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Indexing is a simple low-cost way to obtain a diversified investment portfolio which tracks the markets. At least that's the theory. Problem is, many investors get led astray. Before they know it their portfolios become jam-packed with the new breed of expensive and risky exchange-traded funds. What was once a solid investment portfolio becomes a speculative one.

At its core, index investing is simple, with a goal of investing with the broadest diversification possible.

On this point, though, the investment industry tends to focus on pleasing speculators while doing a disservice to individual investors.

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There are relatively few index mutual funds and most of them are pricey. The number of exchange-traded funds (ETFs), on the other hand, has exploded in recent years. Morningstar.com tracks 842 ETFs, nearly 30 per cent of which are less than three years old.

On the TSX, there are 81 ETFs trading and most are under three years old. Like mutual funds, ETFs began life as simple products. The first ETFs offered broad exposure to important asset classes and came with rock bottom fees. But popularity attracted competition and many new ETFs embodied bad habits from their mainstream mutual fund counterparts.

New ETFs have become focused on increasingly small slices of financial markets, allowing investors to make bets on specific countries, regions, industries, commodities, and investment themes.

But the theory supporting indexing argues against making such focused bets. What it does support is obtaining the broadest exposure possible to mirror the market, as opposed to engaging in all manner of speculation.

If you buy into the theory that skilled investment managers can't be reliably identified in advance, it seems a stretch to believe that you can pick and choose the sectors that will fare the best in the future. For the index investor, the first lesson is to keep it simple. Use a single index fund, or ETF, to gain exposure to each asset class. An entire indexed portfolio should stick to a total of 10 funds or fewer.

LOW COST

Cost is indexing's primary advantage over active management. It's easy to build a broadly diversified ETF portfolio with a management expense ratio (or annual fee) of 0.3 per cent annually. Yet many ETFs cost more. For every six ETFs in Morningstar.com's universe, one boasts an expense ratio 0.3 per cent or less, one has annual fees north of 0.75 per cent, while the other four lie in between. Fourteen per cent of Canadian ETFs cost 0.3 per cent or less and 30 per cent charge more than 0.75 per cent per annum. This is where investors may be lured into biting the high-fee ETF carrot.

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I like the variety of ETFs available. But investors faced with too many choices either feel overwhelmed and sit on their hands, or buy too much of what they should avoid. Many people make poor decisions when it comes to specialty ETFs. For instance, many investors overdosed on commodity ETFs in recent years after being wooed by the China growth story.

There is nothing wrong with commodities; hard assets are a valid portfolio component. But buying something like an oil ETF because everyone is excited isn't investing. It's speculation and it goes against the foundational tenets that support index investing.

Successful indexing comes down to a few simple rules:

Minimize your costs. Aim for all-in fees of less than 0.5 per cent.

Don't get cute with your picks. Resist the itch to attempt to outsmart the market and stick to broadly diversified funds.

If you're unsure how to split your investments among stocks and bonds, then a good starting point is to put half into each.

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Finally, rebalance only when your mix gets out of whack (say by at least 10 percentage points) to avoid making decisions driven by fear or greed.

These rules should serve index investors well over time.

Dan Hallett, CFA, CFP is president of Dan Hallett & Associates Inc., a Windsor, Ont.-based investment research firm.

dha@danhallett.com

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