The Myth that ETFs are Always and Necessarily Better than Mutual Funds

It's all about costs and investment strategy. Whether a fund is an ETF or a mutual fund doesn't matter all that much. If the costs to buy into, to manage and to run the fund are low and it passively invests in a broad market index, the results for the retail individual investor will be good. The fact that mutual fund fees in Canada have been high and net investor returns have been low as a consequence does not mean it has to be so. In fact, ETFs are catching up to mutual funds in both good and bad ways. The recent proliferation of new ETFs with active trading strategies, narrow asset groupings and leveraging, foretell that investor returns will be poor.

That it is possible for mutual funds to equal the original virtues of ETFs is evident at the US fund company Vanguard, which offers both ETFs and mutual funds.

Here is a sample of funds with identical holdings and thus returns, apart from fees. In fact, the ETFs of Vanguard are merely a share class of the same asset base.

• US Total Stock Market ETF (symbol: VTI) - MER 0.09%
• US Total Stock Market Index Fund (VTSMX) - MER 0.18% no purchase or redemption fee

• US total Bond Market ETF (BND) - MER 0.14%
• US Total Bond Market Index Fund (VBMFX) - MER 0.22% no purchase or redemption fee

• Emerging Markets ETF (VWO) - MER 0.27%
• Emerging Markets Fund (VEIEX) - MER 0.39% plus purchase fee 0.50% and redemption fee 0.25%

The mutual fund on-going MER fees are a bit higher but for someone trying to make regular small purchases through an automatic savings and investment plan, avoiding the payment of trading commissions on ETFs, even when they are $1o per trade from a discount broker (a $10 cost on a $1000 purchase is a 1% "fee") makes the two alternatives very similar. Add in the convenience of automatic dividend reinvesting (DRIP) and tax record keeping that mutual funds offer, and ETFs lose their advantage. Vanguard even has a handy ETF vs mutual fund calculator to compare which version you would be better off to buy, considering fees, holding period, frequency and amount of purchases and commission costs.

The big problem for Canadians, of course, is that Canadians are not allowed to buy US mutual funds.

To its credit, one Canadian ETF provider - Claymore Canada - has adopted useful mutual fund features by offering pre-authorized chequing contributions (PACC) for buying its ETFs, along with a DRIP and a systematic withdrawal plan (SWP), all at no transaction cost. And all of BMO'sETF family new offer DRIP as an option, though not the PACC and SWP (yet?).

If only some mutual fund visionary in Canada would catch up to good aspects of ETFs ....

Vanguard Enters UK Market. Canada Next?

Vanguard will begin selling eight equity index funds and three fixed income funds in the UK as of tomorrow June 23rd (announcement here). This will bring the lowest cost fund competitor to the British public. Vanguard's annual Total Expense Ratios of the various funds vary from 0.15 to 0.55%, less even than the range of iShares ETFs - list on Stock Encyclopedia - (e.g. the Japan Vanguard fund will have a TER of 0.3% while the iShares ETF has a TER of 0.59%) or OEIC tracker funds like the M&G UK All-Share Equity Index Tracker (TER of 0.49% compared to Vanguard's 0.15%) which also serve the passive index investor. It will be interesting to see how much sales commission, if any, gets charged against a purchase of the new Vanguard funds in the fund supermarkets such as Hargreaves & Lansdown, Fidelity UK and FundsDirect where the DIY investor will be able to buy the funds. The M&G Tracker funds have no sales charge.

Admittedly Canada is not as large a market as the UK, but with the expense ratios of Canadian mutual funds being even higher, is it not time for Vanguard to enter the Canadian market? Vanguard's comment today when I asked: "At this time, Vanguard does not have plans to launch funds in Canada."

Acknowledgements to the Telegraph where I found this item.

The Impossible: Buying US Mutual Funds in Canada

A reader asks this question:
"I am currently setting up an RRSP for my daughter who plans on providing small monthly contributions. ETF's seem out of the question because of the monthly transaction costs associated. Vanguard index mutual fund for american and international exposure seemed like a good idea since their MER's are so much lower than comparable Cdn products. However my broker (TD ) tells me that they don't offer this. Are you aware of anyone in Canada that does? Any suggestions?"

