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The advantages of constructing your RRSP portfolio using ETFs

by Wayne Cheveldayoff, 2006-01-19

Exchange-traded funds (ETFs) are still less popular than mutual funds or direct stock and bond ownership but they have several advantages for Canadians building their RRSP portfolios.

The overwhelming advantage is that investors will be sure to get at least the return of an index, such as, for example, the S&P/TSX Composite Index, whose total return including dividends in 2005 was 24 per cent.

If you owned individual shares or equity mutual funds in 2005, your returns may not have kept pace if you didnít have at least an index weighting in soaring energy stocks.

In the first nine months of 2005, only 13% of actively managed Canadian equity mutual funds were able to do as well as the index, according to Standard and Poorís Index Versus Active Funds Scorecard for Canadian funds (www.spiva.standardandpoors.com).

S&P says that the indexís winning performance applies over longer periods as well. Over the five years to the end of September, only 39.6 per cent of actively managed Canadian equity mutual funds outperformed the S&P/TSX Composite Index. The U.S. picture is similar, with only 23.7 per cent of U.S. equity funds having outperformed the S&P 500 Index in the five-year period.

A second important advantage of ETFs is their low cost. The index-linked ETFs offered in Canada have an annual management expense ratio (MER) of 0.55 per cent or less, versus MERs in the range of 2.5 per cent a year for a typical Canadian actively managed equity mutual fund. The extra fees are part of the reason for the poor track record of active managers.

While the low fees are attractive, a drawback of going with index-linked ETFs is you wonít get the outsized returns of active managers who happen to guess right on such things as market direction, individual stocks or energy prices.

While there are many active managers each year that beat the index by a lot, the statistics prove there are few that can do so over five or 10-year time frames. It means that investors choosing to go with ETFs are trading off the ability to get greater-than-index returns in the short run for the certainty of getting equal-to-index returns over both the short and longer run.

With just the ETFs trading on the TSX, Canadians can put together a properly diversified portfolio linked to the broad stock index, individual sectors such as energy and gold, international stocks and traditional and real return bonds.

While broad-market-index ETFs have been around a long time, Barclays Global Investors and other ETF issuers have recently been expanding the sector ETFs, giving investors a lot of choice.

In Canada, Barclays late in 2005 added ETFs tracking income trusts, materials companies, dividend-paying stocks, and real return bonds to a previous iUnits list that included sector funds for science and technology, natural resources, financial services, real estate and precious metals, two bond indexes and two international stock indexes. (see www.iunits.com). Barclays is the only ETF issuer in Canada since TD Bank recently closed its four ETFs.

In the United States, Barclays (see www.ishares.com) and other issuers have hundreds of ETFs linked to such broad indexes as the Dow Jones Industrial, Nasdaq 100 and S&P 500, numerous sectors such as health care, energy services, home construction, various styles such as growth, value, mid-cap and small-cap, and many countries such as Germany, Sweden, South Africa, South Korea, Japan, China and so on. (Yahoo Finance, Smart Money and CBS Marketwatch have good ETF sites.)

With the elimination of foreign ownership restrictions on RRSPs, the world is really at our doorstep. You can buy any of these ETFs just like you would buy any stock.

You may be wondering, if ETFs are so good, why havenít I heard about them from my investment advisor?

The answer may be that the investment advisor truly believes in active management and feels skilled in choosing index-beating stocks or equity mutual funds for you.

But keep in mind (you can bet advisors do) that while there is a standard sales commission on ETFs like there is for stocks, there isnít a trailer fee attached. In contrast, advisors get trailer fees on mutual funds ranging from 0.5 to 1 per cent annually in addition to sales commissions.

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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©2006 Wayne Cheveldayoff