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