Wood block ETFs for a solid portfolio

Posted on: January 3, 2012 in: Portfolio Strategies with 0 comments

It’s just days since Christmas and crisis! Two little boys, buried under wrapping paper, flit frantically from Beyblades to Wii to Lego. They collapse, overcome not by plastic fumes but by too much choice.

This could just as easily describe the world of exchange-traded funds, circa 2012. Early investors were happy with the ETF equivalent of a few wood blocks. Now there are over 1,600 ETFs, in every shape and color, some with triple-zoom, some virtually real.

The basic premise of ETFs is powerful: An efficient, low-cost way to invest in a broad, diversified set of stocks or bonds. With many ETFs you can almost ignore company-specific risk and focus instead on the one thing that matters most to your portfolio: asset allocation. The decision to invest X% in bonds and Y% in stocks and adjusting that to reflect economic conditions affects your portfolio more than picking, say, TD over CIBC.

However, the overwhelming growth in exotic ETFs means investors risk losing themselves in arcane ETF details at the expense of ignoring the big asset allocation decision.

Instead, when building your portfolio, first think carefully about economic conditions, then make your asset allocation decision and after that, head to the back of the store. That is where you will find a good selection of solid wood blocks. I’ve chosen a few of these that are TSX-listed – though there are many other good ones – with which to begin building a basic balanced ETF portfolio.

BROAD MARKET EQUITIES

Canadian Large-Cap Equities
iShares S&P TSX 60 (XIU/TSX)   
Fee: 0.17%          Balanced Allocation:      10 to 15%

XIU holds the 60 biggest Canadian companies, with 26% in banks. Its 36% allocation to energy and mining firms connects it closely to global economic growth and commodity demand, especially from emerging markets. Generally, that is a good thing if you don’t mind high but volatile growth. In a balanced portfolio, consider allocating between 10 and 15% to XIU. More conservative investors could opt for higher dividend, lower volatility ETFs like Claymore S&P/TSX Canadian Dividend ETF (CDZ/TSX).

 

U.S. Large-Cap Equity
iShares S&P 500 Hedged to C$ (XSP/TSX)             
Fee: 0.24%          Balanced Allocation:      10 to 15%

XSP invests in the 500 biggest U.S. firms. Many people are thoroughly pessimistic about the United States. There are some good reasons for that. But the fact remains that it is the world’s largest economy by far and is showing signs of economic renewal. XSP is more diversified than XIU, with info tech, financials and energy holding the biggest weights.

 

International Developed Market Large-Cap Equity
MSCI EAFE Index Fund Hedged to C$ (XIN/TSX) 
Fee: 0.50%          Balanced Allocation:      10 to 15%

The XIN invests in large developed markets like Britain, Germany, Japan and Australia. It is well-balanced across a range of sectors, with financials and industrials being the largest. Europe’s troubles have hit XIN hard this year. But XIN represents the largest share of the global economy. Its holdings are multinationals like Nestle and Shell. Watch your timing on entry but do not ignore XIN. On XIN’s currency hedge, it is only on U.S. dollar exposure and not the other currencies.

 

Emerging Market Large-Cap Equities
Vanguard MSCI Emerging Markets Index ETF (VEE/TSX)               
Fee: 0.49%          Balanced Allocation:      4 to 8%

Emerging markets performed terribly in 2011. But new pro-growth policies in most emerging markets should see a rebound in 2012. Longer term, emerging markets are the drivers of global economic growth and investors would do well to have some exposure, even if it comes with higher volatility. Be sure to adjust exposure in response to global economic trends. Emerging market growth drives commodity prices but this will change as these economies develop. The VEE ETF has just been listed in Canada but it is based on Vanguard’s comparable U.S. product, which has offered bargain-priced emerging market exposure for years.

 

FIXED INCOME

iShares DEX Universe Bond Index   (XBB/TSX)   
Fee: 0.30%          Balanced Allocation: 40 to 60%

Compared to individual bonds, bond ETFs are more liquid and have a constant time to maturity. They also benefit from better bid/ask spreads. XBB holds a mix of Canadian government and quality corporate bonds with a maturity of about 10 years. If you believe interest rates will rise soon, you would want an ETF with a shorter maturity like iShares XSB/TSX, or, if vice versa, iShares XLB/TSX. Alternatively, you might split your allocation across all three.

SECTOR-SPECIFIC EQUITIES

ETFs that focus on a specific sector have proliferated in recent years. Two issues with them: they are more micro than macro and they have more company-specific risk than the wood block ETFs. The better ones minimize these effects but still, they should be used judiciously and only as part of a diversified portfolio. A couple to consider are: the BMO Equal Weight REITs ETF (ZRE/TSX) with high dividends and lower volatility; the iShares S&P/TSX Capped Energy ETF (XEG/TSX) is more volatile but does well when commodities rally. For both of these, limit allocations to about 6%.

 

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