Maybe your broker should have said instead that it is illegal for US funds to be sold in Canada. All funds must be licensed / registered with the provincial securities commission, e.g. the Ontario Securities Commission, and file a prospectus with it. So I believe Vanguard could theoretically be sold in Canada if it went through all the legal rigmarole of registration and licensing but it hasn't so far. I tried quickly without success to find a link to the actual regulation on the OSC website, though I came across this snippet from another document that confirms the situation:
"Policies that prevent US mutual fund companies from soliciting business in Canada, forbid advisors to recommend US funds to Canadian clients, and prevent the distribution of US mutual funds without filing a prospectus in Canada, all serve to protect the Canadian mutual fund industry. Severe tax consequences also deter Canadian investors from investing in US mutual funds." Source: letter to OSC, Re: An Alternative Trading System, Oct.13, 1999 (I believe the last sentence may refer to the fact that income received from US funds would lose their tax-advantaged character as dividends, or capital gains)

The other alternative of opening an account with a US broker used to be possible years ago but has been shut down by the US authorities - see this (justified) rant by ByloSehi. Sadly, you must forget those great Vanguard mutual funds.

You are aware of the Vanguard ETF option and its limitations for your situation. Perhaps you could accumulate the cash in the TD RRSP in a money market mutual fund to gain a little interest and get the RRSP deduction as well as the regular savings in operation. Once or twice a year you could buy the ETF to minimize the trading fees. I'd also check out brokers like Questrade that offer lower trading fees even for small accounts.

Another option would be to buy TD e-Series (Internet only) mutual funds for a few years. Their fees aren't great but at around 0.48% are not nearly as high as most Canadian mutual funds. After accumulating $20-25k, you could then switch to ETFs. Who knows, by then Vanguard may have expanded to Canada or the Canadian funds may have substantially lowered their fees (both of which are likely to occur at the same time ... call it the Walmart effect)?

I leave you with this statement from the same letter (see p.3) linked to above:
"The result of Canadians being denied access to the US mutual fund industry is the existence of a healthy and productive mutual fund industry in Canada that benefits the Canadian economy." ... but not the Canadian consumer / investor!

Tax-Loss Selling Index ETFs: How to Do It Right

When December rolls around it is time to look over the portfolio and see where certain holdings are in a significant net loss position to decide whether it is time to lock in the loss to offset against current year or past year capital gains (past year because losses can be carried back or appllied against gains up to three years in the past to reduce taxes and get a refund). The objective is to reduce net capital gains to reduce taxes.

In looking over my own holdings, as shown in the model portfolio at the bottom of this blog, just about everything is showing a loss since I remodelled the portfolio in May and booked a pile of capital gains. Lesson number one is therefore to keep a running total of capital gains to be able to tell at any moment whether it is necessary or advisable to do any tax loss selling at all for this year's return. That's why I have my Cost Base tab in the model portfolio spreadsheet, which I update with every trade. Note that capital losses can be carried forward indefinitely into future years so if you think you may have higher income down the road, it may be beneficial to take a loss now to offset future higher gains. For the passive index investor, present market difficulties and losses presents an opportunity to lock in those losses with the confidence and expectation that sectors / asset classes (e.g. REITs have taken a hammering) will eventually recover. The indefinite carry forward feature of CRA rules means that one doesn't have to try predicting when markets will recover, only that they eventually will recover (if they never do, we are all in deep trouble or if you die before they do, will you care?). Patience is a virtue.

First, I note that one holding - AGG, the US Intermediate Term Bond Fund - has gone up in price in US funds from $99.37 to $100.38 yet it shows a loss in Canadian dollar terms, which is what counts for Canadian tax purposes. The reason for that is, of course, the tremendous appreciation of the Canadian dollar vs the US dollar; in this case, the C$ has appreciated from about CAD1.0920 per USD on May 23 to about 1.0167 today (yup, that's right appreciation means it takes less CAD to buy USD). It is thus very worthwhile to track a portfolio taking into account the shifting exchange rate. Volatile exchange rates can easily and quickly change a net Canadian dollar gain into a loss (or vice versa).

However, most of my portfolio is held within my RRSP or my LIRAs so there is no chance to claim capital gains or losses. Two holdings are in my non-registered taxable portfolio - VV, Vanguard's US Equity Large Cap ETF and VNQ, Vanguard's US REIT ETF. In the case of these two holdings, the USD price loss has been accentuated by the falling USD, creating a significant enough opportunity to spend the commission costs to lock it in.

Note that the Canada Revenue Agency does not require, nor does it accept, the reporting of foreign exchange gains or losses of $200 or less (see page 18 of the CRA's Capital Gains guide T4037).

Note also that the date on which to do the foreign exchange calculation is the settlement date, when you receive the money from a sale, or pay the money for a purchase, NOT the trade date, which is three business days earlier. It is thus a fact of life that the exchange rate will shift, perhaps a lot, between the trade date and the settlement date, so you can never know exactly how much your gain or loss on foreign property will be. Well, perhaps if you had millions at stake it might be worth locking in the exchange rate with a foreign exchange futures transaction but for us hoi polloi, it won't be practical.

