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Strategy Lab If you're still in mutual funds, it's time to switch

Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.

Most Canadians don't drive gas-guzzling cars that were built in the 1950s. Even if they could, such cars wouldn't be practical. Technology has improved. Cars are now more efficient. Most actively managed mutual funds are like those gas guzzling jalopies. Our banks and fund companies love them because they're profitable to sell.

Smart Canadians buy ETFs. They cost a lot less. The typical actively managed fund costs about 2.4 per cent per year. If the fund manager generates an 8 per cent return, before fees, investors in that fund would give up 30 per cent of their profits to the mutual fund provider.

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ETF investors pay nothing close to that. Vanguard, Horizons, iShares and BMO battle for business. So costs keep dropping. Unlike a price war at the gas pumps, once an ETF provider drops a fund's cost, it stays down. In fact, investors could now build a diversified portfolio of ETFs that costs less than 0.16 per cent per year.

If your money is still in actively managed funds, it's time to make the switch.

ETF providers post two sets of costs. One is the fund's management fee. This is what the fund company takes. It's usually followed by the MER (management expense ratio). Index fund managers don't do much trading. As assets grow, however, they have to increase their holdings of stocks that they already own. They also add new shares when another stock gets added to a benchmark index. When adding shares, the company pays trading commissions. These costs come from the assets of the fund itself. The MER includes the fund's management fee plus the cost of trading.

Build a portfolio with Canadian stock, U.S. stock and international stock market exposure. Add a Canadian bond ETF for a touch of stability. The higher your bond allocation, the lower your risk. The lower your bond allocation, the higher the potential returns.

For Canadian stocks, you could choose between three equally cheap, equally diversified choices: Vanguard's FTSE Canada All Cap Index ETF (VCN), iShares Core S&P/TSX Capped Composite Index ETF (XIC) and BMO's S&P/TSX Capped Composite Index ETF (ZCN). Each ETF contains at least 235 stocks. They include small-cap, mid-cap and large-cap equities. Their management fees are a scant 0.05 per cent. Audited MERs will shift a bit, year-to-year, depending on trading activity. But they're likely to be similar. BMOs audited MER for 2014 was just 0.09 per cent.

Comparative performances will differ slightly, depending on how well management can track its benchmark index. But these are experienced indexing firms. If one ETF gains a slight performance advantage in one year, it might not necessarily maintain that edge. When choosing between one of these indexes, just close your eyes and point. Over time, there won't be much difference.

Investors could add global stocks with a single ETF. The iShares Core MSCI All Country World Index ETF (XAW) was launched in February. It contains 5,801 holdings. About 53 per cent of them are U.S. stocks. The rest are diversified across other regions, including 22 developed market countries and 23 emerging markets. Its management fee is 0.20 per cent. iShares estimates its year-end MER will total just 0.22 per cent.

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Those wishing to rebalance global stock exposure on their own could choose from a series of other low cost funds.

For U.S. equities, I recommend Vanguard's U.S. Total Market Index ETF (VUN). It has 3,824 holdings, including large-cap, mid-cap and small-cap stocks. It's also cheap, sporting an MER of just 0.16 per cent per year.

If you don't mind giving up a bit of diversification, you could pay even less. Vanguard's S&P 500 Index ETF (VFV) charges a management fee of just 0.08 per cent, and a total MER of 0.13 per cent. But it doesn't contain mid-cap or small-cap stocks.

Vanguard's FTSE Developed ex North America Index ETF (VDU) provides cheap, broad exposure to developed world stocks, excluding those on the North American markets. Its MER is 0.26 per cent. BMO's MSCI EAFE Index ETF (ZEA) costs 0.25 per cent. But it holds just 504 stocks, compared to 1,401 stocks for Vanguard product.

Vanguard's FTSE Emerging Markets Index ETF (VEE) leads the low cost battle for developing market stocks. Its MER is 0.29 per cent. It contains 1,023 stocks.

Investors should round out their portfolio with a bond index. Vanguard's Canadian Short Term Bond Index ETF (VSB) charges management fees of 0.10 per cent. Its MER is 0.15 per cent. This index contains Canadian government, and investment grade corporate bonds expiring between one and five years. Fixed income interest rates are historically low. By choosing a short-term bond index, investors will reap rewards when rates rise.

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The key to investment success doesn't come from following the markets and trying to figure out which country's index will flourish or flounder. Instead, build a diversified portfolio. Stick to your allocation. And rebalance once a year. If you can do that, you'll beat most investment pros, after fees.

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