Building a basic portfolio using ETFs

A traditional balanced portfolio asset mix holds 60% stocks and 40% bonds. Your initial portfolio planning might use that mix as a starting point — let your own situation guide you from there. As we mentioned, a higher allocation to stocks will create a more aggressive portfolio. This means greater potential for growth but also a greater chance of portfolio volatility — volatility is typically measured by the degree of price fluctuation. With the 60/40 asset mix as a starting point, you might be comfortable being more or less aggressive. Always do a reality check to make sure your circumstances match your psychological comfort level. In other words, you have to be both emotionally comfortable with volatility and your circumstances have to be able to accommodate a riskier, more volatile portfolio if that’s what you choose. If the answer is yes, you may want to start with a higher allocation to equities. Those with a short time horizon or uneasiness around volatility might consider a higher allocation to bonds.

After zeroing in on target asset mix percentages, the next step is to research and select ETFs. With over 1,300 ETFs in Canada to choose from, many investors simply won’t have the time, interest or patience to research all possible choices. A basic strategy that simplifies your options is to focus on Index ETFs. Specifically, focus on those Index ETFs that represent the two main asset classes: stocks and fixed income. You might consider further breaking down the stock allocation into Index ETFs that target Canadian stocks, U.S. stocks and international stocks.

An index ETF tracks the performance of a specific market benchmark or index as closely as possible. To accomplish this, the fund's manager buys all (or a representative sample) of the stocks or bonds in the index it’s tracking and then updates and maintains the Index ETF over time. Some index funds may also use derivatives, such as options or futures, to help achieve their investment objective.

Since the makeup of most indexes changes from time-to-time, the fund manager of the Index ETF will monitor the changes and update the ETF when necessary. There are two common reasons for index changes. The first is to reflect corporate events, like takeovers or bankruptcies, that might mean a company is no longer public or no longer trading. The second is to adjust the index composition so companies that best reflect the current economy remain, and less relevant companies are replaced.

Index ETFs offer a way to invest in a broad range of companies and track the market without needing to be an expert in picking many individual investments. These ETFs are typically offered at a relatively low cost because they don’t require active stock picking. Because they provide instant diversification along with low fees, they offer the convenience of a one-stop-shop to begin portfolio building.

The cost of a well-diversified ETF that tracks the broad Canadian equity market will typically be around 5 or 6 basis points annually; note that this is 0.05 to 0.06%, not 5 to 6%. U.S. equity index ETF fees may be a little higher, while international equity index ETF fees are often in the 20-25 basis point range. This fee, known as the Management Expense Ratio (MER) is built into the price of the ETF — you won’t see it as a separate charge. However, it will likely slightly lower the performance of the Index ETF fund versus the Index itself. To check the MER for any fund you’re considering, look at the ETF description, where the MER is almost always prominently displayed.

There are 2 paths to consider:

1. Select an Asset Allocation ETF, also known as a Balanced ETF, which has allocations to stocks and bonds in a single ETF. There are many Asset Allocation ETFs available, so it’s relatively simple to find one with asset mix percentages that match or approximate your chosen target asset mix. This option may require less research but may not exactly match your asset mix preferences. If you’d like to further fine-tune, consider Option 2.
2. Choose individual ETFs for each asset class you want to include and, based on your target asset mix, invest the calculated percent in each ETF type. This lets you hit the target asset mix percentage more precisely.

Be sure to use Investor’s Edge ETF screener, which lets you pick your criteria and easily filter through hundreds of ETFs to find choices that meet your specifications.

Once you’ve chosen your Asset Allocation ETF or created your portfolio, the asset mix will need periodic rebalancing. You need to do this because the gains in some ETFs will outshine other ETFs, and these portfolio stars will become larger portions of your asset mix over time. What starts as a portfolio with 60% stocks and 40% bonds can easily drift to become a portfolio with 70% stocks and 30% bonds when stock prices are gaining steadily and bond prices are declining. Of course, the opposite can also occur, when bonds are doing well and stocks are declining.

If you invest in an Asset Allocation ETF rather than choosing Index ETFs yourself, the ETF fund manager will monitor the asset mix and periodically rebalance the fund to maintain the stated asset mix percentages. If your circumstances change and you feel a different asset mix is more appropriate for you, the solution is quite straightforward. You’ll sell your current Asset Allocation ETF and buy another that reflects the new asset mix percentage.

Typically, the fees for Asset Allocation ETFs are higher than a similar blended portfolio of Index ETFs that you select. Some investors find the convenience of having a manager rebalance the portfolio worth the higher fees — this is a choice you’ll have to make yourself.

As mentioned, with individual ETFs there will come a point where you’ll have to sell some holdings to decrease their size in the portfolio and buy others to maintain your target asset percentage mix. It makes sense to consider rebalancing regularly, perhaps monthly or annually, or when the portfolio strays from a target mix percentage by a certain predetermined amount, perhaps 7 to 10%.

Rebalancing will mean selling some of the “winning” assets and buying more of the “losing” assets. Some investors may find it psychologically difficult to sell some of their best performers and buy more of the laggards to get back to 60/40, but it’s a necessary step to maintain your target asset mix percentage. This strategy also allows you to potentially lower your cost basis, as you’re generally buying some of the lagging asset group at a lower average price and selling some of the outperforming group at a higher average price.

Once you’ve created a basic ETF portfolio, there are other ETFs available that can address more specific investor needs or interests. Some of these will give you specific exposure to subsets of an asset class. For example, there are fixed income ETFs that target emerging market debt, U.S. investment grade corporate debt or even Canadian floating rate notes. Other ETFs address particular interests or investing segments; ESG-focused ETFs are one currently popular example. There are also a wide range of ETFs that focus on industry groups — gold stocks, financial stocks and many others — or specific country ETFs.

We’ll consider these options in more detail in Fine-tuning your portfolio using ETFs.