Simple index portfolios

Simple index portfolios are a collection of portfolios that contain broad based representation from the major asset classes: Canadian bonds; Canadian equities; and global equities. The choice of broad based funds is dictated by a decision to use a passive investing philosophy to keep costs to a minimum and to accept market returns, which helps keep things simple to manage these portfolios. There portfolios are often implemented using one or more exchange-traded fund (ETF).

Depending on the level of simplicity desired, one can build one of a:
 * single asset allocation ETF that matches the investor's desired asset allocation
 * three-fund portfolio using one index fund or ETF for each of these asset classes.
 * four-fund portfolio which further decomposes the global equities into two index funds or ETFs (US equities and international equities). The developed markets portion of "international equities" is generally known as MSCI EAFE, is is comprised of Europe, Australasia and the Far East (EAFE).
 * five-fund portfolios which split the international equities into EAFE and emerging markets.

These portfolios are well suited for do-it-yourself (DIY) index investors in the accumulation stage, with retirement as their main goal. As discussed on the Financial Wisdom Forum (see this and the next 15-20 posts), simple index portfolios can also work during the withdrawal stage. They would also work for self-directed Registered Education Savings Plans (RESPs), although the asset allocation would need to be made much more conservative as the children approach the age of post-secondary education. Finally, similar portfolios can be implemented in Defined contribution pension plans or group RRSPs if inexpensive index funds are available.

Investment philosophy
The are two elements to the investment philosophy behind the portfolios presented here: keeping it very simple, and using index products.

Simplicity
Simple does not mean simplistic or unsophisticated, and does not mean missing out on good returns. Portfolios composed of three to five index funds or index ETFs are simple to set up and rebalance, and widely diversified. They require no monitoring, almost no ongoing work (e.g., rebalancing once per year), and no external advice (think fees). Because of the simplicity of the portfolio and its passive management (see below), the investor’s urge to tinker should be suppressed more easily. There should be fewer behavioural issues (the whole process can be automated to take emotion out of equation) and the portfolio should be fully invested all the time, so it won’t miss on any gains.

Despite the beauty of simplicity, investors are often attracted by complexity: "our investing brain seems hard-wired to resist straightforward solutions". Complex solutions promise market beating returns, and it is difficult to 'settle' for a portfolio that can never beat the market :

"It’s hard to let go of the dream. Carlson quotes Benjamin Graham, who said, “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” One of the most difficult obstacles investors face is the nagging feeling that there’s something better out there. Market returns can now be had for less than 10 basis points, and these are almost certainly enough to allow investors to reach any realistic financial goal. Yet we sabotage ourselves by rejecting an easy A-minus and instead wind up with a C or D. “It’s amazing how easy it is to do worse by trying to do better.”"

According to Jason Hsu and John West, complex, high-turnover strategies can be used by managers or agents to justify higher fees, but may have lower returns than simple strategies after fees and taxes. They also add that "simplicity leads to better investor outcomes not because simplicity in and of itself produces better investment returns, but because a simple strategy encourages investors to own their decisions and to less frequently overreact to short-term noise.''"

Indexing
The fundamental principle for passive investing is that "costs matter". Bogle states "No matter how efficient or inefficient markets may be, the returns earned by investors as a group must fall short of the market returns by precisely the amount of the aggregate costs they incur" and Sharpe states "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs." The simple index portfolios are based on the investment philosophy of accepting market returns, and minimizing costs.

Accepting the market returns means investing in index funds or ETFs that track broad stock and bond indices, preferably total market indices. In the absence of funds tracking total market indices for some equity asset classes, funds that track stocks with large and medium capitalizations will do, as such indices can have relatively similar risk-return characteristics to total market indices (e.g., ). If nothing else is available, a large-cap index will do. Minimizing costs means keeping all costs down: management expense ratios (MERs), trading commissions, bid-ask spreads, tracking errors, currency exchange fees, and taxes (see How to choose ETFs for index investors).

We cannot know the best asset allocation in advance, so we pick a reasonable one and stick to it, rebalancing the portfolio every year or two.

We cannot time the market, so we add money to the portfolio whenever it becomes available, and stay fully invested all the time. Adding funds is a great way to rebalance to the target allocation since it minimizes transaction costs and taxes (for taxable accounts).

Set your level of risk
The investor first decides on their choice of asset allocation between fixed income and equities, to balance risk and return by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. In the examples below we will use 50:50 for simplicity.

Domestic vs foreign asset classes
The investor then decides how much exposure to foreign markets is appropriate. In the examples below we use Canadian bonds only. Canadian bonds are good for portfolio diversification, have no foreign currency risk, and can be purchased cheaply as index funds or ETFs.