The settlement date rule is especially important to note when one is selling right at year end - if the trade date is in 2007 but the settlement date is in 2008, you cannot report the loss on your 2007 return, you must report that in your 2008 tax return, probably not what you want if you are trying to minimize taxes now. Due to normal holidays when exchanges are closed, this year the last trading day for counting transactions in 2007 is Dec.24th. Incidentally, I phoned CRA and asked for a reference to a written guide where this rule on the settlement date is stated but they had none to point me to except general statements like subsection 40.1 of the Income Tax Act which mentions gains or losses are counted when actual value is received.

Incidentally, there are of other things than ETFs to which tax loss selling applies and a good summary of tax loss selling by Kevin and Keith Greenard appeared in the Dec. 8, 2007, Victoria Times Colonist. As the Greenards point out, it is worthwhile to review capital agins reported in the last three years since present year losses can be carried back to offset past tax and obtain a refund.

One tip that can reduce your foreign capital gain or increase your capital loss by about 2% depends on the exchange rate that you use to convert to/from Canadian to US dollars (or other currencies if you are able to trade in such). The CRA accepts as standard the published Bank of Canada rates account and the funds had not passed into or out of actual CAD. Though they could not quote me a written source to confirm this and therefore there may be some doubt they misunderstood what I was asking, which might mean it is incorrect, such a position conforms to the logic of what a real trade would follow. but these are nominal mid-market (half-way between buy and sell) rates not the rate you or I pay to our broker to buy or sell. The commission charged by the brokerage means you get fewer USD when you buy them / buy the US equity, and less CAD when you sell. In the case of BMO Investorline, it's about 1% commission each way, or 2% for a round trip. The CRA told me when I called their public tax info line at 1-800-959-8281 that I could use the actual broker buy-sell rate, even though the purchase and/or sale may have occurred entirely within a USDCRA is not that unfair to force people to use FX rates that understate their costs or over-state their proceeds of sale. In other words, you and I are better off using the broker foreign exchange rate instead of the Bank of Canada rate . The only requirement is that you must document and be able to show the CRA, if they should ever ask, the actual broker rate. I simply took a screen shot image of the BMOInvestorline FX quote for the CAD-USD exchange on my settlement date. You must also use the same method of FX, Bank of Canada or broker rate, on reporting both original purchase and eventual sale. You don't have to follow the same method for all holdings, however - it can vary holding by holding.

Another key rule has to do with passive index ETFs (or mutual funds), identical properties and a superficial loss. If you want to sell for a tax loss but stay invested in the market in the same asset class, you must not buy an ETF that tracks the same index as the one you just sold for the loss. Otherwise, CRA will deny you the loss, i.e. deem it a superficial loss, and treat your transactions as if you had never sold the losing ETF (your adjusted cost base of the new ETF will be considered the same as the old one). That the practical interpretation of identical properties regarding ETFs is such is stated on pages 164-165 in Howard Atkinson's book on ETFs, the New Investment Frontier III (see my review of this book here). Jamie Golombek, with AIM Fund Management at the time, in a Canadian Tax Highlights March 2002 article referred to a Dec. 5, 2001 CRA bulletin (TI 2001-008038) that used the example of two funds which track the TSX 300 from different companies as being identical in CRA's view. I am still awaiting a response two weeks later to my enquiry to CRA's public info line on the matter to confirm this interpretation.

Update January 11, 2008 - a representative of CRA phoned and said that the 2001 bulletin mentioned above is the only and latest information on the subject. He also emailed me a copy. Some key excerpts: "... the determination of whether investment instruments are identical properties requires a review of all the facts of each particular situation which would include a review of the legal structure of the investment entity, the composition of its assets, risk factors, rights of investors and any relevant restrictions. ... a TSE 300 Index Fund, for example, would generally not be considered identical to a TSE 60 Index Fund. ... Accordingly, an investment in a TSE 300 index-based mutual fund of a financial institution would, in our view, generally be considered indentical to an investment in a TSE 300 index-based mutual fund of another financial institution."

In my case, VV tracks the MSCI US Prime Market 750 Index and I bought IVV, the iShares ETF that tracks the S&P 500 Index. By the CRA rule if I now try to sell the IVV and buy SPY, the SPDR S&P500 to lock in further losses (a hefty drop this week), that loss would be disallowed. The VNQ that I also sold tracks the Morgan Stanley REIT Index while my replacement fund, the RWR from SPDR tracks the DJ Wilshire REIT Index. That should not violate CRA's test while keeping me fully invested.

It is thus very handy to keep a list of alternative acceptable ETFs within each asset class, such as the one in the Asset Allocation tab at the bottom of this page. You should also note what index they track to comply with the identical properties rules when selling for tax losses. In my original off-line spreadsheet, I've added that info in the cell Notes, though unfortunately the Notes cannot be displayed in the Google on-line spreadsheet.

