Using financial technology to drive investment that would result in retirement preparedness for Canadians

By: Adedeji Philip Adetunji
Master of Business Administration, Student Investment Fund
University of New Brunswick, Fredericton

Copyright © 2021 Adedeji Philip Adetunji. All rights reserved.

Introduction

A successful retirement plan, envisioned with a lifestyle of choice for Canadians, starts with a sound financial decision driven by financial literacy (see FCAC’s Retirement Planning for details). Financial technology has aided financial decisions through various investment vehicles such as exchange-traded funds (ETF). Many Canadians may not be investing enough for a better retirement; hence, ETFs as an investment vehicle can be used to improve their financial literacy level. In Canada, the retirement plan is based on three primary pillars: Old Age Security, Canada Pension Plan, and private savings. Although the Canadian retirement income system has been very effective in reducing elderly poverty, results show that it has been much less successful in maintaining Canadians' living standards after retirement (Mac-Donald, Moore, Chen, & Brown, 2011).

With the growing number of professionals in Canada, early preparedness towards retirement that is inevitable should be the focal point. Most young graduates face many financial issues such as a student loan, buying a house, purchasing a brand-new car, and going on vacation. Hence, early understanding and the use of ETFs would be a great tool to improve financial literacy to achieve a successful retirement.

An actionable recommendation to solve financial literacy through ETF includes incorporating investment programs about ETFs in Canadian institutions, providing incentives that would encourage ETF investing, and establishing regulatory activities that would be less cumbersome in administering investment opportunities.

This paper focuses on the third pillar of the retirement plan, which involves private savings (see FCAC’s Savings and Investments for more details), by examining ETFs from a broad perspective as a financial innovation tool that can be used to satisfy Canadians' needs towards their retirement.

Exchange traded fund (ETF)

Exchange-traded funds (ETFs) are becoming one of the most successful and widely used investment innovations. They have become popular investment vehicles and traded on major stock exchanges across the world. ETFs are offered on equities, bonds, and gold. Even with the divided opinion from renowned investment experts about bitcoin, some countries have ETFs to track bitcoin, including Canada, through The Ontario Securities Commission (OSC) approving Bitcoin ETF in February 2021. The exchange- traded fund allows investors to buy a large basket of individual stocks or government and corporate bonds in one purchase. Unlike mutual funds that cannot be traded on the stock exchange, one of the most important features of ETFs is their liquidity that can be comparable to equities.

Although ETFs and mutual funds have many similarities, the option to invest in any of the financial products largely depends on the investor-specific circumstances. Like any other public investment instruments, ETFs are traded on the stock exchange, with investors bearing their transaction costs especially operational fees like an index mutual fund. Secondly, tax-sensitive investors may prefer ETFs, while conventional funds may be preferred by tax-exempt investors or those insensitive to taxes (Agapova, 2011). Another vital aspect of ETFs as an index-linked investment vehicle is that they tend to mirror the economy cyclicality that exists. When an economy is growing, an equity-based ETF's value would be impacted positively and vice versa. This research paper would include a literature review, the uniqueness of ETF investment, and ETF data analysis for the S&P/TSX 60 index. It is incorporated in Canada and seeks to provide long-term capital growth.

Literature review

Yiannaki defines ETFs as a basket of securities, which provide investors with immediate diversification and exposure to many indexes (Yiannaki, 2015). The wide range of importance that ETFs are beginning to exhibit has created acceptable innovation. According to Bhattacharya and O'Hara, at the heart of ETFs' remarkable rise lies an important innovation in financial engineering (Bhattacharya & O'Hara, 2018). The financial innovation created by ETFs compared to traditional investment fund such as a mutual fund is liquidity enhancement. In addition, the ability for investors to verify their positions and prices is a big plus compared to mutual funds. Investors can access their holdings anytime, get clarity around the fund's investment approach (risk and returns profile), access to the investment cost and other investment product structures.

Characteristic of ETFs as an innovative tool

Diversification

ETFs are tradeable securities that derive their value from a pre-defined basket of securities that constitute an index. This investment tool replicates the basket of return and risk faced by security. Such a basket of investment instrument is not limited to stocks but also seen in bonds, commodities and cryptos, et cetera. Unlike creating a portfolio to minimize risk and maximize return, investors in ETFs do not need an expert to assist in portfolio construction. The fund allows investors to access different investment securities in a bucket without going through the complexity of creating a broadly diversified portfolio. Investors can spread the risks by entering a market with hundreds of security instruments or exposed to a wide variety of business sectors. Hence, any wide swings in crucial sectors can be offset by other sectors within a single position. This will minimize the risk of loss if one investment performs poorly over a certain period.

Passive investment opportunity

Like any other investment vehicle characterized by a passive strategy to meet future retirement obligations, ETFs tend to follow the same strategy that tracks a particular benchmark over a longer time horizon. An ETF is becoming a popular passive investment opportunity for existing and potential investors because of the low transaction costs and high liquidity of the investment vehicle. According to Sakarya and Ekinci, ETFs exemplify the so-called "passive investment" tools by which an investor, willing to invest in a particular index, invests in an ETF rather than purchasing the equities of the index separately (Sakarya & Ekinci, 2020).

Tax efficiency

ETFs are mostly passively managed, which itself creates fewer transactions that would result in tax. Compared to conventional mutual funds, ETFs are traded anytime such that investors can control when to trigger taxes by actualizing the gains. ETFs' long-term horizon characteristics make the capital gains arising from the investment subject to a long-term capital gain rate. The capital gain rate is more favourable than a mutual fund, where investors will pay capital gains taxes while holding the investment. As pointed out by Poterba and Shoven, ETFs reduce the tax burden on investments in corporate stocks relative to investment in such stocks held through mutual funds (Poterba & Shoven, 2002).

Lower transaction expenses

Since investors do not invest directly in companies, ETFs eliminate individual shareholder record- keeping, thereby reducing ETFs' operating cost with the cost savings potentially reflected in their overall expenses (Agapova, 2011). Also, fees associated with the traditional mutual fund, especially load fees, which can be in the form of front-end or back-end, are not in ETFs. Load fees is an expense-paid when an investment is purchased or sold. However, ETFs have other fees similar to mutual funds, including operational fees and commission charges. Generally, an ETF tends to have a lower aggregated expense in the form of a Management Expense Ratio (MER) than a mutual fund or other similar traditional investment vehicles. Suppose an ETF fund has an MER of 0.05 per cent, and the ETF portfolio generated six per cent annual returns. The investment net percentage return will be 5.95 per cent. If, on the other hand, an investor opted for a mutual fund, which has an MER of two per cent, assuming the same six per cent annual returns, the net percentage return will be four per cent. The difference in the net return percentage would impact the future wealth expected.

Data analysis

The data analysis section focuses on iShares S&P/TSX 60 Index ETF (XIU), representing an ETF comprised of the top 60 Canadian companies. XIU has been chosen over XIC (iShares Core S&P/TSX Capped Composite Index ETF)^{Footnote 1}  because it is relatively less volatile and takes a conservative approach for long term accumulated growth. For this research, month end closing prices for XIU has been considered. The data has been extracted from Bloomberg and it ranges from 2001 to 2020.

The graph below depicts the increasing trend of the average yearly price and average yearly adjusted price (including dividends and splits) from the iShare S&P/TSX 60 Index ETF (shown in exhibit 1 and 2).

Figure 1: XIU Average Price Performance (XIU historical yearly average price performance from 2001 to 2020)

The average yearly price can be seen to be increasing from CAD11.25 in 2001 to CAD24.13 in 2020. With passage of time, the spread between the adjusted price and the unadjusted price is also increasing which can be attributed to the extra income from investing in XIU in the form of dividends and share splits.

A dip noticed from 2008 to 2009 can be logically attributable to the financial crisis that affected most economies. In the long run, ETF performance tends to grow alongside with the nation's economic growth.

To take advantage of this linkage to the growing economy, young Canadians who aim to achieve a successful retirement plan must demonstrate a consistent investment attitude daily, weekly, monthly, or yearly by investing in an investment vehicle like ETFs.

Let us consider a scenario where a Canadian invests $100 every month from January 2001 to December 2020 at an average monthly rate of 0.467% (5.74% annualized see appendix I) in iShare S&P/TSX 60 Index ETF. The monthly income (i.e. dividend received) is presumed to be reinvested into the investment vehicle. The investor would have an ETF investment value worth $44,066 using the future value calculation^{Footnote 2}  from a principal amount of $24,000 accumulated over 20 years, as shown in the computation below.