In the examples below we split the equities equally between Canadian and global, as done in the FPX Indexes, for illustrative purposes. The justification for having at least half of equities in global stocks is to (1) reduce portfolio volatility (see global diversification), (2) reduce country risk, and (3) adjust for the lack of sector diversification (or high concentration in three sectors, financials, energy and materials) of the Canadian market. The justification for a large overweight in Canadian equities relative to their weight in world indices is to avoid too much foreign currency exposure, and benefit from preferential tax treatment of Canadian dividends (in non-registered accounts only).

Choosing specific investment vehicles
Now that the asset allocation is decided, the investor must select specific passive investment vehicles to implement it. There are three decisions to take: (a) how many funds to use (three, four or five); (b) whether to employ index mutual funds or ETFs (or both); (c) whether to use currency hedging for the global equities.

How many funds?
In all simple index portfolios there will be one fund for Canadian bonds, and one for Canadian Equities. The three-fund portfolios keep the entire global equity exposure within one fund for maximum simplicity; this global equity fund will possibly include emerging markets. One advantage of using a single fund for foreign stocks is that there is no need to decide on a specific and constant allocation between different foreign countries or groups of countries: the markets will sort it out.

Four-fund portfolios split the global equities into US and EAFE indices, which each represent roughly half of global equities. Emerging markets are typically ignored in four-fund portfolios. Five-fund portfolios bring the EM back using a dedicated EM fund, which will typically represent a small percentage of the whole portfolio (e.g., 3% in the examples below) and may not make a large difference.

So, how many funds? The smaller the number of funds is, the easier it will be to rebalance the portfolio. The “urge to tinker”, i.e. the temptation to make frequent changes, is minimized with all simple index portfolios, but suppressing this urge is perhaps best accomplished with only three funds, the ultimate boring portfolio. Note that “boring” is a compliment when addressed to truly convinced passive investors. But four funds is very simple too, and opens up the possibility of using four index funds, without the need for a brokerage account required for ETFs. When using ETFs, four funds may also be less expensive than three, depending on a number of factors.

So three is good, four is good, what about five? For larger portfolios using ETFs, the EM fund can certainly be added without turning rebalancing into a nightmare or driving costs up. But for smaller accounts, three or four funds seem ideal.

Index mutual funds or ETFs?
Index mutual funds and ETFs are both good choices, each with its pros and cons (see comparison of index funds and ETFs). In summary, index funds are ideal for small portfolios and frequent contributions, but ETFs may be cheaper and offer more choice. On a practical level, one major advantage of using index funds is that they do not require a brokerage account, which generally only waive or reduce fees and commissions once a significant (typically $50,000) account balance has been reached. The major attraction of ETFs as building blocks for simple index portfolios is their extremely low MERs. The four ETF portfolio used below as an example has a weighted average management fee of 0.15% (the full MER will be a few basis points higher), compared with 0.44% for the equivalent four index fund portfolio. But there are other costs to ETFs that index funds don’t incur: trading commissions, bid-ask spreads, currency exchange costs, on so on. These are more difficult to quantify than the MERs, but matter just as much, and may make the cost advantage disappear depending on assumptions. ETF investors have to choose among a vast number of different products (see How to choose ETFs for index investors for help). Investors wanting to build a simple index portfolio with only three funds will find that ETFs are their only option. The five-fund portfolio is also dramatically cheaper with ETFs relative to index funds, for small accounts. In a brokerage account, it is possible to use both index funds and ETFs to take advantage of their respective features.

Another consideration is whether to use Canadian vs US-listed ETFs for the ETF(s) covering foreign stocks. In the examples below, we use TSX-listed products only to avoid the complexities of currency exchange.

Currency hedging
Foreign equities expose the Canadian investor to currency fluctuations, which may reduce, or add to, yearly returns. In the examples below we do not hedge the currency exposure of foreign stocks, because (1) over several decades, the currency fluctuations should even out ; (2) hedging adds to costs; (3) for Canadians, hedging may add to the volatility of portfolios and (4) the foreign exposure is only 25% of the portfolio in our examples.

Three index funds
According to Bylo's list of low-MER, no-load index funds available in Canada, and this Globefund filter, there are no relatively low-cost (<1.0% MER), no load, open-ended index mutual funds that track a global equity index as of January 2016. Therefore, Canadian investors wishing to persue a passive strategy with only three funds will have to use ETFs, or move to a four-funds portfolio with index mutual funds.

Three ETFs
Three-ETF portfolios consist of Canadian bonds, Canadian stocks and global stocks. Here we show an example using TSX-traded ETFs from Vanguard Canada:

Suitable alternatives from other vendors are mentioned in the following pages: Canadian bonds and Canadian equities. For global stocks, a TSX-listed option is XAW. There are US-listed options for the global equity ETF, such as VT, but they include a small percentage (3-4%) of Canadian equities.

