Exchange-Traded Funds For Canadians For Dummies

1. ETFs offer low-cost, diversified investment options for Canadians

ETFs enable the average investor to avoid shelling out fat commissions or paying layers of ongoing, unnecessary fees.

Cost-effective investing. Exchange-Traded Funds (ETFs) have revolutionized investing for Canadians by providing a low-cost alternative to traditional mutual funds. ETFs typically charge much lower management fees, often ranging from 0.05% to 0.50%, compared to the average mutual fund fee of 2.5%. This significant cost difference can have a substantial impact on long-term returns.

Diversification benefits. ETFs offer instant diversification by tracking indexes that represent entire markets or specific sectors. This reduces the risk associated with investing in individual stocks. For example, purchasing shares of the iShares S&P/TSX 60 Index Fund (XIU) provides exposure to 60 of the largest and most liquid Canadian companies across various sectors.

• Popular Canadian ETF providers:
  • BlackRock iShares
  • BMO ETFs
  • Vanguard Investments Canada

2. Understanding the basics: What ETFs are and how they work

Just as a deed shows that you have ownership of a house, and a share of common stock certifies ownership in a company, a share of an ETF represents ownership (most typically) in a basket of company stocks.

ETF structure. ETFs are investment funds that trade on stock exchanges, similar to individual stocks. They are designed to track the performance of a specific index, sector, commodity, or asset class. When you buy an ETF share, you're essentially purchasing a small portion of a diversified portfolio of securities.

Trading mechanics. ETFs can be bought and sold throughout the trading day at market prices, unlike mutual funds which are priced once daily. This provides investors with greater flexibility and liquidity. ETFs are created and redeemed through a unique process involving authorized participants, which helps keep the ETF's price closely aligned with its underlying net asset value (NAV).

• Key ETF features:
  • Intraday trading
  • Transparency of holdings
  • Tax efficiency
  • Lower costs compared to most mutual funds

3. Building a stock portfolio with ETFs: Large cap, small cap, value, and growth

The historical average for Shiller's adjusted P/E over the past 50 years is 19.5.

Diversification strategies. Building a well-rounded stock portfolio using ETFs involves considering different market capitalizations (large cap vs. small cap) and investment styles (value vs. growth). This approach helps to balance risk and potential returns across various market segments.

Market capitalization. Large cap ETFs, such as the iShares S&P/TSX 60 Index Fund (XIU), offer stability and consistent dividends from established companies. Small cap ETFs, like the iShares S&P/TSX Small Cap Index Fund (XCS), provide exposure to potentially faster-growing companies with higher risk-reward profiles.

Investment styles. Value ETFs focus on companies perceived to be undervalued by the market, while growth ETFs target companies expected to grow faster than average. Combining these styles can help balance a portfolio across different economic cycles.

• Example ETF allocations:
  • Large cap value: 30%
  • Large cap growth: 20%
  • Small cap value: 15%
  • Small cap growth: 10%

4. Diversifying globally: International and emerging market ETFs

If you expect emerging market stocks to continue to clock such phenomenal returns, you are sure to be disappointed.

Geographic diversification. Investing in international and emerging market ETFs can help reduce portfolio risk by spreading investments across different economies and currencies. This approach can potentially enhance returns and provide a hedge against domestic market downturns.

Developed markets. ETFs tracking developed international markets, such as the iShares MSCI EAFE Index ETF (XIN), offer exposure to established economies in Europe, Australasia, and the Far East. These markets generally provide stability and moderate growth potential.

Emerging markets. ETFs focused on emerging markets, like the iShares MSCI Emerging Markets Index ETF (XEM), provide access to faster-growing economies such as China, India, and Brazil. While potentially offering higher returns, these investments also come with increased volatility and political risks.

• Factors to consider in global investing:
  • Currency risk
  • Political and economic stability
  • Market correlations with domestic investments
  • Relative valuations (P/E ratios) of different markets

5. Adding bonds, REITs, and commodities to your ETF portfolio

There isn't a single person who wouldn't love to own a few shopping malls, or some big office buildings, and collect thousands of dollars in rent month after month.

Asset class diversification. Incorporating bonds, Real Estate Investment Trusts (REITs), and commodities into an ETF portfolio can further enhance diversification and potentially improve risk-adjusted returns. These asset classes often have low correlations with stocks, providing portfolio stability during market downturns.

Bond ETFs. Fixed income ETFs, such as the iShares Core Canadian Universe Bond Index ETF (XBB), offer steady income and act as a buffer against stock market volatility. They can be categorized by duration (short-term, intermediate-term, long-term) and credit quality (government, investment-grade corporate, high-yield).

REIT ETFs. Real estate investment through ETFs like the BMO Equal Weight REITs Index ETF (ZRE) provides exposure to the real estate market without the complexities of direct property ownership. REITs often offer higher dividend yields compared to the broader stock market.

Commodity ETFs. ETFs tracking commodities such as gold, oil, or agricultural products can serve as inflation hedges and provide further portfolio diversification. However, these investments can be more volatile and may require careful consideration.

• Allocation considerations:
  • Bonds: 20-40% (depending on risk tolerance and age)
  • REITs: 5-10%
  • Commodities: 0-5% (optional)

6. Constructing and maintaining a balanced ETF portfolio

If you want to use all of your available options, you may be asking yourself which ETFs (and other investments) should get dibs on becoming retirement assets, and which are best deployed elsewhere?

Portfolio construction. Building a balanced ETF portfolio involves selecting a mix of asset classes that aligns with your investment goals, risk tolerance, and time horizon. The process typically starts with determining an appropriate stock-to-bond ratio, then further diversifying within each category.

Asset allocation. A common starting point for asset allocation is the "100 minus your age" rule, where the percentage invested in stocks equals 100 minus your age. However, this is just a guideline, and individual circumstances may warrant adjustments. Within each asset class, consider diversifying across different styles, sectors, and geographies.

Rebalancing. Regularly rebalancing your portfolio (e.g., annually) helps maintain your target asset allocation and can potentially improve returns by systematically buying low and selling high. This process involves selling portions of overperforming assets and buying underperforming ones to return to your target allocation.

• Key portfolio management steps:
  1. Determine overall asset allocation
  2. Select appropriate ETFs for each category
  3. Implement the portfolio
  4. Monitor and rebalance periodically

7. Using ETFs for retirement planning and income generation

If worse came to worst, do you have family or friends who would help you if you got in a real financial bind? If the answer is yes, you can add a tablespoon of risk.

Retirement planning. ETFs offer an effective tool for building and managing retirement savings. Their low costs and diversification benefits make them well-suited for long-term investing through registered accounts such as RRSPs and TFSAs.

Income generation. In retirement, ETFs can be used to create a steady income stream. Dividend-focused ETFs, bond ETFs, and REIT ETFs can all contribute to generating regular cash flow. The "4% rule" suggests withdrawing 4% of your portfolio value annually as a sustainable retirement income strategy, though this should be adjusted based on individual circumstances.

Tax considerations. Properly allocating ETFs between registered and non-registered accounts can help optimize tax efficiency. Generally, income-producing ETFs (bonds, REITs) are best held in tax-advantaged accounts, while growth-oriented equity ETFs may be suitable for non-registered accounts to take advantage of preferential capital gains tax treatment.

• Retirement portfolio strategies:
  • Gradually increase bond allocation as retirement approaches
  • Consider low-volatility equity ETFs for stability
  • Use dividend ETFs for income generation
  • Maintain some growth exposure for inflation protection

Last updated: August 17, 2024