Andrew Hallam is the index investor for Globe Investor's Strategy Lab. Follow his contributions hereand view his model portfolio here.
A portfolio of low-cost index funds is like a team of NHL superstars.
If history is any guide, every player on the indexing team is likely to perform better over the long term than 80 per cent of his professional peers: every goalie, every defender and every forward. Together, they make opposing teams shudder.
Low-cost index funds achieve such sterling performance because they're cheap. Over time, that cost advantage gives them a big step on the opposition – higher-cost, actively managed mutual funds. According to Allan Roth, who teaches investments and behavioural finance at the University of Denver, actively managed portfolios have only a 2-per-cent chance of keeping pace with a portfolio of indexes over 20 years.
But how do you know which indexes to buy, and how to position them?
Start with your defenders. They won't score like Sidney Crosby, but when the stock market is tossing bombs at your goal, you'll be thankful they're there.
The classic defenders tend to be bond index funds – compilations of loans that investors make to governments or corporations in return for regular interest payments. Conservative investors are especially fond of strong bond defenders.
A sound rule of thumb is to use your age as a benchmark for the proportion of bonds in your portfolio. A 30-year-old, for example, may wish to have 20 to 30 per cent of her money in bonds. A 60-year-old may opt for 50 to 60 per cent.
Age, however, isn't the only consideration. A 50-year-old police officer expecting a government pension could afford to take higher portfolio risks. She might settle for just 30 per cent in bonds, knowing that her pension is likely to provide steady income if the stock markets get scuttled.
If you're building a portfolio of exchange-traded index funds, Vanguard's short-term Canadian government bond ETF is a solid option. You can purchase it through any discount brokerage, and it might be the leanest, most muscular defender in the bond market camp, costing just 0.15 per cent each year in fees.
With your defence intact, put a gritty Canadian at the centre of your offensive line – and give him plenty of ice time. Vanguard's MSCI Canadian ETF is tough to beat. With a miserly annual cost of just 0.09 per cent, it will skate circles around most other Canadian stock market products.
On right wing, add an American player. Feared by most U.S. money managers, Vanguard's Total Stock Market ETF outperformed 78 per cent of actively managed U.S. large-cap funds over the past five years. Studies show that when actively managed American funds face off against the U.S. index, they usually underperform – and the odds of an active fund beating the market diminish with time. Costing just 0.06 per cent a year, Vanguard's total stock market ETF is poised to score points – for you, not for the financial services industry.
On left wing, play an international index. Give him similar ice time to the American player because Europe, Australia and the Far East have a combined market capitalization that's similar to the United States. In the quest for the biggest bang for your buck, consider Vanguard's MSCI EAFE international index, costing just 0.12 per cent a year.
For a wild-card entry, add a dash of emerging markets – but just a dash. These small, fast-growing economies are volatile, but can produce some pleasant surprises. Vanguard's MSCI Emerging Market Index costs less than half a percentage point each year and makes a worthy addition to the team.
For a 40-year-old investor, an all-star indexing lineup could look something like this: 40-per-cent Canadian bond market, 30-per-cent Canadian stocks, 15-per-cent U.S. stocks, 10-per-cent international stocks, with 5-per-cent emerging market exposure. Nobody knows where the world's stock and bond markets are headed over the next year, five or ten. But an indexed portfolio is likely to outclass most competitors, decade after decade.
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Andrew Hallam