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Gail Bebee is a Personal Finance Author and Speaker. (Tory Zimmerman/The Globe and Mail)
Gail Bebee is a Personal Finance Author and Speaker. (Tory Zimmerman/The Globe and Mail)

New to direct investing? Part 4

ETFs: easy, tax-efficient funds Add to ...

Gail Bebee is the author of No Hype - The Straight Goods on Investing Your Money. She can be reached at gbebee@gailbebee.com; her website is www.gailbebee.com. This is part four of a 12-part series for people that are new to investing on their own.

It began with a simple idea. Why not create a fund which would replicate the performance of the 35 companies in the TSE 35 Index and trade on the exchange? And so, the first exchange-traded fund (ETF), called Toronto Index Participation Shares or TIPS, was launched on the Toronto Stock Exchange in 1990.

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New to direct investing? The series

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Today, ETFs are one of the fastest growing investment products globally. And why not? These products offer investors many attractive features:

• Easy diversification and asset allocation, even for relatively small portfolios,

• Better returns over the long term than most mutual funds. To wit, as of mid-year, 2009, only 7.6% of active Canadian equity funds outperformed the S&P/TSX Composite Index over the five-year period.

• Lower fees than equivalent mutual funds. According to a Morningstar study published earlier this year, the typical Canadian equity fund charges a Management Expense Ratio (MER) of between 2.00% and 2.50%. MERs for equity ETFs that track established indices are virtually all less than 0.75%.

• More tax-efficient than mutual funds - fewer capital gains distributions, so there's less tax to pay.

• Easy to buy and sell - ETFs are listed on stock exchanges and can be bought and sold like stocks whenever the stock exchange is open.

• An efficient way to meet the needs of buy and hold and time-pressed investors.



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In Canada, there are currently over 100 exchange traded funds covering all the major asset classes and beyond. The four Canadian ETF suppliers are: industry leader Barclays Global Investors which owns the iShares™ brand, Claymore Investments, Horizons ETFs and Bank of Montreal. South of the border, over 700 American-domiciled ETFs were available at the end of 2008 . Unlike U.S. mutual funds, these ETFs can be purchased in Canada.

Those new to direct investing would be well-advised to stick to plain vanilla ETFs which track well-established indices and leave the more exotic funds such as the leveraged ETFs offered by Horizons ETFs to more experienced investors. With this in mind, here are my thoughts on the various ways direct investors can use ETFs to add value to their portfolios.

For parking cash, there's Claymore's Premium Money Market ETF . With a management fee of 0.25% it's more than competitive with money market mutual funds. However, you pay a commission to buy and sell units, so your purchase needs to be large enough and held long enough to amortize these costs.

For an all-in-one investment solution using ETFs, direct investors can buy the iShares™ and Claymore ETF portfolios that I discussed in Part 2 of this series.

Using only ETFs, you can build a complete investment portfolio to match your personal risk profile. Some discount brokers even walk you through the process. At BMO Investorline, clients complete an asset allocator quiz to define their risk profile and then choose an ETF model portfolio which best matches their risk tolerance. The six portfolios range from income to aggressive growth. RBC Direct Investing includes ETF model portfolios for four different risk profiles in their online educational material for clients. Visitors to Claymore Investments' web site can view five sample portfolios constructed, as you would expect, from Claymore ETFs.

With a bit of research, you can put together your own customized ETF portfolio once you decide on an overall investment plan. Here's an example of an all ETF portfolio which balances risk between safer fixed income and higher risk-higher reward investments:

Asset class

Allocation %

ETF

MER, %

Cash

5

Claymore Premium Money Market ETF (CMR)

0.25

Fixed income

25

iShares™ CDN Bond Index Fund (XBB)

0.30

Fixed income-Inflation protection

10

iShares™ CDN Real Return Bond Index Fund (XRB)

0.35

Preferred shares

10

Claymore S&P/TSX CDN Preferred Share ETF (CPD)

0.45

Canadian equities

20

BMO Dow Jones Canada Titans 60 Index ETF (BCA)

0.158

U.S. equities

15

iShares™ CDN S&P 500 Hedged to Canadian Dollars Index (XSP)

0.24

International equities

10

Claymore International Fundamental Index ETF (CIE)

0.65

Real estate

5

iShares™ Canadian REIT Sector Index Fund (XRE)

0.55

Of course, you don't need to have an ETF-only portfolio. You can use these funds to gain targeted exposure to specific geographic or market sectors or investing styles. For example, to buy Canadian real estate (without actually owning the bricks and mortar), you could purchase the iShares™ Canadian REIT Sector Index Fund and own a piece of all the major real estate investment trust companies in Canada. If you want to invest only in companies which meet certain performance levels for metrics such as total cash dividends or sales, an ETF tracking a fundamental index could be the answer. Claymore Investments offers a series of ETFs based on this approach.

Exchange-traded funds are a valuable financial innovation. I believe they have a place in the portfolio of virtually all investors. As with any investment, it's buyer beware. Do your homework and reap the rewards of these easy to buy, low-cost, tax-efficient investment products.

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