FV = P [(1+i) ^n – 1)]/i

P = $100, I = 0.467%, n=240 (that is 12 months *20 years) FV = $100[(1+0.00467) ^240 – 1]/0.00467

FV = $44,097

If a monthly median rate of return (which is a more robust approach) is considered, it will result in a higher future value.

P = $100, I = 1.081%, n=240 (that is 12 months *20 years)

FV = $100[(1+0.01081) ^240 – 1]/0.01081 FV = $112,890

The effect of compounding is crucial in investment as this makes the $24,000 invested over the investment horizon grow faster because interest is calculated on the accumulated return over time as well as on the original principal. However, inflation erodes the benefit earned from an investment, especially when the inflation rate is greater than the expected rate return. Canada's inflation rate from 2001 to 2020 has been between 0.3% to 2.91% annually compared to an annualized return of 5.74% used in the scenario above. This shows that the average yearly return of 5.74% from the ETF is not eroded with Canada's level of inflation during the period.

Recommendations

A consistent investment attitude in ETFs by Canadians rather than a one-time investment would contribute towards a successful retirement plan. Canadians can use the services of various investment platforms provided by financial institutions to start investing in ETFs. However, actions by all stakeholders that would encourage investment in ETFs are required.

Government and regulatory bodies

Government and regulators should provide an incentive (such as tax-free opportunities, reduced transaction cost, et cetera) through financial institutions to encourage ETF investing. An example could be a structure like the historic homeownership savings plan but tailored to promote more general savings by allowing a cumulative tax deduction for up to $10,000 for citizens under 30 years of age. If they withdraw the funds before age 65, they will be taxed but suffer no tax burden if they do so after 65 years of age.

In addition, the financial affairs of young people are usually uncomplicated during their academic years. However, life after that tends to become complex. Young Canadian students through various institutions can enter ETFs investing competition to create awareness of the investment financial innovation that exists and introduce them to its practicality and processes. This would pave the way for them to apply investment concepts as their financial status becomes complex because of different financial needs in the short-run and long run.

Regulatory bodies

Regulators should encourage ETF investors with less cumbersome activities such as administrative tasks adopted by financial institutions before investing in ETF.

Conclusion

At different stages of life, the whole concept of financial literacy, which is not limited to investment, is the primary focus of this paper. Emphasis on budgeting is increasingly crucial after graduation (see FCAC’s Budget Planner to help create a customized budget). This is because, at that stage, there might be past commitments such as student loans to repay and future desires such as buying a house, going on vacation, and increasing standard of living, et cetera. Overall, financial preparedness towards meeting the desired retirement goal is driven by consistent investment habits from young professionals. All stakeholders such as governments, financial service providers, educational institutions, and other entities have a crucial role in a remarkable retirement plan that is inevitable for Canadians.

References

• Agapova, A. (2011). Conventional mutual index funds versus exchange-traded funds. Journal of Financial Markets, pp 323 - 343.
• Bhattacharya, A., & O'Hara, M. (2018, April). Can ETFs Increase Market Fragility? Effect of Information Linkage in ETF Markets.
• Bloomberg L.P. (n.d.). [iShares S&P/TSX ETF monthly stock price data, 2001-2020 in CAD]. Retrieved March 4, 2021 from UNB Bloomberg Terminal.
• Mac-Donald, B.-J., Moore, K., Chen, H., & Brown, R. (2011). The Canadian National Retirement Risk Index: Employing Statistics Canada's LifePaths to Measure the Financial Security of Future Canadian Seniors. University of Toronto Press Journals, pp.73 - 94.
• Poterba, J. M., & Shoven, J. B. (2002, May). Exchange-Traded Funds: A New Investment Option for Taxable Investors. The American Economic Review.
• Sakarya, B., & Ekinci, A. (2020). Exchange-traded funds and FX volatility: Evidence from Turkey. Central Bank Review.
• Yiannaki, S. M. (2015). ETFs performance Europe - a good start or not. Procedia Economics and Finance. Rome & London: Elsevier.

Exhibits

Exhibit 1

The table shows yearly average adjusted (for dividends and splits) prices for XIU. To calculate these average adjusted prices, an average of month end closing prices is used.

Exhibit 2

The table shows yearly average unadjusted prices for XIU. To calculate these average unadjusted prices, an average of month end closing prices is used.

Exhibit 3

The table shows monthly adjusted prices for XIU from January 2001 to December 2020. The data has been used to calculate average monthly return, average median return and annualized mean and median return.