Thoughts on How to Start a Portfolio from Scratch

A reader has asked:
"This question is about what to do with your money if you have a lot of it to invest every month. Lets say I had $5k per month to invest, how much would you recommend I save up before I purchase more ETFs and as such, re balance my portfolio? You see, if you read what I have been reading, many people promote the passive strategy (i.e: minimal trades per year, spending less time watching each individual holding etc)...now, I have been reading blog posts, and people have been saying that they wait until they have about 2-3k saved up, and then they "buy more ETF's". But if I did that, I would be buying ETF's every month or 12 times/year, and if I have 6-7 holdings (even at e*trades low cost of 9.99) I'm still spending over $700+ in the year just on trades. So that seems bad right? On the one hand I hear I should wait and just "do the couch potato" and re balance once per year - but I also feel like sitting on $60,000 (saving $5k/month for a year) and just plopping in such a large sum every December would be ridiculous. So the answer must
lie between purchases every month (too often) and purchases once per year (not often enough). What is recommended and why? How often should I purchase more?"

My comments:

• first, all what follows supposes that the intent is to establish a diversified portfolio with specific proportions of the total portfolio value to be invested in various asset classes; my own portfolio structure is shown at the bottom of my blog - you can see the percentages for each asset class on the Asset Allocation tab and the ETFs I have chosen, as well as alternatives. You can adjust the percentage allocations as you wish, the point is to set a target allocation.
  
• for someone who will quickly accumulate a portfolio in excess of $100k, using only ETFs and a broad range of them - I have 16 of them in mine - makes it possible to invest in minor asset classes which can provide greater diversification and higher returns.
  
• in practical terms there is a trade-off between trading costs and portfolio balance; since any cost is a certain negative return, I believe that's the most important consideration, especially in the short term (a couple of years) while the portfolio is building. At $10 per trade, the commission on a $5,000 purchase is 0.2% but for $1,000 it is 1.0%, which starts to hurt. Do that twice in a year to re-balance and it takes away an appreciable chunk of returns. For that reason, until two or three years had passed (at your rate, you would have $120k invested after two years) I would be very surprised if any asset class had changed so much that it was necessary to do a trade only for re-balancing, so I would only use new funds to progressively establish the portfolio, asset class by asset class and not bother doing trades specifically for re-balancing
  
• I would therefore do one monthly trade - a purchase of one ETF with all of the $5k - to get the funds invested immediately. There is no reason to sit on the cash and wait; the method I outline below is simple enough I believe.
  
• I would also start with core asset class ETFs to get the basics in place (sooner rather than later since one never knows when it might be necessary to interrupt the build-up; it will be better to leave an in-progress portfolio that is at all times reasonably balanced ).
  For example to build my portfolio:
  

month 1 - buy $5k of XIU,
month 2 - buy $5k of VGK,
month 3 - buy $5k of XBB,
month 4 - $5k of VV,
month 5 - $5k of VPL,
month 6 - $5k of VWO,
month 7 - $5k of VGK again,
month 8 - $5k of XBB again,
month 9 - $5k of XIU again,
month 10 - $5k of XSP,
month 11 - $5k of DJP,
month 12 - $5k of VGK again.

Total trading costs $10 x 12 = $120. The first table shows the investments at end of year 1 in terms of dollars, actual percentage of portfolio and the eventual target portfolio percentages for reference. The smaller asset classes are over-invested but that quickly begins to change in year 2. The row and column totals for the assets are already taking shape.

• Continuing this pattern in year 2 buying $5k per month, month 13 - buy $5k of XBB, month 14 - XMD, month 15 - AGG, month 16 - XRE, month 17 - XSU, month 18 - RWX, month 19 - XBB, month 20 - EFV, month 21 - XBB, month 22 - VGK, month 23 - XIU, month 24 - XBB. Only one non-core asset class remains to enter the portfolio - VNQ, US Real Estate. The row and column totals are getting close to the target allocations.
  

• The principle is simply to put each new month's purchase into the asset class that is furthest away from its target percentage. Since the evolution of the markets will move the actual percentages away from their initial purchase value, putting each new purchase into the asset class that is furthest away in actual terms as of the day of purchase will perform re-balancing. As long as you continue to put new money in, I would not see a need to do any annual re-balancing at all. For my model $100k portfolio, in the six months since I set it up in May the furthest any asset class has moved away from the target as of today is VGK, down $930; multiply that by 5 to get a hefty $500k portfolio and that could be re-balanced with one purchase. As time goes on, each $5k purchase represents a smaller and smaller percentage of the total portfolio, and each previous purchase goes down in percentage terms, bringing ever greater accuracy to the portfolio balance, especially among the minor asset classes.
  
