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BUILD YOUR OWN RRSP WITH ETFs
Cheap, flexible exchange-traded funds can make ideal building blocks, ROB CARRICK suggests
BY ROB CARRICK
Here's a little project for a cold weekend afternoon in RRSP season: Build your own pension fund.
Some of the sharpest investing minds in the country run pension funds, but you can do it yourself in an hour or so spent in front of a computer.
We're not talking about some rinky-dink exercise in guesswork here.
By the time you're done, your registered retirement savings plan will be a precision-built machine that runs maintenance-free for the long run, aside from minor tune-ups every six to 12 months.
To start, you'll need a self-directed RRSP account at an on-line broker, which will allow you to buy stocks for as low as $25 to $29.95 a transaction. If you need help picking an on-line broker, check out the survey done in last week's Globe Investor Weekly (it's archived on Globeinvestor.com).
The reason for the on-line brokerage account is that it's the most efficient way to buy exchange-traded funds, or ETFs. These will be the building materials for your pension fund.
ETFs are index funds that allow you to buy the returns of about 160 different stock and bond indexes in Canada, the United States and globally.
Because they passively mirror an index and don't require any active stock picking, ETFs are ultra cheap to run.
The management expense ratio on the ETF that tracks the S&P/TSX composite index is 0.25 per cent, whereas the average Canadian equity fund charges 2.81 per cent.
In practical terms, this means you have a choice of getting what the index makes less 0.25 per cent, or what the average fund's managers can achieve, minus 2.81 per cent (published fund returns are always net of management expenses).
Now you see why almost two-thirds of Canadian equity funds couldn't match the return of the S&P/TSX composite index in the past 10 years.
All right, it's building time. To start, you need a blueprint, or asset allocation model. Academic studies have shown that the mix of investments you use accounts for as much as 90 per cent of your returns, with the actual securities chosen accounting for the remainder.
Your own personal asset allocation depends on your age, risk tolerance and the rate of return you need to generate enough money in your RRSP to keep you comfortable in retirement.
For this exercise, though, let's look at what pension funds use and call it a default asset mix for conservative investors.
Here's the average mix as reported by consultants Watson Wyatt Worldwide following a survey of Canadian pension funds in the latter part of 2003 (the numbers have been rounded somewhat):
Bonds: 40 per cent.
Canadian equity: 30 per cent.
U.S. equity: 10 per cent.
International equity: 12 per cent.
Alternative investments such as real estate, mortgages and hedge funds: 5 per cent.
Cash: 3 per cent.
With this blueprint in hand, let's look at some of the building materials you can use.
Bonds
You have two choices here, the iUnits Government of Canada five-Year Bond Fund, or iG5 (XGV-TSX) and a sister 10-year government bond fund called the iG10 (XGX). They're designed to provide the yield of five- and 10-year government bonds with semi-annual cash interest payments.
Like real bonds, these ETFs rise in value when interest rates decline and lose value when rates climb. But whereas bonds mature at some point and return your initial investment to you, bond ETFs are always fluctuating according to market forces. All in all, these ETFs are a good bond proxy for small investors because of the low MERs of 0.25 per cent (the average bond mutual fund MER is 1.84 per cent). The iG5s are a little less volatile than the iG10s (shorter-term bonds are less volatile than those with longer-terms), so a more conservative investor might take the 40-per-cent bond allocation and fill three-quarters of it with iG5s and the remainder with iG10s.
Canadian equity
Here, you have to decide whether to buy the S&P/TSX 60 index, or the much broader S&P/TSX composite. If you like the blue-chip nature of the 60 index, then use the iUnits S&P/TSX 60 Capped Index Fund, or i60C (XIC), which keeps a maximum 10-per-cent ceiling weighting on any single stock in this index of Canadian heavyweights.
If you prefer the larger S&P/TSX composite, which comprises 223 stocks at present, then consider the TD S&P/TSX Composite Index Fund (TTF). There are versions of this fund that focus on growth and value funds in the index, but you can ignore those.
