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Building a solid portfolio foundation to survive a market slide

Sound investment portfolios are not built on the fear caused by a rotten week for the stock markets.

Individual investors are best served by developing a personalized blueprint that mixes stocks, bonds and cash, and then finding investments to act as building blocks. If you've got the right blend of assets and some solid stocks or funds, you've done all you can to prepare for market declines.

There's no simpler tool for building portfolios than exchange-traded funds, which are low-cost index-tracking securities that trade like stocks. The only major hitch is a proliferation of products that has created dozens of choices in areas such as Canadian stocks and bonds.

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To help investors cut the clutter, the investment firm National Bank Financial has created a select group of ETF picks that can be arranged in various ways to suit both conservative investors who are wary of the stock markets and aggressive investors.

Pat Chiefalo, an analyst at NBF, describes the research as "a quick tool of reference for people who want to start using ETFs in a portfolio setting."

His first step was to create a list of the TSX-ranked ETFs that scored best using four criteria - liquidity, performance, cost and diversification. Mr. Chiefalo's thinking with liquidity, or the volume of trading, is that it's preferable to own investments of any type that are actively traded. To find liquid ETFs, he looked at three-month average daily trading volumes, and he also considered the size of an ETF. It's a rough rule that bigger ETFs tend to trade more.

His look at performance began with the idea that ETFs are a low-cost vehicle for investing directly into stock and bond indexes, and an alternative to either choosing your own securities or buying a professionally managed mutual fund. Because the return you get from an ETF should be what the index makes minus fees, there's no point in comparing all ETFs by their overall historic returns. Rather, the question is how well an ETF's returns match up against its underlying index.

Mr. Chiefalo evaluated ETF performance by looking at what's known as tracking error, or the extent to which a fund deviates from index returns minus fees. Strictly speaking, any kind of deviation - up or down - represents tracking error. However, the National Bank screening process favoured ETFs with returns that came in higher than expected.

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Cost differences between ETFs were measured in two ways, the first being management expense ratio, or MER.

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ETFs have a huge cost advantage over mutual funds in terms of their MERs, but Mr. Chiefalo said there are significant differences between ETFs themselves. "The difference is much smaller, but you're still giving up return every time you spend extra on management fees."

The other cost factor relates to what's known as the bid-ask spread, or the difference between buyers that are bidding for a stock or ETF and what sellers are asking. The ideal ETF would have only a tiny spread of a couple of cents, which means you could theoretically buy without having to pay a premium over the market price of the moment, and sell without having to take a hit on price.

Diversification, the final selection criteria, looked at the total number of holdings in an ETF, and the top 10 holdings themselves. ETFs with the largest number of total holdings were favoured, as were those where the 10 largest holdings didn't overshadow everything else. The idea here is to limit the damage to the ETF if one or two particular holdings go bad.

The final ETF list compiled by Mr. Chiefalo included 16 funds in six categories: Canadian, U.S. and international equity, Canadian fixed income, real return bonds and alternative investments, which in this case means real estate. ETFs from the market-leading iShares family dominate the National Bank selections, but Claymore and BMO funds are well represented, too.

For simplicity's sake, Mr. Chiefalo limited this exercise to core investment categories and left out both sub-categories such as small stocks and individual sectors. Actively managed ETFs were also excluded (read more about them here: http://tgam.ca/Kdh), as were inverse and leveraged ETFs, which allow more sophisticated investors to profit from both up and down markets.

To help investors make use of the final ETF list, Mr. Chiefalo created asset mixes for five different investor profiles - income, conservative, balanced, growth and maximum growth. These profiles are merely suggestions. You can compare them to other suggested mixes and adjust them, or develop your own. The point is to find your ideal mix, and then use the list of selected ETFs as building blocks.

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Periodic rebalancing is required once you've built your portfolio, which means that twice a year or so you must sell some of your best-performing ETFs and use the proceeds to buy more of your biggest decliners. The goal: bring your mix of assets back to your original blueprint. Expect to pay a minimum of $5 to $29 per trade at an online broker.

Rebalancing in the kind of market craziness we saw Thursday is never a good idea, mind you. In fact, two TSX-listed ETFs, the iShares Dow Jones Canada Select Dividend Index Fund and iShares S&P/TSX Capped REIT Index Fund, fell far more than their underlying stocks at one point, in theory handing sellers a bigger loss than they should have sustained.

