though it has paid off in other markets, those performance differences relative to market indexes can be really hard for some investors to live through. If you're worried about short-term underperformance and even the possibility of long-term underperformance, this approach may not be for you. If you're wondering whether this kind of approach makes sense for your specific psychology, account types, tax brackets, time horizon, all that kind of stuff, this is the kind of question a good portfolio manager can answer in the context of a financial plan. There's a link in the description if you want to talk to someone at my firm, PWL Capital. Okay, onto the US equity funds from Avantis. CLV, the

Avantis CIBC US large cap value ETF. It has a management fee of 0. 25%. It focuses on large cap stocks as the name suggests, but tilts towards smaller, cheaper, and more profitable large caps while excluding small stocks and high price stocks entirely. Calv is similar to the USlisted AVLV, which has beaten the US market since it launched in September 2021. I know that's too short of a horizon to tell us anything useful, but it's the data we have, and it's worth mentioning. CAUS, the Avantis

CIBC US all cap equity ETF has a management fee of 0. 19%. It's a US total market fund with moderate tilts towards cheaper and more profitable stocks. This is an interesting fund for total US market exposure without taking on too much tracking error. That's the performance differences relative to the market since its tilts are not that aggressive. Its USlisted equivalent has beaten the US market since it launched in September 2019. C AUV, the Avantis CIBC US Small

Cap Value ETF, has a management fee of 0. 35%. It's heavily tilted toward the smallest, cheapest, and most profitable stocks in the US market while excluding large stocks entirely. This fund, while having high expected returns, should be expected to have lots of tracking error since it's very different from the market. Its USlisted equivalent, AVUV, has beaten the US market since it launched in September 2019. But you can also see in the chart how significant the performance difference has been over intermediate periods, including some periods of underperformance. The international funds follow a similar logic. So I'll move through them a bit faster before getting to what is, in my opinion, the most exciting fund in the

lineup. CADE is the Avantis CIBC International Equity ETF. It has a management fee of 0. 29%. It invests in total market international developed market stocks with a moderate tilt towards smaller, cheaper, and more profitable companies. It doesn't have an exact US-listed equivalent since CAD as I mentioned earlier excludes Canada while the US listed AVDE includes it but AVDE for what it's worth has beaten international developed markets since it launched in September 2019. CASV is the

Avantis CIBC global small cap value ETF with a management fee of 0. 39%. It offers exposure to a globally diversified portfolio of small cap value stocks that emphasizes the smallest, lowest priced and most profitable company. Again, this fund should be expected to perform very differently from the global stock market due to its exclusion of the largest stocks and emphasis on the lowest price and highest profitability small caps. There's no US equivalent for CASV, which includes US and international developed stocks. But AVDV, the Avantis International Small Cap Value ETF, which excludes US stocks, has beaten international developed markets by a wide margin since it

launched. There's also an emerging markets fund CAEM with a management fee of 0. 39% for which the characteristics details have not yet been published but it follows the same principles of tilting toward higher expected return stocks across emerging markets. The US listed version of this fund AVM has outperformed cap weighted emerging markets since inception. All those performance histories were short since Avantis hasn't been around that long. But if you want to see how this investment approach has performed over the long run, I detailed Dimensionals's long-term performance relative to comparable Vanguard funds in another video, and they have decades of history. I know that was a lot of tickers, and your head might be spinning wondering how to use them, which is why C A, the

Avantis CIBC all equity asset allocation ETF, is probably the most exciting product in the lineup. It's like VEQT, Vanguard's equity asset allocation ETF, but made up of the ETFs I just described. So, you get exposure to a globally diversified portfolio of stocks with a Canadian home country bias and built-in tilts toward the type of stocks I've been talking about. This is a one-stop shop for a lowcost, broadly diversified portfolio that takes full advantage of the last 30 years of financial economics research and mitigates the nuance downsides of index funds all in a single ticker just like VQT and XQT and all the other EQs that we have in Canada. It even has its own subreddit just like the others. To

understand whether you should care about this, I'll get a little nerdy. And by that I mean excessively nerdy since I know you guys are into that kind of thing. In their 2015 paper detailing their five factor asset pricing model, Eugene FMA and Ken French explain the theoretical rationale for the factors in their empirical asset pricing model. The dividend discount model which is a model for what the price of a stock should be says that the theoretical value of a share of stock is the discounted value of expected dividends per share. Equation one here shows that the price M at time t is equal to the expected future dividends per share discounted at the long-term average expected stock return R. Miller and Mediglani's famous 1961 paper showed that given investment policy dividend policy is irrelevant to the valuation of shares. Yes, this is the same reason that dividends are irrelevant when evaluating the expected returns of a stock. With dividend policy irrelevance, the value of expected dividends is equal to expected earnings minus expected investment. Following Miller and Mediglani, the total market value of the firm stock is given by equation two. Here we have the expected earnings and the expected change in book equity, which is another way of saying asset growth or investment. Scaling both sides of equation two by the book value of equity, equation three gives the theoretical valuation equation as presented by F and French in their 2015 paper. This valuation equation makes three statements about expected stock returns. One, if we hold everything in equation three constant except for the market value of the stock M and the expected stock return R, then a lower ratio of market value to book value must imply a higher expected stock return. All else equal, a company with a lower price must have a higher discount rate. This is called the value premium. Two, if we hold everything in equation three constant except for expected future earnings and the expected stock return, then higher expected earnings must imply a higher expected stock return. All else equal, if two companies trade at the same price, the company with higher profits must have a higher discount rate. This is an expression of the profitability premium. The discount rate is sort of interchangeable with the expected return. Three, if we hold everything in equation three constant except for the expected growth in book value of equity and the expected stock return, then higher expected asset growth must imply a lower expected stock return. All else equal, if two companies trade at the same price, the company with higher investment must have a lower discount rate. This is an expression of the investment premium. To bring it back

to the Avantis ETFs, they use these valuation concepts to systematically tilt their holdings towards smaller, cheaper, and more profitable companies, targeting companies with quantifiably higher expected returns. While the theory is there to support it, the reason that these ideas are interesting to investors is that these premiums have existed in stock returns around the world as far back as we have data. That does not mean that stocks with these characteristics will always outperform. They can have and have had some periods of severe underperformance, but they have outperformed in the long run and over most historical time periods. An important insight from the valuation equation and the observed empirical characteristics of stocks is that the premiums should not be considered in isolation. For example, a portfolio that focuses on profitability without controlling for relative price is likely to result in a portfolio of highpriced growth stocks. Think overpaying for growth. And a portfolio that focuses on value without controlling for profitability is likely to result in a portfolio of stocks with weak profitability. Think cheap for a reason. These characteristics are related to each other and those relationships can't be ignored. The stocks with the highest expected returns in the market will tend to be the stock with both low relative prices and robust profitability. This makes targeting value and profitability jointly one of the most important aspects of managing a portfolio targeting these expected return premiums. And it is exactly what Avantis is doing. This isn't only about earning higher expected returns either. It's about targeting multiple return premiums that may show up at different times. For example, over a period where the equity risk premium, that is what you get with a market cap weighted index fund, does poorly. Other premiums may do well. It's not really diversification since we're not adding any new assets, but it is providing access to more sources of expected return, which can mean a more reliably positive long-term outcome. One notable example is the US lost decade from 1999 through 2010. The US market was flat for more than a decade, but small cap and value stocks in the US delivered meaningfully positive returns. There are other historical examples like this. Japan being at least as interesting, though it's important to keep in mind that small cap value can also go through long periods of underperformance. Lowcost market cap weighted index funds are sensible investments for most people most of the time, much more sensible than the traditional actively managed funds that many Canadians still invest in. But market cap weighted index funds are not perfect. They offer exposure to a single expected return premium, the market premium. But they ignore other wellestablished return premiums that can be pursued systematically and at a low cost. For many years, Canadians had to jump through hoops to invest this way. But the launch of CIBC's Avantis ETFs has made this investment approach more easily accessible. One thing I mentioned

earlier is that unlike index funds, these Avantis funds don't mechanically buy IPO stocks just because an index tells them to. If you're holding VEQT or any cap weighted index fund in your RSP, TFSA, or whatever account, that distinction may matter now more than ever. Some of the largest private companies in the world, SpaceX, OpenAI, and Anthropic among them are set to go public. And when they do, your index fund may be forced to buy their shares very likely at high prices. It's worth understanding how that works and what it could cost your portfolio in the long run. That video is right