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There are a number of reasons why investors are moving toward exchange-traded funds these days. Here's one from Warren MacKenzie, president and CEO of Weigh House Investor Services.

"A while ago I had a couple visit me for a second opinion on their portfolio. What I saw was rather shocking. They had about $4-million dollars in 80 mutual funds!"

The problem with having so many funds, Mr. MacKenzie says, is that they tend to average out, in the case of equities, to the market return less fund management fees. So by replacing those funds with one exchange-traded fund (ETF), you can earn an extra 2 per cent annually.

But which ETFs should you choose to get exposure to Canadian stocks? A few can be found trading on the Toronto Stock Exchange.

Let's assume you are a passive investor following a "lazy portfolio" approach such as MoneySense's Couch Potato, Rotman Professor Eric Kirzner's Easy Chair, DeGroote Professor Richard Deaves' Simple Recipe, or variants to be found on financial blogs.

The primary question would be: what would be the best broad-based ETF to represent Canadian equities in such portfolios?

Some viewpoints are offered below.

One takeaway could be that the answer depends on the particular needs of investors.

ETFs for Canadian stocks

Jean Lesperance, a blogger at Canadian Financial DIY, says iShares Canadian Large Cap 60 Index Fund is the proven performer. "It is has been around the longest and has attracted the greatest trading volumes. In addition to having the lowest annual fees (0.17 per cent) of the main contenders, is has lower costs in the form of small bid-ask spreads, low tracking error, and negligible premiums to net asset value.

Ram Balakrishnan, who blogs under the name Canadian Capitalist, says "in my opinion, the iShares Canadian Capped Composite Index Fund is a slightly better choice as it tracks a broader index [more than 250 stocks compared with 60 for Canadian Large Cap]and the weight of a single stock is capped at 10 per cent [avoids the Nortel effect]" The cost is greater but "would be negligible for long-term investors when spread over the entire holding period."

Investor Education:

  • All about ETFs
  • How to make ETFs part of your RRSP
  • The bad boys of the ETF world
  • Are ETFs your cup of tea?
  • How do ETFs fit my investment strategy at this stage in life?
  • How do Exchange-Traded Funds (ETFs) work?

Donald Dony, editor of the Technical Speculator advisory, prefers Claymore Canadian Fundamental Index Fund "because it is fundamentally weighted, which removes some of the volatility and provides slightly superior returns according to tests on past data." You may also be able to use Claymore's dividend reinvestment, preauthorized contribution, and systematic withdrawal plans at some brokerages.

The BMO Dow Jones Canada Titans 60 Index Fund, which is similar in composition to the iShares Canadian Large Cap 60 above, actually has the lowest annual expense (0.15 per cent) of all ETFs tracking Canadian equities.

But having launched only within the past year, volumes are low. This situation should change as people become more familiar with it.

"With an index that rebalances only annually, [it]should incur lower transactions costs in the management of its portfolio," Mr. Lesperance points out. The annual rebalancing also likely entails fewer capital-gains distributions, he adds.

The value of small-caps

Several academic studies have found that small-cap and value stocks generate higher returns than the broad market over the long run.

To increase exposure to these sectors, some passive investors may add small-cap and value ETFs to their holdings of core ETFs.

The iShares Canadian Small-Cap Index Fund tracks more than 185 small caps and charges an annual fee of 0.55 per cent. Top industry sectors (as of mid-February) are materials (30 per cent), energy (25 per cent) and finance (13 per cent).

The iShares Canadian Completion Index Fund tracks more than 150 mid- and small-cap stocks, charging an annual fee of 0.55 per cent. Top industry sectors are materials (22.4 per cent), energy (26 per cent) and finance (23.9 per cent).

The iShares Canadian Value Index Fund tracks more than 60 stocks and levies an annual fee of 0.50 per cent. Top industry sectors are finance (60 per cent) and energy (15 per cent).

Not for passive investors

Other ETFs track Canadian equities but are not for passive investors.

The Horizons AlphaPro Managed S&P/TSX 60 Fund is an actively managed ETF with a much higher fee than passive ETFs. Passive investors don't believe stock pickers can beat the market over time - so it is better to get the market return with lower-cost ETFs.

The HBP S&P/TSX 60 Bull Plus Fund is a leveraged ETF that delivers twice the market's return on a daily basis. For longer periods, maintaining constant leverage on a daily basis can cause this ETF to return much less. Indeed, if volatility is high, this ETF could decline when the market is rising (for details, Google "constant leverage trap").

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