• With fewer ETFs in the portfolio, it would be even easier to attain the target percentages - instead of VGK, VPL and VWO, you could simply buy VEU, the Vanguard Rest-0f-World (non-US), for XIU and XMD, take XIC, the S&P TSX Composite, for XSP, VV, XSU, buy VTI, Vanguard's US total market fund (though that would mean all your US holdings would be subject to the effects of the US$ fluctuations, something I think is too extreme, preferring to have half of my US large cap equity in the hedged XSP). The only minor one I would always wish to own is real estate due to its proven negative correlation with other asset classes, which thus provides very valuable volatility reductions for the portfolio.
  

That's it.

The Slippery Meaning of "Value" in ETFs and Indexes

Investing in Value stocks through an ETF brings diversification and higher returns to an equity portfolio. That has been proven in finance research published by Fama and French in their famous three factor model of stock returns, available in all its mathematical glory at the Social Science Research Network. The implications for investing are explained in english language at the Index Fund Advisors.

As the old saying goes, there's many a slip between the cup and the lip. When the research-proven notion of Value, which is simply that the price of a stock is cheap based on the ration of the stock's market price to the company's book value (p/b)(book value is simply assets minus liabilities in the financial statements), the meaning of Value gets transformed and expanded by index providers. Index-based ETFs need to have a reference index and they take them from such providers as Morningstar, Russell, MSCI, Standard & Poors and Dow Jones/Wilshire.

The best explanation of the way Value, and other indexes such as large vs small cap are constructed, is here at the Moneychimp.

So what do we find that the index providers have added to the original p/b measure? First, there are additional historical price measures like price/earnings, price/sales and dividend payout ratio. That might not be so bad as the basic principle that the stock is somehow low-priced compared to a fundamental historical measure is still respected. But where the definition of value really starts to take on hocus-pocus falsity is those indexes that include forecasted of such numbers as earnings! What lunacy! That replaces the best guess, as expressed in the price, of the market, whose guess is better, as shown time and again by research, with the guesses of analysts who are more wrong than right,

How do the index providers stack up?
The Bad

• Russell - "...the Price-to-book ratio and the I/B/E/S forecast long-term growth mean"; affects IWM, IWW
• MSCI - p/b, dividend yield and 12-months forward earnings /price; affects VBR, VTV
• Morningstar - 50% weighting on forecasted estimates; affects JKL
  
• Dow Jones/Wilshire - uses p/b and p/ projected earnings (see the Moneychimp link above); affects XCV

The Good

• Standard & Poors - uses p/b, p/cash flow, p/sales and dividend yield; affects IJS, IJR, RZV

It's very disappointing that Vanguard has chosen such a flawed index for its Value funds since the company's funds are better in other respects than those of the competition by having lower fees and greater diversification. VBR and VTV will be leaving my portfolio as a consequence next year.

The Best US Large-Cap Index ETFs Compared

Back in May in my post on the complete overhaul of my portfolio, I showed a chart of my selected ETFs along with some credible contenders in several asset class categories. In one of these, US large-cap companies, my choice was Vanguard's offering, the Vanguard Large-Cap Index Fund (ticker VV), over some very good other choices, the iShares S&P 500 Index Fund (ticker IVV) and the grand-daddy of ETFs, the SPDR aka Spiders (SPY). Along with those, I've included the iShares Canada S&P 500 currency hedged version (XSP) and the TD e-Series S&P 500 currency hedged fund (fund symbol TDB904) for the benefit of Canadian investors like me who don't want to face the negative consequences of a Canadian dollar continuing to rise vs the US$.

The chart illustrates the factors that I believe justifies the conclusion that Vanguard is the best, though not by a great deal. I've coloured the cells light blue where the particular factor favours that ETF. The visual impression is a bit misleading since a number of cells at the bottom all have to do with tax efficiency.

Vanguard's VV is better on:

• MER, or Management Expense Ratio, which is the overhead paid to Vanguard to manage the fund - the lower the number, the better it is for the investor
• on the premium/discount, in this case the discount, which is the average amount the market price of the ETF deviates from the Net Asset Value (NAV), the value of the under-lying stock holdings; the smaller this number the better, the investor neither gains nor loses as the fund is fairly priced; in this case VV is tied with SPY for the best
• 3-year performance, which is higher in VV's case; now some will note that VV uses a different index than all the others, which use the S&P 500 and thus the result should not therefore be comparable. I'm going to stick my neck out a bit by saying that the others suffer from using the S&P 500, a flawed index (as noted by Peter Bernstein in his book, which I reviewed a few days ago). Check out the text below on the S&P 500's flaws and see if you agree with me. The fact that everyone uses it, as they do the far worse Dow, doesn't make it good!
• all the various tax efficiency measures; especially note that the ratios at the bottom of the table, higher in VV's case, mean that the investor loses less to the government through taxes on VV than the other funds. Canadians should note that the source of this is US websites like Vanguard and the absolute numbers reflect US taxpayers but I believe the relative advantage of VV is still there. The size of the 2006 distribution by VV, which would be a highest-rate income item for a Canadian, compared the that of IVV, confirms this conclusion.
  

