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ETFs a sturdy alternative for the long haul

00:00 EST Thursday, January 24, 2002

Building an RRSP with exchange-traded funds can be child's play.

Think Lego. Snap together four or five ETFs in the right way and you'll have a sturdy registerered retirement savings plan built for long-haul investing.

With an ETF, you buy into a stock index as opposed to a collection of stocks chosen by a fund manager (there are also a couple of bond ETFs). You make whatever the index does, minus a very small amount that is attributable to management fees and glitches in duplicating the index's numbers.

Investing with ETFs offers two big attractions, the first being simplicity. There are about 135 Canadian and U.S. exchange-traded funds, but only a dozen and a half or so are mainstream enough to be suitable to the conservative nature of an RRSP. No question, the selection process is much easier than wading through thousands and thousands of mutual funds and stocks.

Moreover, ETFs are a buy-and-forget proposition. They don't change managers, they don't change investing styles. You can hold ETFs forever, as long as you regularly check your portfolio to make sure that your allocation to stocks, bonds and cash is still what you want it to be.

The second, and more important, benefit of ETFs is low cost. These funds are listed on stock exchanges, which means you'll have to pay a brokerage fee to buy them (expect to pay $25 to $29 for orders through an on-line broker). Once you've bought an ETF, though, it will be immensely cheaper to own over the long term than almost all mutual funds.

The most popular ETF in Canada -- the iUnits S&P/TSE 60 Index Participation Fund, or i60 -- has a management expense ratio of 0.17 per cent. The average Canadian equity mutual fund has an MER of around 2.5 per cent.

In rough terms, MERs are lopped off the top of a fund's gross returns. What's left over is reported to you as the fund's performance.

To see what this means in dollar terms, let's take a $20,000 investment in i60s and in an equity fund with a 2.5-per-cent MER. We'll say the i60s return an average 10 per cent annually for 10 years before expenses are deducted, while the fund manager is clever enough to beat the market and make a gross return of 11 per cent.

At the end of the 10 years, the i60s are worth $50,999 after factoring in the MER, while the average fund is worth $44,086. The higher fees of the mutual fund have left you almost $7,000 worse off, even though the fund did better than the index before expenses.

Past experience shows that many fund managers simply can't continually outperform the market sufficiently to counteract the dead weight of their MERs. In the past 10 years, 35 of 72 Canadian equity funds underperformed the Toronto Stock Exchange 300 composite index, while 40 of 41 U.S. equity funds lagged the Standard & Poor 500 index's returns when expressed in Canadian dollars.

The best way to explain how to use ETFs in portfolio building is to use some examples. The list of the ETFs used and their proportions for each portfolio are contained in the accompanying chart.
The 'ultra-frugal, long-term
investor' portfolio

The goal here is to keep costs to the absolute minimum by picking the ETFs with the cheapest MERs. Remember, the lower a fund's MER, the closer your returns are to what your target index makes.

For Canadian equity exposure, we'll use the SSGA Dow Jones Canada 40 Index Participation Fund, or DJ40. The 0.08-per-cent MER for this fund is one of the great bargains in investing today.

The problem with DJ40s is that they haven't attracted much of a following and thus don't trade actively. As a result, you may find that you have to pay a little above the market price to buy them, and receive a little less when you sell them. If you're investing for the long term, this problem will be more than offset by the razor-thin MER.

For U.S. exposure, the iShares S&P 500 Index Fund has been selected because of its 0.09-per-cent MER. That's just a little cheaper than the 0.12 per cent charged by the more popular Standard & Poor's Depositary Receipts, or Spiders.

For international coverage, the iUnits MSCI International Equity Index RSP Fund has been chosen. It qualifies as domestic content for your RRSP, so you don't have to worry about the fact that you've used up your 30-per-cent foreign content limit with the iShares S&P 500 fund.

Exposure to the bond market comes in the form of the iUnits 5 Year Canada Bond Fund, which tracks the yield on the five-year Government of Canada Bond. The MER is 0.25 per cent, which compares to 1.77 per cent for the average fixed-income mutual fund.

