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portfolio strategy

Nervous investors have to feel vindicated when looking at the stock market plunge in the second half of 2015.

After peaking at close to 15,525 in the spring, the S&P/TSX composite index fell into a decline that at midweek had taken it down as low as 12,872. That's a drop of 17 per cent, which is severe enough to suggest now is actually a good time to start moving into stocks for long-term investing. Too nervous to make that move? Here's some help in the form of a conservative portfolio of exchange-traded funds.

I asked the ETF analysts at National Bank Financial (NBF) to create this portfolio for investors who are holding a lot of cash because of concerns about a stock market pullback. Preaching the benefits of long-term investing isn't enough to help these people see beyond the safety – but pitifully low returns – of cash. Also needed is some kind of an investment plan that balances a degree of safety with the higher return potential of stocks.

This is what the Conservative ETF Investment Portfolio is all about. It puts a 41-per-cent weighting on stocks, a 51-per-cent weighting in bonds, a 5-per-cent weighting in alternative investments and assigns cash a weighting of 3 per cent. This blend comes from the NBF investment strategy committee, which issues quarterly recommendations on how to structure portfolios for five different investment profiles. The conservative ETF Portfolio's mix offers the second-lowest risk level.

ETFs are low-cost investment funds that trade like a stock. The cheapest ETFs track the returns of major stock and bond indexes, while pricier versions employ managers to pick securities. The conservative ETF portfolio uses mostly index-tracking funds, and that helps keep the weighted average management expense ratio for this portfolio to about 0.3 per cent. You'll probably have to pay brokerage commissions to buy ETFs, but the cost of running the conservative portfolio is very cheap.

Daniel Straus, ETF analyst at National Bank Financial, said risk is addressed in three ways in the conservative ETF portfolio. First, there's the heavy bond weighting. "An investor in cash who is going to move to a portfolio like this should be reassured that the bond side of the equation is going to provide an anchor during times of distress," he said.

Bonds protect a portfolio against a stock market crash or recession, but yields are puny in today's low-rate world. The conservative ETF portfolio adds a bit of extra yield by adding two corporate bond ETFs to a core bond fund that has a 60-40 ratio of government and corporate bonds.

The conservative ETF portfolio's heavy bond weighting makes it vulnerable to the bond price declines that would happen if interest rates move higher. With the U.S. Federal Reserve expected to nudge rates up from historic lows later this month, this is a valid concern. But it's also worth noting that some analysts believe the U.S. economy is losing momentum and thereby hurting the case for higher rates. And here at home, the Bank of Canada this week made a point of discussing the tools it might use if our already sluggish economy worsens.

If it turns out that the economy is weakening, then we could see bond prices rise and thereby produce some capital gains for holders of the conservative ETF portfolio. If bond prices fall, the damage would be limited to some extent by the emphasis on short-term bonds (they're less vulnerable than long-term bonds to rate increases).

A second way the portfolio addresses risk is by incorporating low-volatility ETFs in the portfolio. "These ETFs definitely deliver what they promise, which is lower volatility in the form of lower drawdowns in times of distress and lower day-to-day whipsaws," Mr. Straus said.

Low-volatility U.S. and global ETFs are used in the portfolio alongside traditional index-tracking funds. For Canada, Mr. Straus chose a dividend ETF instead of a low-volatility product. "History shows that when you choose companies that pay stable dividends and have good cash flows to support them, you avoid companies that inject risk into a portfolio."

A third way the portfolio contains risk is by avoiding emerging markets, which have been particularly weak in recent years. Mr. Straus said emerging markets tend to move in the same direction as developed stock markets, but with more velocity. As such, they're suitable only for more aggressive portfolios.

If there's a controversial aspect to the conservative ETF portfolio, it's the inclusion of a small weighting in a fund that tracks an index of hedge funds and another fund that holds real estate investment trusts, or REITs. The point here is to own things that don't track the stock and bonds markets. Some hedge funds strive to offer this result, and so can the hard real estate assets that REITs hold.

Hedge funds can be opaque and unpredictable, and REITs are already a part of the core Canadian market ETF included in the conservative portfolio. If you choose to skip the small alternative weighting in the portfolio, just add the money to your Canadian, U.S. and international stock market exposure.

The approach taken with currency hedging in the conservative portfolio will be of particular interest to investors wondering how to position their U.S. and international holdings at a time of weakness in the Canadian dollar.

An ETF using currency hedging protects you if our currency rises, but denies you the added gains when our dollar declines. Unhedged ETFs have done well in the recent slide by our dollar, but they'd be hit hard if our currency were to rebound.

The conservative ETF portfolio avoids choosing between hedged and unhedged funds by including both. For example, the weighting in foreign stocks uses a 50-50 split between hedged and unhedged.

With more and more companies entering the ETF business in Canada, it's getting increasingly difficult to pick the best funds from the close to 500 listed on the TSX. Mr. Straus said his criteria for choosing funds include low fees, strong diversification and liquidity in the ETF itself and also its underlying assets. Liquidity means being able to buy and sell quickly and at a competitive price.

If you're a nervous investor sitting in cash, take some time at year end to consider your strategy for 2016. The stock market declines of late may support your fears, but they also represent a buying opportunity for the next 10 years and longer. The conservative ETF portfolio is a suggestion for capitalizing on this opportunity while managing risk.

Conservative ETF Investment Portfolio

Asked to design a portfolio of exchange-traded funds especially for conservative investors, here's what some people at National Bank Financial came up with: