This blog post is adapted from my French column with the newspaper Les Affaires.
As of June 30, 2017, 644 exchange traded funds (ETFs) were listed in Canada, giving investors plenty of options. Mutual funds, however, are still more numerous at 20,000. In this article, we will discuss how to build an ETF portfolio.
Crucial first step: define your investment strategy
Choosing ETFs before defining your investment strategy is putting the cart before the horse. Your strategy should determine your criteria for selecting ETFs, and not the reverse. It will help you decide the types of ETFs that are best for you. My personal strategy is to optimize how I capture global market returns, while keeping fees and taxes as low as possible. You can adopt a similar strategy or focus on dividends, stock market sectors, etc. The key is to have an effective strategy that will continue to perform well over time.
Portfolio structure
The websites of ETF providers give excellent information on the underlying portfolio of each fund, whether allocated by sector, country, maturity or credit rating (for bond ETFs). The websites also provide information on the market capitalization of the portfolio securities, the price/earnings ratio, the price/book ratio, and the dividend yield. With my strategy, I am looking for a market capitalization weighted portfolio that represents the overall market as much as possible. For Canadian stocks, for example, an ETF must include all liquid stocks — small, mid and large cap
Tracking error
If you opt for index ETFs, your portfolio will be transparent, which is one of the main advantages of these funds. The more faithfully managers replicate their index, the better it is. By contrast, if the return is too far from the benchmark index, there are no possible excuses. You should know, however, that tracking errors vary based on the targeted asset class: while they are very low for the best Canadian stock and bond ETFs (sometimes less than 0.10%), they are higher for American and International stocks and bonds due to higher management fees, foreign government withholdings, and variances caused by different time zones. Tracking error information is also often provided on ETF websites in tables that show the fund’s return compared to the benchmark index return. If you are hesitating between two index ETFs in the same class, it is better to choose the one with the lowest tracking error, especially if the variance is significant.
Management fees
Let’s say your portfolio is worth $50,000. If you pay 0.50% more than necessary in fees, it will cost you $250 per year. Carefully compare the management expense ratios (MERs) of the ETFs that interest you (provided on the security’s website) and make sure that you are not paying too much. Keep in mind that your portfolio is like a small business: its success depends in part on cost control.
After-tax returns
When you go shopping, you never have the opportunity to pay in before-tax dollars. The goal of your portfolio should therefore be to maximize your after-tax returns. Based on the circumstances, certain ETFs offer rather mediocre after-tax returns. One of the most important traps to avoid in taxable investment accounts is investing in bond ETFs with high premiums, meaning that the securities in the portfolio have a price significantly higher than 100% of the par value. In these circumstances, the taxes may offset almost all of the portfolio’s income. It is better to choose an ETF that invests in bonds with values that are close to, or even below, the par value. In addition, ETFs with strategies that require frequent buying and selling of securities will probably make significant capital gains on which holders must pay taxes. In contrast, ETFs with relatively stable content usually cost less in taxes. To summarize, the risks of paying more taxes than necessary are high, and choosing the right ETF, based on the circumstances, will preserve your portfolio’s profitability.
Choosing providers
Selecting one or more ETF providers depends in part on the confidence that you have in the provider: its reputation, its management fees, the quality of its products, or the type of strategy. Based on my own criteria, the three largest Canadian providers (iShares, BMO and Vanguard) offer ETFs with the required characteristics.
Conclusion
If you take away one thing from this article, it should be that you need a clear investment strategy before you even start thinking about choosing ETFs. Once you have a well-defined strategy, portfolio construction, tracking errors, management fees, taxes and your preferred ETF providers will help guide your decision.