Exchange traded funds - ETFs

Money Digest, Jan, 2003

We like ETFs. The reasons are many.

When you invest, you take many risks. The market may go down, the industry you invest in may go down, the stock you invest in may go down, your returns will be substantially reduced by commissions and taxes. What if you reduce or even eliminate most of these risks except for market risk (i.e., you are affected by the direction of the market but not by other types of risk)? In this case you can be certain--to the extent it is possible in investing--that you will come out ahead, since the direction of the market has always been up in the long run.

ETFs eliminate individual investment risk by investing in a broad range of stocks, usually index-based. They minimize commissions by charging a low fee. Because ETFs do not trade stocks (except occasionally) but simply hold them, your tax liability is minimized while you are holding the ETFs.

When you buy an ETF you are investing in a small proportional fraction of all the stocks in one of the many Canadian, U.S. and global stock indexes such as the S&P/TSX Composite index, S&P/TSX 60 index, the S&P 500, the Nasdaq 100 or the Dow Jones industrial average. ETFs give you choices. For instance, if you want to invest in new economy stocks, you can invest in an ETF of the Nasdaq 100. If you are interested in huge U.S. companies you can invest in an ETF of the Dow Jones industrial average. You can also, if you choose, diversify among different indexes. Your money is always fully invested in the index of your choice. ETFs, unlike index mutual funds, do not change or modify their strategy in search of higher returns (which can result in lower returns).

There are many ETFs

Since each ETF holds a number of stocks that fulfil some stringent criteria, even when you invest in a single ETF you are diversified. Thus for example, when you invest in the S&P/TSX 60 index, your money is automatically invested in 60 of the largest Canadian companies. This provides excellent diversification even though you hold only a single ETF. But as you build your portfolio, you may want to diversify geographically, investing your money in the U.S. and other countries abroad. In addition, you may also want to hold some fixed income securities or invest in some sectors of the economy (such as financial services or information technology) that interest you. All this can be achieved using a combination of the 16 ETFs traded on the Toronto Stock Exchange in Canadian dollars. (See the panel.)

How to build an ETF portfolio

Building an ETF portfolio is simple. Suppose you want to divide your portfolio equally among the following investments:

* Long term Government of Canada bonds

* Real Estate Investment Trusts (REITs)

* Large cap Canadian stocks

* Large cap U.S. stocks

* Large cap global stocks

This can easily be achieved by investing in the following five ETFs:

Here is a sample blueprint for building a portfolio with ETFs traded on the Toronto Stock Exchange. Long Term Government of Canada Bonds: 20% iUnits Government of Canada 10 Year Bond Fund (symbol: XGX);

Real Estate Investment Trusts: 20% iUnits S&P/TSX Canadian REIT Index Fund (REITs; symbol: XRE);

Canadian Equities: 20% iUnits S&P/TSX 60 Index Participation Fund (symbol: XIU);

U.S. Equities :20% iUnits S&P 500 Index RSP Fund (symbol: XSP);

Global Equities (symbol: XIN): 20% iUnits MSCI International Equity Index RSP Fund.

If your aim is to diversify conservatively without trying to get-rich-quick, ETFs may be all that you need.

ETFs traded on TSX

                                      Underlying
Name                                  asset                       Symbol

iUnits S&P/TSX 60                     S&P/TSX 60                     XIU
iUnits S&P/TSX 60 Capped              S&P/TSK 60 Capped              XIC
iUnits S&P/TSX Cdn MidCap             S&P/TSX Canadian Midcap        XMD
iUnits S&P 500 Index RSP              S&P 500                        XSP
iUnits MSCI Int'l Equity RSP          MSCI Int'l Equity              XIN
iUnits S&P/TSX Cdn Energy             S&P/TSX Cdn Energy             XEG
iUnits S&P/TSX Cdn Financials         S&P/TSX Cdn Fin Services       XFN
iUnits S&P/TSX Cdn Gold               S&P/TSX Cdn Gold               XGD
iUnits S&P/TSX Cdn Information Tech.  S&P/TSX Cdn Info Tech/         XIT
iUnits Gov't of Canada 5-Year Bond    Gov't of Cda 5-Year bonds      XGV
iUnits Gov't of Canada 10-Year Bond   Gov't of Cda 10-Year bonds     XGX
iUnits S&P/TSX Cdn REIT               S&P/TSX Cdn REIT               XRE
TD S&P/TSX Composite                  S&P/TSX Composite              TTF
TD S&P/TSX Capped Composite           S&P/TSX Capped Composite       TCF
TD Select Cdn Growth                  Dow Jones Cdn Growth           TAG
TD Select Cdn Value                   Dow Jones Cdn Value            TAV