ETF school is back in session.
Over the past several months, this column presented a five-part ETF Buyer's Guide that examined individual funds in the Canadian, U.S. and international equity categories as well as dividend and income funds, and bond funds. The series has been collected into an e-book that is available for Globe Unlimited subscribers to download at no cost (click here).
Now, we move onto portfolio-building with ETFs. To start, let's look at a model portfolio created by National Bank Financial analysts for investors seeking a monthly flow of income.
Income seekers, would you consider a yield of 3.9 per cent to be attractive in today's market? That's what NBF's Monthly Yield Portfolio provides through the combination of 14 different ETFs listed on the Toronto Stock Exchange.
It's near impossible to get more than a 3-per-cent yield from investment-grade corporate bonds and guaranteed investment certificates maturing in five years or less. Many stocks have higher dividend yields than that, but the yield for the blue-chip S&P/TSX 60 index is only about 2.6 per cent.
So where does the 3.9-per-cent yield on the Monthly Yield portfolio come from?
The answer is a blend of Canadian, U.S. and international dividend-paying ETFs, some bond funds, some preferred share funds and some "alternative" funds in the real estate investment trust (REIT), high yield bond and emerging markets bond categories.
We need to be clear about the type of yield we're talking about here. NBF refers to "cash yield," which is based on a fund's previous 12 months of distributions divided by share price. This yield you get moving forward may differ.
You should also be aware of how cash yield differs from total return, which combines the income you receive from bonds and dividends with changes in share and bond prices. This is particularly relevant to bonds, which in today's market conditions are on track for a total return that is less than the cash yield.
In other words, you'd get the income from your bond ETFs, but their market price could fall. The best indicator of total return for bonds is yield to maturity, and you'll find it displayed on all online bond ETF profiles.
Now for some basic points of portfolio building, as applied to the Monthly Yield Portfolio.
1. Asset Mix:
NBF has gone with a somewhat aggressive mix of 53 per cent stocks, 35 per cent bonds and 12 per cent alternative investments. Income investing is sometimes considered to be synonymous with conservative investing, but this portfolio would by no means sidestep a stock market correction.
Likewise, its exposure to bonds, preferred shares and REITs suggests some vulnerability to rising rates. The point here is that the 3.9-per-cent yield comes with some risk of price declines for the ETFs in the portfolio.
2. Global content:
Markets in the United States and internationally have been strong in recent years and you don't want to ignore them in most portfolios.
That's why NBF has allocated one-third of the portfolio to dividend ETFs holding global stocks, and 4 per cent to emerging market bonds.
3. Sector exposure:
The stock and bond indexes tracked by typical ETFs are sometimes skewed to one sector or another.
Here in Canada, financials dominate many dividend, stock and bond funds. NBF has limited financials to 35 per cent of the portfolio, which is pretty much in line with the S&P/TSX index and less than many dividend ETFs. Exposure to other sectors ranges from a low of 3 per cent for materials to 16 per cent for energy.
4. Bond duration:
Duration, expressed in years, is a standard measure of risk in a bond fund. The weighted average duration of bonds in the Monthly Yield Portfolio is comparatively low at 2.9 years, which means the bonds would fall 2.9 per cent in price if interest rates rose one percentage point.
5. Corporate vs. government bonds:
When interest rates rise, as they did last summer, corporate bonds tend to fall less in price than government bonds. On the other hand, government bonds are a better cushion against a stock market crash or a recession. NBF navigates the bond market by putting 10 per cent of the Monthly Yield Portfolio in government bonds and 18 per cent in corporate bonds.
The best argument for using ETFs is that they provide diversification at a very low cost. NBF says the weighted average management expense ratio for the Monthly Yield Portfolio is 0.51 per cent, which compares to an average 2.4 per cent for the 12 largest Canadian balanced mutual funds with a tilt toward stocks over bonds. Online brokerage commissions are increasingly priced at $10 or less per trade, which means buying the 14 ETFs in the portfolio would cost no more than $140 at many firms.
NBF estimates the portfolio is less than half as volatile as the S&P/TSX composite index over the past three years.
NBF says that of the 3.9 percentage points of yield, roughly 1.4 points come from Canadian dividends that benefit from the dividend tax credit in non-registered accounts. Another 1.1 points or so come from foreign dividends, which do not qualify for this tax credit.
The last chunk of income is accounted for by bond interest, which is taxed as regular income in non-registered accounts. Some of the funds in the portfolio will include a return of capital in their distributions.
The 2013 version of the Monthly Yield Portfolio produced a total return of 7.5 per cent, based on a 3.5 per cent price gain and a yield of 4 per cent. NBF's performance numbers are based on quarterly rebalancing – selling some of the best performers and buying more of the worst in order to bring the portfolio back up to its target weighting. To save on commissions, you could rebalance semi-annually or even annually.
Coming soon: An ETF growth portfolio.