This post is about your investment portfolio. Which funds you hold, what percentages and what account you will put them in.
One objective of these blog posts is to provide a simple reference for saving and investing for retirement. I want to take much of the available information on the internet and simplify it so that it is can serve as concise reference material. Often when you do that much of the background information that goes into determining the best saving and investing strategy may be lost, but I don't want that to happen. I will structure this blog post to begin with the basics and providing more detail later on in this post and the subsequent one.
Let be clear. I want you to save fees on your investments, by investing in low fee, Index ETFs inside a self-directed account, that includes an RRSP, TFSA and possible a Taxable account. If you go to a bank or an investment company, they will sell you mutual funds that may have as MER (management expense ratio) of over 2%. They take 2% of your account balance each and every year. Think about that. That means over 30 years they will take over 60% of YOUR investment balance. Another way to think of this is that if you are counting on 5% return on your portfolio, then if you loose 2% to fees, you will need to save 67% more money to have the same income in retirement. That's a big deal.
The supporters of these high fee mutual funds will tell you the fee is worth it to have an actively managed fund so that it outperforms the market (the Index). But, it has been shown that most funds under-perform the benchmark Index to their fund class. Also, many of the mutual funds with high fees are simply closet index funds, which track the index, less of course their high fee.
I will have 4 sections as follows. The first two are in this post, and the second two are in the subsequent post.
1. What I Use. This will summarize what I am use without providing much supporting information.
2. Basis. Much of this section will be explanation of why I selected what I did and references to other, more qualified recommendations.
3. Alternatives. This section will provide alternatives, such as different percentages or choices of funds.
4. Complications. Sometimes things seem so simple on the surface. While we need to make sure we keep our overall objectives clear and simple, there are still complicating factors (usually from tax considerations). Those that I have discovered will be presented in this section.
All the investment products I use are ETFs, so I just need to decide which ETFs to hold, what percentage of each and what accounts to put them in.
What I Use
I hold ETFs in the following percentages by class. I have also listed which specific ETF I hold in these classes.
25% Bonds - ETF symbol XBB, iShares Canadian Universe Bond Index ETF
30% Canadian stocks - ETF symbol XIU, iShares S&P/TSX 60 Index
30% US stocks - ETF symbol XSP, iShares Core S&P 500 Index ETF (CAD-Hedged)
15% International stocks - ETF symbol XIN, iShares MSCI EAFE Index ETF (CAD-Hedged)
You may see that some other recommended weightings for a portfolio will have an equal weight to each of the three equity classes of Canadian, US and International stocks. I have chosen to underweight the International stocks relative to the Canadian and US ones. I have seen that the Canadian and US markets outperform the international ones as a whole. Also the tax treatment of XIN is not as advantageous as XSP or XIU.
You will also note that my US and International funds are hedged, so that there is no currency risk. Since I put together this portfolio over 3 years ago I have done some reading that would convince me not to hedge these classes. More on this later.
The following shows my portfolio (in the iShares hedged column), listing the ETF symbols along with some other valid alternative portfolios. Click on the ETF symbol for a link to the respective companies' webpage on the fund. I don't think you can go wrong with any of these, they will all provide similar investment returns.
The hedged portfolios have the currency hedged in the US and International ETF, so there will be no change in value if the canadian dollar changes. The US/Intl combined portfolio replaces the 2 US and International ETFs with one. This reduces the number of funds you have to manage in your accounts, but may not be optimal from an after tax point of view.
Which funds in which account? Each of these funds pay dividends or interest income (either quarterly or monthly). The ones with the highest amount of tax for this income are the ones you want to have in your tax advantaged accounts (RRSP and TFSA). The classes sorted by highest to lowest taxable income is Bond, International, US and then Canadian. Which ones you have in which account will depend on what percentage of your overall investment portfolio is in the tax advantaged accounts. Just remember that you want them protected in the order listed. I'll come back to this in more detail in post #9.
I hold ETFs in the following percentages by class. I have also listed which specific ETF I hold in these classes.
25% Bonds - ETF symbol XBB, iShares Canadian Universe Bond Index ETF
30% Canadian stocks - ETF symbol XIU, iShares S&P/TSX 60 Index
30% US stocks - ETF symbol XSP, iShares Core S&P 500 Index ETF (CAD-Hedged)
15% International stocks - ETF symbol XIN, iShares MSCI EAFE Index ETF (CAD-Hedged)
You may see that some other recommended weightings for a portfolio will have an equal weight to each of the three equity classes of Canadian, US and International stocks. I have chosen to underweight the International stocks relative to the Canadian and US ones. I have seen that the Canadian and US markets outperform the international ones as a whole. Also the tax treatment of XIN is not as advantageous as XSP or XIU.