Can't decide which index to use? Indexing purists would suggest that the broadest index is the best, which means the S&P/TSX composite, in this case. Note than the i60C's MER is a bit cheaper _ 0.17 per cent to the TD fund's 0.25 per cent.
U.S. equity
One of the greatest ETFs bargains is the iShares S&P 500 Index Fund, which trades on the American Stock Exchange under the symbol IVV. The MER on this fund is 0.09 per cent, which is a little cheaper than the 0.12 per cent charged on the better known Standard & Poor's Depositary Receipts (SPY-Amex), which are often called Spiders.
Yet, there are slightly more expensive U.S. ETFs that may work better because they offer exposure to small- and mid-capitalization stocks as well as the large-caps that comprise the S&P 500. Example: The Vanguard Total Stock Market Viper (VTI-Amex), which tracks the very broad Wilshire 5000 total market index and has an MER of 0.15 per cent.
Note that there's a TSX-listed ETF that tracks the S&P 500 -- the iUnits S&P 500 Index RSP Fund, or i500R (XSP).
It's a viable choice, but you'll have a higher than average MER of 0.30 per cent that reflects the fact that this fund is specially designed to count as domestic content in your RRSP. If you're not bumping up against the 30-per-cent foreign content limit, and you won't with this portfolio blueprint, then this feature isn't worth the higher cost.
International equity
Go for the iUnits MSCI International Equity Index RSP Fund, or iIntR (XIN-TSX), which is like the i500R in that it's fully eligible for RRSPs. The MER here is 0.35 per cent, which is the same as a similar U.S.-listed ETF.
This fund tracks the Morgan Stanley Capital International Europe, Australasia and Far East Index, which covers most of the globe outside North America.
Alternative investments and real estate
The term alternative investment generally refers to hedge funds, but there aren't any ETFs based on hedge fund indexes at this point.
Real estate is a different matter thanks to the iUnits S&P/TSX Capped REIT Index Fund, or iREIT (XRE-TSX), which wraps together seven REITs in sectors such as hotels, retail, commercial and retirement residences.
You get the opportunity for capital appreciation with the iREIT, plus quarterly distributions of cash that now yield about 7.2 per cent on an annual basis. The MER is 0.55 per cent.
If you prefer not to invest in REITs, you could shift the 5-per-cent weighting for this category to U.S. and international equities. Or, if you like the idea of a little extra diversification, then you have dozens of Canadian and U.S. sector ETFs to choose from.
The Canadian sector ETFs focus on TSX-listed financials, information technology, gold, energy and mid-cap stocks. The problem with these funds is that they focus on stocks that are already present in the S&P/TSX composite and/or 60 indexes. The net effect is that you might be diminishing your diversification by owning a sector ETF as opposed to enhancing it.
As for U.S. sectoral ETFs, four interesting U.S. possibilities are:
Nasdaq 100 tracking stock (QQQ-Amex): Called Cubes, these very popular ETF units wire you into the largest stocks listed on the Nasdaq Stock Market and have a reasonable MER of 0.2 per cent.
iShares MSCI Emerging Markets (EEM-Amex): Has a hefty 0.75-per-cent MER, but then emerging market mutual funds are often above 3 per cent.
iShares Dow Jones Select Dividend Index (DVY-NYSE): Holds the 50 U.S. stocks with highest dividend yield, as well as a record of raising dividends for five straight years. The MER is 0.4 per cent.
iShares Russell 2000 (IWM-Amex): Provides U.S. small-cap exposure, with an MER of 0.2 per cent.
Cash
All you need is a plain old money market fund. On-line brokers have lots of these funds to offer.
The knock on the indexing strategy used by this RRSP portfolio is that it creates a risk that your holdings will be hit harder in a market downturn than if you invested in actively managed mutual funds. If you're concerned, then consider using this pension concept for half your RRSP and picking conservative mutual funds for the remainder. Or, you can sit back and let your homemade pension fund work for you through the years, with only periodic rebalancing to keep your asset allocation in line.
This is hardly the most exciting approach to RRSP investing, but then excitement has never been a phrase much associated with pension funds.
More information
Globeinvestor.com's Filter function allows you do an inventory of ETFs listed on all North American stock exchanges.
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