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For a taste of the action, consider the move this spring by BlackRock to cut the management fee on its flagship iShares Core S&P/TSX Capped Composite Index ETF (XIC) from 25 basis points to 5 basis points. Sure, the company was trying to protect its dominant position in the market, but a cut is a cut. (Yong Hian Lim/Getty Images/iStockphoto)
For a taste of the action, consider the move this spring by BlackRock to cut the management fee on its flagship iShares Core S&P/TSX Capped Composite Index ETF (XIC) from 25 basis points to 5 basis points. Sure, the company was trying to protect its dominant position in the market, but a cut is a cut. (Yong Hian Lim/Getty Images/iStockphoto)

Strategy Lab

Value investors, build a portfolio of three dirt-cheap ETFs Add to ...

Norman Rothery is the value investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

Index investors are partying like it’s 1999. The bull market is giving them reason to cheer, and fund companies are slashing their fees. It’s now easy to build a portfolio stuffed full of dirt-cheap exchange traded funds (ETFs).

For a taste of the action, consider the move this spring by BlackRock to cut the management fee on its flagship iShares Core S&P/TSX Capped Composite Index ETF (XIC) from 25 basis points to 5 basis points. Sure, the company was trying to protect its dominant position in the market, but a cut is a cut.

Not to be outdone, the Bank of Montreal quickly reduced the management fee on its S&P/TSX Capped Composite ETF (ZCN), a very similar product, from 15 basis points to 5 basis points.

I love the smell of competition in the morning. But the big firms aren’t duking it out as much when it comes to the niche value-oriented funds I like.

I’m particularity attracted to index funds that focus on small value stocks because many academic studies suggest they tend to beat the market over the long term.

Professors Eugene Fama and Kenneth French published a famous paper on the subject in 1993. They observed that returns vary depending on a portfolio’s beta, size, and value characteristics. Small stocks tend to outperform large stocks. Value stocks, with high book-value-to-price ratios, tend to outperform more glamorous stocks with low ratios.

Both professors sit on the board of directors of Dimensional Fund Advisors (DFA), which is a large money manager. So, it should come as no surprise that the firm uses their research to run funds that try to capture the premium offered by small value stocks. Problem is, in Canada, you can only buy DFA funds through an approved advisor, which is less than ideal for self-directed investors. After all, as all good indexers know, costs matter.

Take the DFA Canadian Core Equity fund as an example. Its A units cost 149 basis points annually (MER). That’s huge, compared to the 5 basis point management fee charged by the broad-market ETFs mentioned previously. But the DFA fund comes with a side-order of advice and the ETFs do not.

Performance-wise, the DFA fund generated average annual gains of 7.80 per cent over the 10 years to the end of June, according to globefund.com. The S&P/TSX Composite Total Return Index gained 8.77 per cent annually over the same period. The index beat the fund by 97 basis points annually. On the other hand, the advice that came with the DFA fund might have been worth enough to make up for the difference.

Thankfully, self-directed investors can get exposure to small value stocks using less costly products. I asked Dan Hallett, vice president and principal of HighView Financial Group, for a few suggestions.

He suggested the First Asset Morningstar Canada Value Index ETF (FXM) for exposure to Canadian equities. It’s a relatively new offering that costs 68 basis points annually (MER) and tracks 30 mid-cap value stocks on the TSX.

For U.S. stock exposure he pointed to the Vanguard Small Cap Value ETF (VBR). It has an expense ratio of only 9 basis points and follows a diversified portfolio with more than 800 small value stocks.

Moving internationally, Mr. Hallett opted for pure small-cap exposure with the Vanguard FTSE All-World ex-US Small Cap ETF (VSS). It has an expense ratio of 20 basis points and follows over 3,000 stocks.

A portfolio with equal amounts of all three would cost about 0.32 per cent per year, not including commissions, taxes, and other frictions. That’s a bargain compared to a similar collection of DFA funds, provided you don’t need advice.

With a little luck, the cost-cutting trend will spread to niche index funds. It’d be even better if it spreads to the cost of getting personalized investment advice too.

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