Fixed-income exposure in this portfolio has been set at a level that would be appropriate for a modestly aggressive long-term investor. To enhance diversification, the equity portion of the portfolio is tilted slightly in favour of global stock indexes -- if you prefer more Canadian content, you can adjust accordingly.
The 'better safe
than sorry' portfolio

This more conservative portfolio uses a 50-50 split between stocks and bonds. For greater safety, you could pare back the equity holdings and put the proceeds in bond ETFs.

The choice here for exposure to the Canadian stock market is the TD Select Canadian Value Index Fund, which focuses on constituents of the TSE 300 composite index that have been identified by the Dow Jones indexing people as value-oriented stocks. The value discipline focuses on undervalued stocks, which in theory should limit the risk of being exposed to an overpriced market.

For a conservative spin on the U.S. market, the iShares S&P 500 value fund is a good choice because it focuses on stocks in the index with the lowest price-to-book ratios, an indicator that a stock may be undervalued.

The iIntR will do here for global coverage, while the iG5 suffices for the bulk of the bond portion of the portfolio. One addition is the iG10, which tracks the 10-year Canada bond. Longer-term bonds are somewhat riskier than shorter-term bonds, but the addition of the iG10 will serve to diversify your fixed-income holdings a little.
The 'risk, what's that?'
portfolio

This portfolio shows how you can use ETFs to cover both broad-based and sectoral indexes, the latter offering more risk but also more potential reward.

Adding to the risk profile of this portfolio is the complete lack of any bond exposure.

The broad Canadian fund here is the i60, which is the most actively traded ETF in the country. From there, we branch out into TSE-listed information technology and mid-capitalization stocks through a pair of funds that are part of the same family as the i60.

Note that there are other Canadian sectoral funds covering areas such as oil and gas, financials and gold. With ETFs, you can mix and match to exploit the sectors you like best.

In the U.S. market, we'll use the growth version of the S&P 500 value fund mentioned earlier. To tap into the promising biotech sector, we'll add the Nasdaq Biotechnology Index Fund.

If you wanted a broader tech focus, you could substitute Nasdaq-100 Index Tracking Stock units (QQQ-Amex), which are commonly called Cubes. The iINTR is again used for global exposure because it qualifies as domestic content.

The major stock indexes have been quite volatile in recent years, so expect some ups and downs in the equity portion of an RRSP portfolio of exchange-traded funds. If you're concerned about this, you can bulk up on bond ETFs or add some conservative equity funds or individual stocks.

Most importantly, be patient. In the end, long-term ETF investors will enjoy returns that are tied to the historically attractive performance of the major stock indexes.
rcarrick@globeandmail.ca
ETF sample portfolios
The 'ultra-frugal, long-term investor' portfolio
35%
- SSGA Dow Jones Canada 40 Index Participation Fund, or DJ40 (DJF-TSE)
30% - iShares S&P 500 Index Fund (IVV-American Stock Exchange)
10% - iUnits MSCI International Equity Index RSP Fund, or iIntR (XIN-TSE)
25% - iUnits Government of Canada 5 Year Bond Fund, or iG5 (XGV-TSE)
Approximate commission cost at an on-line broker: $115
The 'better safe than sorry' portfolio
20% - TD Select Canadian Value Index Fund (TAV-TSE)
20% - iShares S&P 500/Barra Value Index Fund (IVE-Amex)
10% - iIntRs
35% - iG5s
15% - iUnits Government of Canada 10 Year Bond Fund, or iG10 (XGX-TSE)
Approximate commission cost at an on-line broker: $140
The 'risk, what's that?' portfolio
25% - i60s
10% - iUnits S&P/TSE Canadian MidCap Index Fund, or iMidCap (XMO-TSE)
10% - iUnits S&P/TSE 60 Canadian Information Technology Index Fund, or iIT (XIT-TSE)
20% - iShares S&P 500/Barra Value Growth Fund (IVW-Amex)
10% - iShares Nasdaq Biotechnology Index Fund (IBB-Amex)
25% - iInRs
Approximate commission cost at an on-line broker: $180




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