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Advisor demonstrates the workability of an ETF portfolio in Canada

by Wayne Cheveldayoff, 2004-09-09

Some advisors are recommending the use of index-linked exchange traded funds (ETFs) for their greater tax efficiency and lower annual portfolio management costs.

The pitch usually is that since an actively managed mutual fund rarely outperforms the index over long periods of time, investors can get the same or better performance in the long run from index-linked ETFs and also get some added benefits.

But what would a portfolio full of ETFs look like? Is it workable in Canada where there are relatively few ETFs compared to the United States?

We put the question to Ted Rechtshaffen, president of newly formed, Toronto-based Delta Financial Partners (www.deltafinancialpartners.com), an advocate of using ETFs as the most efficient and cheapest form of diversification, at least for equity holdings.

The sample portfolio he created shows that, although many investors may still prefer trusting their money to a mutual fund manager who picks stocks, an index-linked, ETF-only portfolio is workable in Canada.
Mr. Rechtshaffen’s investment advisory firm, which he started after a career at RBC Dominion Securities, plans to emphasize ETFs, which have very low management expense ratios (MERs), usually under 0.5 per cent annually, and directly charge clients a tax-deductible annual fee of 1 to 1.75 per cent (depending on portfolio size) for advice.
This is in contrast to the situation with regular mutual funds where advisors receive an annual trailer fee (0.5 to 1 per cent) that is embedded in a mutual fund’s MER (typically 2.5 per cent for an equity fund and not tax deductible).
In creating the sample portfolio, Mr. Rechtshaffen assumed it would be for a married couple in their mid-40s, with two kids (11 and 15 years old) and with $140,000 in a registered plan (RRSP), $100,000 in a non-registered portfolio and another $20,000 in a registered educational savings plan (RESP).
The couple is assumed to have a high risk tolerance and willing to take a moderately aggressive stance. Other investment objectives, such as saving for a cottage, or any liquidity or cash flow needs, would also be important in creating a portfolio but for this exercise were not considered to be a factor.
The recommended asset allocation is: (1) RRSP – 60 per cent equities, 35 per cent bonds and 5 per cent cash; (2) non-registered portfolio – 70 per cent equities, 25 per cent bonds and 5 per cent cash; and (3) RESP – 50 per cent equities and 50 per cent bonds.
The ETF chosen for the Canadian equity holding is the TD S&P/TSX Composite Index Fund (MER 0.25%), which contains approximately 220 of the largest and most actively traded stocks on the TSX. This would make up 10 per cent of the RRSP and non-registered portfolios.
Making up 20 per cent of the RRSP would be another ETF that is designated as Canadian content – Barclay’s iUnits MSCI International Equity Index RSP Fund (MER 0.35 per cent) – which seeks to match the performance of the Europe, Australasia and the Far East (EAFE) index.
The U.S. equity content (25 per cent of the RRSP) is supplied by the Vanguard Total Stock Market VIPERs (MER 0.15 per cent), which is designed to mimic the Wilshire 5000 index. This broader index is preferred over a narrower index like the S&P 500 or Dow Jones because the broader index has a larger proportion of fast-growing mid-cap stocks that over longer periods cause it to outperform the large-cap-dominated S&P 500 or Dow index.
Five per cent of the RRSP is allocated to the iShares Goldman Sachs Natural Resources Fund (MER 0.5 per cent), one of the many specialized ETFs available in the United States and perhaps a timely choice given the upward pressure on energy pricing worldwide.
The RRSP bond component is made up of the Barclay’s iUnits Government of Canada 10-year Bond Fund (MER 0.25 per cent), making up 20 per cent of the portfolio, and the Barclay’s iUnits Government of Canada 5-year Bond Fund (MER 0.25%), comprising 15 per cent. These two ETFs were chosen to demonstrate an ETF-only approach but it may be advantageous for the portfolio to invest directly in government or corporate bonds, which would eliminate the MERs.
There is no ETF in Canada for cash, so the cash component in each portfolio is allocated to the Altamira T-bill fund (MER 0.38 per cent).
The same equity and bond ETFs are used in different proportions in the non-registered portfolio (except the iShares MSCI EAFE Index Fund (MER 0.35 per cent) is substituted for the above-mentioned RSP fund of a similar name and purpose).
The RESP equity component is split between the iShares MSCI EAFE Index Fund and the Vanguard Total Stock Market VIPERs, with the bond component all in the Barclay’s 10-year-bond ETF.
Using this ETF approach, a Canadian investor would end up with an annual MER for the entire portfolio of around 0.3 per cent (less if bonds are held directly). Because Delta’s advisor fee of 1 per cent (household portfolio of $500,000 or more) to 1.75 per cent (portfolio under $100,000) is tax deductible, the total after-tax cost (advisor fee plus the MERs), would end up being somewhere around 0.8 to 1.4 per cent for those in the top tax bracket.
In Canada, Barclays has a total of 12 ETFs (viewable at www.iunits.com) and TD Canada Trust has four ETFs (www.tdbank.ca).
For the 100-plus U.S.ETFs, good sources for investors to check are CBS Marketwatch (www.cbsmarketwatch.com) and the U.S.Yahoo finance site (www.yahoo.com) – both of which have special ETF sections with commentary and performance data.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff