Saturday, 26 May 2007

A Starter Diversified Index Portfolio for Canadians

One of my relatives recently asked what an example "starter" portfolio would look like based on the same principles of diversified passive index investing that I tried to use for my own. Here's my answer. First, my definition of "starter" is:
  • any investment amount up to $25k or thereabouts;
  • investor with lesser knowledge of investing and taxes and perhaps less interest too.

Such a definition does not indicate any particular risk-aversion stance, i.e. how conservative or aggressive it should be. In other words, the degree of risk would and should be decided independently based on different factors. Just for the sake of comparison with my own decision on the amount of riskiness and volatility, I'll use the 30% fixed income, 70% equity ratio. The idea of once-yearly rebalancing the portfolio back to the target percentage amounts also applies the same to this as any much larger portfolio. For other levels of risk acceptance, simply use different percentages of the same funds.

Click on the image to see the portfolio. It has these characteristics for these reasons:
1) only five holdings in total - this is to have large enough amounts in each holding to make it likely there will be something worth rebalancing in a year and to make it simpler and easier to do the rebalancing.
2) the five holdings give the maximum amount of diversification / low- or non-correlation base on what I've seen and read. Especially significant is the XRE for real estate, the asset class that seems to offer the most extreme negative correlation with other equities and thus the most diversification effect, the highly desirable quality passive portfolio investors seek.
3) use of TD e-Series mutual funds instead of Exchange Traded Funds (ETFs) because the benefit of slightly higher MERs (e.g. the TD MER of 0.31 vs iShare Canada's XIU's 0.17%) will be more than offset by trading fees in a year when rebalancing takes place (I assume that at a discount broker it will cost $25 per trade so a two-trade rebalancing of one sell and one buy at $50 would compare to 0.14% of $7500=$10.50 in extra MER for the Canadian holding). On top of that, as I've noted before, tax tracking is easier with mutual funds. And adding new money to the portfolio is much cheaper with mutual funds as no trade is required. TD's funds take as little as $100 for additonal contributions. Hopefully a small portfolio will be on the growth path with new money being added.
4) the US holding is the currency-hedged version while the international holding is not, because it seems to me that the multi-decade currency shifts of the US$ vs Canada$ have been large and can drastically negatively affect portfolio returns despite what the US stock market may actually do ... who is ready to predict and stake their financial future on the Canadian dollar either staying the same or depreciating vs the US$ from now on? To me, that's a too-severe and too-concentrated risk. On the other hand, the international holding is not currency-hedged, despite the availability of a hedged version, because the large number of countries and currencies spreads the effect much more and therefore lessens the chance of negative consequences. In addition, I have read material that says Canadian equity investors can benefit from foreign currency exposure so it seems to have positive support for that position as well. If any can point to serious number crunching studies that address the issue of currency risk please tell me as it is an area of doubt for sure. Yet one cannot sit on the fence till the perfect answer is available, huh? So I'm giving it my best guess.

What would come next as an addition to the portfolio? Probably a small cap equity holding, as a diversification and higher expected return asset, which would involve something like US small cap ETFs iShares Canada's currency hedged XSU or Vanguard's VBR, a small cap value ETF, or perhaps the new iShares Canadian small cap ETF XCS.

One negative of the TD e-Series funds is that they are a tied product and can only be purchased through TD Asset Management or TD Waterhouse and only on-line. That may not be convenient for everyone.

Other simple portfolios I have come across include those of Efficient Market Canada and Shakespeare, so take your pick.

That's it. What do folks out there think?


FourPillars said...

I think it looks just dandy!

How did you decide on 10% for REITs? I'm thinking 5% for my portfolio but I really have no idea if I should have more?

Personally I don't do any currency hedging - I think over a long period of time that the currency swings will even out. When I get to a point when I want avoid that risk, then I'll start buying currency-neutral versions of securities.

Outroupistache said...

From looking at sample portfolios in places like Ferri's book and the IFA website, a 10% REIT weighting seems to be for those portfolios with a higher equity component like the 70% I have used. In a 50% equity portfolio it would likely be only 5%.

On currency flows, I wish I could be confident in the "evening out" idea since there is certainly a cost to the hedging. Have you seen any sources that address the question?

FourPillars said...

Thanks, I think I'll change the REIT amount to 10%.

For the currency hedging I can't recall any specific reference that I can quote however I did find this post from Canadian Capitalist which addresses this issue.


dre322000 said...


your posts are fantastic. greatly appreciate the wealth of information that you pass on.

was wondering if i could ask for your opinion...i'm wanting to set up my portfolio based on index funds and asset allocation. Plan to hold about 5 ETFs (4 US dollar based) that I would rebalance on a regular basis(?quarterly). Would like to have 2 RRSP accounts (one for my wife & 1 for myself) and we would each contribute 20K yearly.

Wondering if it makes more sense to
1)set up a TD RRSP account and contribute to efunds regularily (ie every paycheck) and then purchase the 5 ETFs possibly yearly. Cost would be $29 each in commissions, $100 annual fee and 0.9% spread each way for currency conversion to purchase the 4 ETFs
2)open a tradefreedom account and purchase the 5 ETFs every 3 months at 9.95/trade with only 0.2% spread on the currency exchange. The money would sit in a premium savings account at the bank for the 3 months prior to each purchase at about 3%. (also looked at questrade at 4.95/purchase, but currency spread is 0.5% so seems better with tradefreedom).

basically, does it seem better to have much lower commissions & currency fee with money sitting in savings at ~3% vs higher commissions and currency fee, but direclty into e-fund (hopefully earning 8+%)

any thoughts greatly appreciated.

again, thanks very much for all the great posts.

Outroupistache said...

Thanks for praiseful comments, dre. Glad you like the blog.
On quick, back of the envelope calculation, option 2 seems better the way you have described it. The additional foreign exchange costs alone on option 1 0.9% times about $32k per year purchases of US$ ETFs (assuming about the same amount in each ETF, i.e. 4 out of 5) would at $288 by itself exceed the total trading costs of option 2 - about $173 by my rough estimate. The FX costs are especially hurtful since you plan to make continual purchases every year. Besides with option 2, you are mostly invested through the year - after Q1, 25% or $10k is into the market, after Q2, 50% etc. Finally, just went back to the TD website (see link in original post) and the details say there could be a 2% penalty of the purchase cost(!) if the fund is redeemed within 90 days of purchase. Not sure how that would work out if 3/4 was bought earlier and you tried to redeem it all to buy the ETF but who wants the hassle ... can just picture the bureaucracy screwing it up and imposing penalty on the whole amount etc.

Good luck with it.

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