This link is to the article by Vikash Jain in the Financial Post on which I based this portfolio. Tune out the noise with ETFs.
You will also note that my US and International funds are hedged, so that there is no currency risk. Since I put together this portfolio over 3 years ago I have done some reading that would convince me not to hedge these classes. More on this later.
The following shows my portfolio (in the iShares hedged column), listing the ETF symbols along with some other valid alternative portfolios. Click on the ETF symbol for a link to the respective companies' webpage on the fund. I don't think you can go wrong with any of these, they will all provide similar investment returns.
The hedged portfolios have the currency hedged in the US and International ETF, so there will be no change in value if the canadian dollar changes. The US/Intl combined portfolio replaces the 2 US and International ETFs with one. This reduces the number of funds you have to manage in your accounts, but may not be optimal from an after tax point of view.
| Class | Share | iShares | iShares | iShares | BMO | BMO | ||
| (%) | hedged | un- | US/Intl | hedged | un- | |||
| (mine) | hedged | combined | hedged | |||||
| Bond | 25 | XBB | XBB | XBB | ZAG | ZAG | ||
| Canadian | 30 | XIU | XIC | XIC | ZCN | ZCN | ||
| US | 30 | XSP | XUU | XAW | ZUE | ZSP | ||
| International | 15 | XIN | XEF | XAW | ZDM | ZEA | ||
Which funds in which account? Each of these funds pay dividends or interest income (either quarterly or monthly). The ones with the highest amount of tax for this income are the ones you want to have in your tax advantaged accounts (RRSP and TFSA). The classes sorted by highest to lowest taxable income is Bond, International, US and then Canadian. Which ones you have in which account will depend on what percentage of your overall investment portfolio is in the tax advantaged accounts. Just remember that you want them protected in the order listed. I'll come back to this in more detail in post #9.
I am happy the portfolio discussed here. However, if you are interested in more details, then please read on.
The proof is in the pudding?
Basis
The ETFs I've listed above all track a particular index. We are just trying to get the average return that the stock market and bond market will give us. This probably brings up some questions, so lets answer those now.
Does investing in ETFs that track indices really work?
Many people seem to think so. Also, here's a paper on the topic. http://www.rickferri.com/WhitePaper.pdf
Why not buy specific stocks?
These ETFs hold many stocks. If you were to buy as many stocks as these hold you would find the transaction fees to get out of hand. The XSP holds 500 different stocks, so instead of making a single trade for $10, you would have to make 500 trades at a cost of $5000. There are fees to run the ETF fund, but it is very small. The XSP MER is 0.20% which is much cheaper than having to make all the purchases yourself.
These ETFs hold many stocks. If you were to buy as many stocks as these hold you would find the transaction fees to get out of hand. The XSP holds 500 different stocks, so instead of making a single trade for $10, you would have to make 500 trades at a cost of $5000. There are fees to run the ETF fund, but it is very small. The XSP MER is 0.20% which is much cheaper than having to make all the purchases yourself.
Why not buy specific stocks, but make sure to just buy the best ones?
That's known as stock picking. Here are a number of good articles on why you will most likely not be able to beat the market. Remember that 80% of professional stock pickers, aka mutual fund managers, can't beat the market.
Michael James tips on stock picking.
http://www.michaeljamesonmoney.com/2015/01/the-stock-pickers-checklist.html
Read Jim Collins part III of his stock series.
http://jlcollinsnh.com/2012/04/25/stocks-part-iii-most-people-lose-money-in-the-market/
But I think I can invest in just the best stocks like Warren Buffett?
Warren Buffett thinks you should invest in Index funds. Here's Michael James' summary on how Warren Buffett thinks you should invest.
http://www.michaeljamesonmoney.com/2015/03/how-warren-buffett-thinks-you-should.html
That's known as stock picking. Here are a number of good articles on why you will most likely not be able to beat the market. Remember that 80% of professional stock pickers, aka mutual fund managers, can't beat the market.
Michael James tips on stock picking.
http://www.michaeljamesonmoney.com/2015/01/the-stock-pickers-checklist.html
Read Jim Collins part III of his stock series.
http://jlcollinsnh.com/2012/04/25/stocks-part-iii-most-people-lose-money-in-the-market/
But I think I can invest in just the best stocks like Warren Buffett?
Warren Buffett thinks you should invest in Index funds. Here's Michael James' summary on how Warren Buffett thinks you should invest.
http://www.michaeljamesonmoney.com/2015/03/how-warren-buffett-thinks-you-should.html
Why not use mutual funds?
They cost too much. There are mutual funds that try to follow particular stock indices but the MER on these is higher than you will find for ETFs. Actively managed mutual funds try to beat the market, but have high MER fees and most of the time can't beat the market.
