Keep ETFs simple

Exchange-traded funds (ETFs) are a hot ticket right now. Although the Canadian ETF universe is still small compared to conventional mutual funds, the sector has been growing at a much faster rate, fuelled by investors seeking a combination of simplicity and lower costs.

ETFs certainly score big on the cost side of that equation. While traditional equity funds often carry management expense ratios (MERs) in excess of 2.5 per cent, ETFs come in at a fraction of that. For example, the popular iShares CDN LargeCap 60 Index Fund which trades on the Toronto Stock Exchange under the symbol XIU has an MER of only 0.17 per cent. The only mutual funds that come remotely close to that are the e units from TD Asset Management.

ETFs now form the backbone of many so-called “couch potato” portfolios. These are comprised of ETFs that are linked to major market indexes, the theory being that investors can simply invest their money and then forget about it. The markets will do all the work.

Over the long term, studies show that this simple approach really works. But it requires a great deal of self-discipline to stick with an index fund when the stock markets go into a prolonged dive and there’s doom and gloom everywhere. For example, investors in the iShares 60 Index Fund suffered a 16.4 per cent loss in 2001 followed by another 12.5 per cent decline in 2002. At the end of it all, for every $1,000 they had invested at the start of 2001, they had only $732 left two years later. Many people would have bolted by that point, thus defeating the basic strategy of owning ETFs. Those who remained were probably experiencing a lot of restless nights wondering if stocks were ever going to turn around.

So don’t go this route unless you’re prepared to stay the course. If you are, then here is a low-cost, easy-to-manage Canadian ETF portfolio that you can create with just four iShares funds. All the funds trade on the TSX and all are available through any broker. Sales commissions apply, but if you use a discount broker they will be minimal. Ask a financial advisor if this is the right approach for you. The funds are:

iShares CDN Bond Index Fund (TSX: XBB). This fund emulates the return of the DEX Universe Bond Index, formerly the Scotia Capital Universe Bond Index. It is designed to be a broad measure of the Canadian investment-grade fixed income market, encompassing both government and senior corporate issues. This ETF provides a low-cost way to invest in Canadian bonds, with an MER of 0.3 per cent. It offers a stable and safe foundation for an ETF portfolio and has never lost money over a calendar year since it was launched in November 2000. The three-year average annual compound rate of return to Oct. 31 was 4.4 per cent.

iShares CDN Composite Index Fund (TSX: XIC). This provides exposure to the broad S&P/TSX Composite Index for a bargain-priced MER of 0.25 per cent. It’s been in operation since February 2001 and consistently outperforms the average for the Canadian Equity mutual fund category – the three-year average annual compound rate of return to Oct. 31 was 21.7 per cent. However, like all equity index funds, it will take a hit when stock markets slide. That happened in 2002, when the fund lost 14.1 per cent. If you don’t think you can deal with that type of situation, then ETFs are not for you.

iShares CDN S&P 500 Index Fund (TSX: XSP). As the name suggests, this fund tracks the performance of the S&P 500 Index, which covers the largest corporations in the U.S. The wrinkle here is that the fund is hedged back into Canadian dollars, thus removing currency risk from the equation. Of course, that can be a two-edged sword – if the loonie drops against the greenback, your returns will suffer. As you might expect because of the hedging, this fund has significantly outperformed most U.S. equity mutual funds in recent years. The three-year average annual compound rate of return to Oct. 31 was 11.2 per cent. The MER is 0.24 per cent.

iShares CDN MSCI EAFE Index Fund (TSX: XIN). To round out the basic ETF portfolio, this fund tracks the results of the Morgan Stanley EAFE Index, which includes securities from Europe, Australasia, and the Far East. Here again, the fund is hedged back to Canadian dollars so there is no foreign currency exposure. The units have outperformed their mutual fund counterparts in the International Equity category with a three-year average annual compound rate of return of 16 per cent. The MER is 0.5 per cent, higher than the other iShares we have selected but still cheap by mutual fund standards.

If you want to use these four funds to create a moderate-risk balanced portfolio, try this mix:

Bond Index Fund: 40 per cent
Composite Index Fund: 30 per cent
S&P 500 Fund: 15 per cent
EAFE Fund: 15 per cent

This provides a 60-40 equity/bond asset mix and the portfolio would be suitable for RRSPs and RESPs. To decrease risk, increase the Bond Fund weighting.