The National Bank Financial select ETF list is a great simplifier for portfolio-building, but there are even easier-to-use tools available. They're called asset allocation ETFs and they're basically groupings of funds that are tailored to specific investor needs. Here are the four TSX-listed ETFs in this category:

  • Claymore Balanced Income CorePortfolio ETF (CBD) Includes 11 underlying ETFs, targets a roughly even split between stocks and bonds.
  • Claymore Balanced Growth CorePortfolio ETF (CBN) Includes 15 ETFs with a target asset mix of 75 to 85 per cent stocks and the rest in bonds.
  • iShares Conservative Core Portfolio Builder Fund (XCR) Contains 16 ETFs listed on the TSX and NYSE, has about 80 per cent of its assets in bonds.
  • iShares Growth Core Portfolio Builder Fund (XGR) Contains 21 ETFs that provide exposure to bonds, stocks, commodities and real estate through real estate investment trusts; the bond weighting is about 64 per cent, but it's aggressive enough to include a portion in emerging markets bonds.

Mr. Chiefalo said these asset allocation ETFs provide a reasonably priced alternative to a build-it-yourself portfolio, with one reservation. There are only two asset mixes available from both iShares and Claymore, and they may not suit some investors.

We're in an especially challenging time for investors right now because stocks are weakening at a time when the expectation of rising interest rates is weighing on the outlook for bonds. And yet, bonds showed this week that they still provide a usual safe refuge from falling stocks. Where should you be and what should you do? The properly designed portfolio answers all questions.

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National Bank Financial has simplified the process of ETF investing by creating some asset mixes for different kinds of investors, and a list of exchange-traded funds to use in building these portfolios.

Step One: Choose an Asset Mix

Percentage %

Max

Income

Conservative

Balanced

Growth

Growth

Equities

22

38

48

60

70

Canadian

11

23

29

31

30

U.S.

6

9

11

17

22

Foreign

5

6

8

12

18

Fixed Income

68

58

43

30

15

Cdn Bonds

51

43.5

32.2

22.5

11.2

Real Return Bonds

17

14.5

10.8

7.5

3.8

Alt. Investments

0

0

5

10

15

Real estate

0

0

2.5

5

7.5

Other*

0

0

2.5

5

7.5

Cash

10

4

4

0

0

Note: NBF's model portfolios call for hedge funds to be partnered with real estate in the "other" category. Since there is no hedge fund ETF, NBF advises that investors can substitute exposure to commodities or double up on real estate.

Step Two: Choose Your ETF From the NBF select list

Reported

ETF

Ticker

Fee*

Canadian Equity

iShares S&P/TSX Capped Composite Index Fund

XIC

0.25

iShares S&P/TSX 60 Index Fund

XIU

0.17

BMO Dow Jones Canada Titans 60 Index ETF

ZCN

0.15

Claymore Canadian Fundamental Index ETF

CRQ

0.65

U.S. Equity

iShares S&P 500 Index Fund (CAD-hedged)

XSP

0.24

Claymore U.S. Fundamental Index ETF - C$ Hedged

CLU

0.65

BMO U.S. Equity Hedged to CAD Index ETF

ZUE

0.22

BMO Dow Jones Industrial Avg Hedged to CAD Index ETF

ZDJ

0.23

International Equity

iShares MSCI EAFE Index Fund (CAD-Hedged)

XIN

0.49

BMO International Equity Hedged to CAD Index ETF

ZDM

0.46

Claymore International Fundamental Index ETF

CIE

0.65

Fixed Income

iShares DEX Universe Bond Index Fund

XBB

0.3

BMO Aggregate Bond Index ETF

ZAG

0.28

Claymore Advantaged Canadian Bond ETF

CAB

0.3

Real Return Bonds

iShares DEX Universe Bond Index Fund

XRB

0.35

Alternative Investments

iShares S&P/TSX Capped REIT Index Fund

XRE

0.55

Note: NBF says all ETFs on its list are suitable for the average retail investor. The higher an ETF places on this list, the better its score in the firm's ranking process.

*Refers to management fees only. The full cost of owning these ETFs will be incrementally higher.

Step Three: Build Your Portfolio (let's try the conservative approach)

iShares S&P/TSX Capped Composite Index Fund

23%

Claymore U.S. Fundamental Index ETF - C$ Hedged

9%

BMO International Equity Hedged to CAD Index ETF

6%

Total stocks

38%

BMO Aggregate Bond Index ETF

43.50%

iShares DEX Universe Bond Index Fund

14.50%

Total bonds

58%

Total cash

4%

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About the Author
Personal Finance Columnist

Rob Carrick has been writing about personal finance, business and economics for close to 20 years. He joined The Globe and Mail in late 1996 as an investment reporter and has been personal finance columnist since November 1998.Rob's personal finance columns appear in The Globe on Tuesday and Thursday, and his Portfolio Strategy column for investors appears on Saturday. More

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