This 3-fund portfolio may appear overly simplistic. Certainly the brokerage statements will look very boring. Yet this portfolio has the following characteristics:
 * Exposure to over 500 Canadian bonds (terms of 1 to over 25 years; credit ratings covering the full investment grade spectrum, include government and corporate bonds)
 * Exposure to over 230 Canadian stocks covering large-, mid- and small-capitalizations
 * Exposure to thousands of large- and mid-capitalization stocks from other developed and emerging markets
 * Will be very easy to rebalance
 * Weighted average management expense ratio (MER) of 0.15% (January 2016)
 * No currency exchange fees for ETF transactions using Canadian dollars
 * No currency hedging of global equities

Model portfolios maintained by Canadian Couch Potato formerly used the same three ETFs as in the example above, with a range of fixed income from 10 to 70% of the portfolio. For equities, his Canadian:Global mix was 1:2 instead of 1:1. His model ETF portfolios now consist of one to two ETFs only, with slightly higher MERs than the 3-ETF examples shown here.

Four index funds
Simple index portfolios with four index funds include Canadian equities, US equities, EAFE Equities, and Canadian bonds. The following table is an example of a simple index portfolio built with "FPX Balanced" allocations, using four TD e-funds as a example of low-cost index mutual funds:

This example has a weighted average management expense ratio (MER) of 0.44% (December 2016). Further discussion of this example is found in Building a portfolio, including links to index mutual funds from other vendors.

Model portfolios maintained by Canadian Couch Potato use the same four index funds as in the example above, with a range of fixed income from 10 to 70% of the portfolio. For equities, his Canadian:US:International mix is 1:1:1. The model with 40% bonds is traditionally known as the Global Couch Potato portfolio from MoneySense

Four ETFs
Simple index portfolios with four ETFs include Canadian equities; US equities; EAFE Equities; and Canadian bonds. Sticking with our 50:50 mix of equities and fixed income, using the FPX Balanced index to allocate equities, and using BMO etfs for illustration purposes, we get:

Equivalent ETFs from other vendors could also be used, and are listed in the following pages: Canadian bonds, Canadian equities, US equities and International equities.

Five index funds
Simple index portfolios with five funds include Canadian equities, US equities, EAFE Equities, emerging markets equities, and Canadian fixed income. TD does not offer an emerging market e-fund so we use CIBC’s Premium Class index funds (minimum $50k per fund, MER between 0.38% and 0.64% depending on the fund) to illustrate a simple portfolio with five index mutual funds.

The regular CIBC index funds have MERs in the 1.14%-1.40% range and could also be used, but the high cost, relative to a four-funds portfolio with TD e-funds, does not seem justified. Recall that the EM fund makes up only 3% of the five-fund portfolio and is unlikely to make a large difference in terms of long-term returns relative to a four-fund portfolio.

Five ETFs
Simple index portfolios with five ETFs include Canadian equities, US equities, EAFE Equities, emerging markets equities, and Canadian fixed income. Justin Bender, a portfolio manager who advocates passive investing, suggests Model Portfolios of five ETFs with "Global Couch Potato"-like allocations, using ETFs from Ishares Canada, BMO or Vanguard. His "40FI - 60EQ" example using Ishares Canada ETFs has 40% Canadian fixed income (XQB), 20% Canadian Equities (XIC), 20% US Equities (XUS), 16% EAFE equities (XEF) and 4% emerging markets (XEC), with a weighted average management expense ratio of 0.14% (Nov. 2014).

Continuing with our 50:50 mix of equities and fixed income, using the FPX Balanced index to allocate equities, and the same ETFs as in Mr. Bender's Ishares Canada example for illustration purposes, we get:

Equivalent ETFs from other vendors could also be used, and are listed in the following pages: Canadian bonds, Canadian equities, US equities, International equities and Emerging market equities.

Possible variations

 * Some investors prefer to use Canadian short bonds ETFs, such as those listed at Canadian bonds, instead of "total market" Canadian bond ETFs. Short bonds are less sensitive to interest rate variations, but should have lower returns over the long term. However, they are recommended by William Bernstein since short bonds do a better job of reducing portfolio volatility.
 * In five ETF portfolios, emerging market equities could be replaced by better portfolio diversifiers such as gold or real return bonds

Other options
To simplify things to a maximum, new investors may wish to consider low-cost balanced funds, indexed or actively managed, while they learn more about investing. Later, they can switch to a simple index portfolio.

The ETF equivalent to the balanced mutual fund is the asset allocation ETF.

Bogleheads wiki

 * Lazy portfolios. Includes examples with short term bonds or inflation-protected bonds, the US equivalent of Canadian RRBs.
 * Bogleheads investment philosophy. Summarizes a "small number of simple investment principles that have been shown over time to produce risk-adjusted returns far greater than those achieved by the average investor". Written for a US audience, but can be adapted easily for Canadians.