There are a bunch of blank cells in the table, where I could not find the numbers despite hours of searching. Canadians will note more blanks for XSP and TDB904, where the available data on comparative websites like Morningstar, GlobeFund and those of the providers iShares Canada and TD Asset Management don't seem to be very forthcoming with data. I had to email iShares Canada to learn why their 3-year performance figure on their website differed so markedly from the S&P's results - turns out they only started hedging XSP in November 2005. Therefore, all note, the numbers may not be 100% accurate!

One disappointment for me in all this is how much one loses in buying XSP or TDB904 for currency protection. There's a big performance loss. It's curious that XSP managed in 2006 to distribute some of its distribution as capital gains instead of income, better because of the lower tax paid on capital gains over income. The tracking error of TDB904 at 6+% is abysmal. I had to calculate that one myself so it may be wrong but the high cash holding of 4% of assets, which came from Morningstar Canada, is consistent with such poor tracking.

The suggested weaknesses of the S&P 500 as a market index include:

• it is really only a large cap index with about 75% of the total market value of US shares
• it weights the companies within the index based on the value of the public float in the judgement of the Standard and Poors selection committee, so this biases the index away from a true market cap weighting that follows from financial theory
• some non-US companies are still in the index, having been grand-fathered upon moving away from the US
• some US companies that are illiquid are excluded like Warren Buffett's Berkshire Hathaway, a gigantic omission as it is a huge company
• delays in adding new companies in new sectors distort the true market weighting – it took a while before Google entered the S&P 500

see http://en.wikipedia.org/wiki/S%26P_500 and a letter by Darren Bramen on this page http://www.aicpa.org/pubs/jofa/apr2000/letters.htm

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?

Major Portfolio Renovation, Canadian Style

It's done at last. I've completely changed my investment portfolio to an asset allocation methodology. For the first time, my investments are now an integrated whole, with the holdings selected to complement each other, as opposed to the disparate, hodge-podge of holdings I have had up to now. There is no longer any single company equity holding in any of my accounts - goodbye Cisco, Oracle, JDS Uniphase, SAP, Microsoft. Most difficult was selling my large holdings of Royal Bank and Scotiabank, which have been such stellar long term performers and have made me so much money. The decision to completely adopt the principles of portfolio theory drove all the changes.

For anyone else contemplating such a move, here is how I did it and where I encountered tricky bits.

The basic idea was to build a portfolio with the highest return and the least volatility/risk through selecting assets that are as a non-correlated as possible, i.e. they do not move and down together - one zigs while the other zags. In addition, the assets themselves are not single companies, they are many companies held together as a mutual fund or Exchange Traded Fund (ETF), in order to remove the effect of single company events.

The end results of my many hours spent on the planning of the renovation are shown in the extract from the spreadsheet I used that is included with this post.

Here are the key features:

• no individual companies eligible for the portfolio, only ETFs and mutual funds to ensure diversification; however, for my 27% Canadian bond allocation I decided to keep the bond ladder I have built; the range of maturities from 2007 to 2026 probably suffices to be diversified and I don't sacrifice yield from management fees e.g. XBB has an MER of 0.30%
  
• the range of asset classes is both geographical, covering more or less all the main economic areas of the world - Canada, the US, Europe, Japan, Pacific nations, emerging countries such as Russia, China, India, Korea, and sectoral, with large cap and small cap companies, value companies (low price/book and other measures), real estate, commodities; these asset classes have been chosen based on multiple sources that demonstrate their un-correlated returns over time - books such as those of Richard Ferri and of Roger Gibson, online resources such as Bylo Selhi and Index Fund Advisors
  
• the diversifying sectoral asset classes each only have a small percentage of the total and where possible this is spread amongst the various geographical areas, in order not to be too concentrated in any one asset class;
  
• no asset class has less than 2% of my total asset allocation and the total number of holdings is 16; this is to ensure that any holding is sufficiently large that when rebalancing comes along in a year, the dollar amount to be rebalanced will be large enough that trading costs will not chew up the amount; as a rough rule of thumb I'll want the rebalancing amount to be at least $1000 since my trading cost is $10/trade (1%); Ferri recommends no more than 15 holdings to keep the rebalancing exercise from being too complicated and I fully agree based on my own experience of doing rebalancing amongst only six ETFs the last few years (XIU, XGD, XIT, XRE, XFN, XMD); given that I have four accounts (open, RRSP, LIRA1 and LIRA2), none of which can transfer money to another, the limit on number of holdings is a practical necessity. It was at this point that a number of candidate asset classes, seen in the bottom chart with the ETF ticker symbols, disappeared from the final allocation.
  
• the reduction of the impact of adverse currency shifts, especially against the US dollar, is the concern that led me to buy more than half of my US large cap holding and US small cap as the currency hedged XSP and new iShares Canada XSU; in the international holdings there is some currency risk but it spread over many countries' currencies so it is more acceptable - whether this is truly an acceptable risk I don't know as I have not been able to find clear answers in the finance research I have read so I will keep looking. In the meantime, however, there really isn't much choice to find ETFs that will fill the asset classes in my chart except to buy unhedged ETFs on US markets, so I've decided that diversification is most important. The only exception might be XIN, the hedged counter-part of EFA, the iShares EAFE fund, but since the global whole market class did not make it into my portfolio it isn't relevant. Of course, it is true that despite the funds selected being traded on US exchanges in US dollars, the currency risk is not the US dollar but those of the under-lying holdings; the US$ is only a pass-through currency.
  
• Vanguard funds appear often in my final selections - VGK, VPL, VNQ, VBR, VV, VWO. As my chart shows, there are other good funds (I didn't put any in the chart that weren't low cost, passive index funds) but Vanguard comes out on top pretty well every time they are available in a class. Why? Vanguard ETFs have the lowest tracking errors; a lower Price/Book in the value category; lower turnover than the avg fund in a category = lower transaction costs, less cap gains distributions; more holdings than the avg fund in a category =more diversification, less risk; the lowest management fees. It may interest some to note that I compared a few TD e-Series funds (TDB900, 904 and 911) but their higher management fees offset their plus of not having trading costs. My fund selections are highlighted in the greeny/yellow colour on the chart.
• The case of the US dollar denominated holdings caused me something of a conundrum. All foreign dividends are taxed as ordinary income, which suggests US$ holdings should go into registered accounts while Canadian holdings that can benefit from lower dividend tax rates should go into the open account. However, it is an unfortunate fact that my broker BMO Investorline won't hold US dollars within a registered account. BMOIL still requires US dollar sales to be converted into Canadian dollars and then back again into US$ for a purchase. There is a spread of about 1.8% between the buy and sell rates on the US$ at BMOIL so when I came to do my rebalancing next year I'd get dinged plenty, probably more than the tax differential. So I will keep as much as possible of my US$ holdings in my open account where I can keep a US$ cash balance. BMOIL could fix this deficiency since there isn't any legal impediment to having US$ in a registered account; I'm sure as soon as another of the major bank brokers does it they will too but it rankles in the meantime to pay extra FX costs for no necessary reason.
  
• my portfolio is treated as one across all the four accounts I have - open/taxable, RRSP, LIRA1 and LIRA2; where I put individual holdings is influenced by other considerations such as taxes but taxes are subservient to doing proper asset allocation. All the fixed income/ bond holdings are in the registered accounts for instance. Dividing up the holdings amongst these accounts proved to be a significant challenge just to make things balance. In addition, I tried to anticipate the rebalancing by placing investments within the same account that might end up needing to be rebalanced up or down e.g. I put a big chunk of the DJP commodities holding into the RRSP along with VGK Europe equity and VPL Pacfic equity as they are historically negatively correlated and the former should go down when the others go up. Similarly, in the open account I put VNQ REITs and VV US large cap, which are also negatively correlated. Hopefully, that will enable easy rebalancing within an account next year but we shall see.
• my asset allocation is NOT driven at all by any income needs, though I am starting into that period of life when withdrawal is beginning (for why this is the correct way to approach things, I rely on experts such as Moshe Milevsky). If I will need to withdraw funds from any account, It will be based on the asset allocation - whichever is above its target will have a portion sold.

So that's it. Any comments or observations welcome!

ETF Screeners, Tools and Primers

Since I have been spending huge amounts of time researching Exchange Traded Funds (ETFs) in preparation for a complete re-structuring of my investments based almost completely on ETFs, it might be of interest for me to relate what I have found of use on the Internet.