Article on actively managed mutual funds. It contains references to the statistics on how many actively managed funds beat the indices. http://whitecoatinvestor.com/people-still-believe-in-active-management/
They cost too much. There are mutual funds that try to follow particular stock indices but the MER on these is higher than you will find for ETFs. Actively managed mutual funds try to beat the market, but have high MER fees and most of the time can't beat the market.
Article on actively managed mutual funds. It contains references to the statistics on how many actively managed funds beat the indices. http://whitecoatinvestor.com/people-still-believe-in-active-management/
Here's an article at Boomer & Echo that presents a comparison of returns for index mutual funds vs actively managed mutual funds. The Index funds win!
http://www.boomerandecho.com/how-index-funds-compare-to-equity-mutual-funds/
Stock markets are risky. Why not just buy GICs?
Yes the stock market can go up and down, but over the long run it has always gone up. Over the long run the US stock market has averaged a 7% rate of return. We are saving for our retirement which is a long term proposition so we shouldn't be concerned with short term drops in the stock market if it will make us a decent return in the long run. GICs are just a way for the bank to steal our money. They do guarantee the principle amount, but interest rates on GICs now are less than inflation so you are actually losing money. On top of all that the interest is fully taxable (unless you have it in your RRSP or TFSA), whereas most of the return from stocks is in the form of capital gains which are only taxed half as much as interest and are not taxed until you sell the ETF, which might be in retirement.
Yes the stock market can go up and down, but over the long run it has always gone up. Over the long run the US stock market has averaged a 7% rate of return. We are saving for our retirement which is a long term proposition so we shouldn't be concerned with short term drops in the stock market if it will make us a decent return in the long run. GICs are just a way for the bank to steal our money. They do guarantee the principle amount, but interest rates on GICs now are less than inflation so you are actually losing money. On top of all that the interest is fully taxable (unless you have it in your RRSP or TFSA), whereas most of the return from stocks is in the form of capital gains which are only taxed half as much as interest and are not taxed until you sell the ETF, which might be in retirement.
Why not a single balanced fund?
Balanced funds are a mixture of stocks and bonds. Bonds return essentially all of their return as interest income and stocks is mostly capital gains, you actually want to use these in your different account types. You'll see later that I want to have the bonds in a tax deferred account (RRSP) and stocks in the Taxable account. If you mix bonds and stocks into the same ETF then you can't make that distinction.
I think the tax reason is one of the most important, however here are another Five Reasons to Stay Away From Balanced Funds from the Financial Post.
Why not start with low cost index mutual funds and switch to ETFs later?
This is definitely a strategy that you could undertake. When you start out saving and are saving small amounts, purchasing mutual funds will be slightly cheaper than ETFs, but the savings are very small. You will see in post #9 where I lay out the saving and purchasing of ETFs, that there are very little transaction costs.
If you hold mutual funds in your Taxable account for some time, there will be unrealized capital gains. When you go to sell these and switch to ETFs you will realize those gains and have to pay tax on them. You would rather keep those taxes, invest them and then pay the tax during retirement.
I prefer to stick to the same funds, hold them as long as possible and defer any capital gains tax.
Of course, switching funds in your RRSP or TFSA has no tax consequences.
Balanced funds are a mixture of stocks and bonds. Bonds return essentially all of their return as interest income and stocks is mostly capital gains, you actually want to use these in your different account types. You'll see later that I want to have the bonds in a tax deferred account (RRSP) and stocks in the Taxable account. If you mix bonds and stocks into the same ETF then you can't make that distinction.
I think the tax reason is one of the most important, however here are another Five Reasons to Stay Away From Balanced Funds from the Financial Post.
Why not start with low cost index mutual funds and switch to ETFs later?
This is definitely a strategy that you could undertake. When you start out saving and are saving small amounts, purchasing mutual funds will be slightly cheaper than ETFs, but the savings are very small. You will see in post #9 where I lay out the saving and purchasing of ETFs, that there are very little transaction costs.
If you hold mutual funds in your Taxable account for some time, there will be unrealized capital gains. When you go to sell these and switch to ETFs you will realize those gains and have to pay tax on them. You would rather keep those taxes, invest them and then pay the tax during retirement.
I prefer to stick to the same funds, hold them as long as possible and defer any capital gains tax.
Of course, switching funds in your RRSP or TFSA has no tax consequences.
How about other types of investments such as real estate?
- Rental properties.
- Real estate speculation.
- Investments with firms or funds that sell actively managed mutual funds.
- Whole life insurance.
- Insurance firms investment products (annuities).
Disclaimer: These posts are not fully comprehensive financial advice. You should seek your own qualified investment, tax and legal advice.
Why not VCN for Canadian stocks?
ReplyDelete