ETF Primers, FAQs and Portfolio Principles:

• Wikipedia's ETF Entry - summary explanation of ETFs; lists of providers and exchanges around the world where ETFs are available; lots of links
• Efficient Market Canada's Example ETF Portfolio - Martin Gale explains how a Canadian can build a simple global portfolio using ETFs
• ETFs vs Index Mutual Funds and ETF vs Open-End Fund Shootout (Wm Bernstein) - pros and cons of each
• IFA Canada - lots of high-quality educational material as well as sample portfolios for this company that sells low cost funds, but the principles are the same.
• Altruist Financial Advisors - links to more complicated and technical references on ETFs (and many other investing topics) under the Reading Room tab
• Bogleheads Forum - fans of John Bogle, Vanguard Fund founder; lots of links to ETF and other investing material in the Reference Library, plus opportunity to ask questions of investing junkies who generally believe in low cost passive investing
• Seeking Alpha - extensive information on all aspects of ETFs, from basics, investment strategy, asset allocation resources and tools, indexes with many links, all of it annotated
  
• Financial Webring - Canadian investors, including those who write the most and have published some excellent resources; permanent section on funds and ETFs; good place for discussion and to ask questions

ETF Screeners and Comparison Data:

• Stock-Encyclopedia.com - Canadian, US and UK-traded ETFs in one place; useful categories / asset classes for portfolio building; ETF names are written out, not abbreviated; ticker symbols always visible to avoid confusion; ETF investment objective and reference index but little else - links to provider / sponsor websites for details; links to multiple quote websites like Yahoo, Bloomberg, Google, MSN Money; doesn't include all ETFs e.g. missing REITs like ICF, IYR; no side-by-side comparisons, portfolios or other fancy stuff but I found it to be very useful for preliminary identification of candidate ETFs because the site is so simple and quick and includes US and Canadian ETFs together
  
• MarketWatch.com (engine for Wall Street Journal and XTF.com - US ETFs only; Quickscreener tool has useful asset classes; includes Management Expense Ratio (MER), Net Assets, Performance, Turnover, Top Ten holdings, Sector breakdown in one compact, easy-to-read page but is missing Geographical breakdown for international funds and Number of Holdings; no links to Providers; fund names are abbreviated making some difficult to understand; no portfolio tool
• Morningstar.com engine for Investors Business Daily) Morningstar.co.uk and Morningstar.ca - US, UK and Canadian sites for each of those countries' ETFs and mutual funds; very sophisticated and complete but consequently complex and slow to use; important things are buried several clicks down, like ticker symbols, holdings, sector and geographical details; enables creation of a portfolio, which can then be characterized using the X-Ray tool to show sector and geographical dispersion, expected returns and other very useful stats to judge whether a proposed portfolio will be well diversified. Very cool! But it only works for the funds within that country so Canadian investors like me who want/need to use US funds to diversify properly cannot see the whole portfolio analyzed. It's still very handy and unique.
• IndexUniverse.com - US ETFs only; you need to register (it's free) to get access to the database and screener; same complete coverage of 498 US ETFs plus articles and commentary, discussion forum; the screener has a lot of variables one can choose but there are a lot of pre-set ones ticked having to do with performance so it is necessary to do a lot of un-clicking then re-clicking to select the factors one needs; the MER is one screen and it has a good increment of 0.25%; US investors have it easy since mutual funds and ETFs can be screened at the same time or separately; names of funds are somewhat abbreviated but not too badly and the ticker can always be made to appear; there are no market quotes, no links to provider websites and no sectoral of geographical breakdown of fund holdings, no total number of holdings within a fund, no portfolio capability.
• GlobeFund.com - Canadian ETFs along with mutual funds and it is hard to tell them apart from the way the data is presented and certainly the entry link doesn't mention ETFs. Nowhere, for instance, is the ticker symbol XSP shown for the ETF iShares S&P 500 C$ on this data page; it is possible to filter using MER, though the increment is only 0.50%; it is difficult to tell apart actively managed from passive funds, a matter of interest to me; the website is generally slow to respond; there are performance figures, sector and geographic weighting charts, though the latter doesn't work properly for the iShares EAFE ETF that is based on the US-traded ticker: EFA and so is marked as 100% US though it is everywhere but there underneath.
• Financial Post / National Post - Canadian mutual funds with the few domestic ETFs, though the website label doesn't say anything about ETFs ... oops, the Claymore Investments range isn't included; a lot less data than the other sites; with so little ETF choice in Canada it would be imperative to include them.
  
• iShares.ca - the most popular Canadian-traded ETFs with lots of useful data and explanations
  
• Vanguard and iShares.com - US websites of low cost US-traded ETFs that will likely attract most Canadian and UK (those who can trade on US exchanges) investors with a bent for passive index investing; good places to get the details on funds to round out the diversification objectives with other asset classes; Vanguard has a neat tool that lets you compare side-by-side any of its ETFs with another of any other company, e.g. for a European holding should it be VGK or IEV or EZU - Vanguard's tool provides more data than some of the big specialized websites above.

Happy research everyone. If anyone has other suggestions for sources, let me know.