How to build an all-ETF portfolio

With these ETFs, investors could now access a globally diversified portfolio of stocks and bonds in various proportions at low expense ratios of 0.24% and below. 

With the launch of asset allocation ETFs in Canada, investing and portfolio management became as simple as periodically buying more and reinvesting distributions. That said, Canadian investors willing to sacrifice simplicity can obtain additional cost savings and diversification by building a customized portfolio of ETFs. Here’s a handy step-by-step guide. 

Determine your investment policy statement

Investing experts usually recommend the services of a fee-only Certified Financial Planner (CFP) when it comes to formulating an investment policy statement (IPS) and throughout the portfolio construction process. A fee-only CFP has expertise that can help DIY investors avoid common mistakes (such as high fees, poor tax-efficiency and under-diversification), optimize for their personal goals and risks, and provide a healthy degree of ethical assurance. Compared to financial advisors who charge based on a percentage of assets under management (AUM), fee-only financial planners are less incentivized to prioritize sales or push unsuitable investment products.

However, Canadian investors venturing out on their own can still create an effective IPS. Think of this as a living, breathing document that defines your investment portfolio’s overall objectives and constraints. There’s no universal template for what an IPS should entail but, in general, it should include:

Asset overview

What accounts do you have? You can open a tax-free savings account (TFSA), registered retirement savings plan (RRSP), registered education savings plan (RESP), locked-in retirement account (LIRA) among others, which are all registered accounts. You can also have non-registered accounts, too. In your asset overview, you will list all your investing accounts, their respective amounts and your plans for contributing yearly. Also list your liquid assets, such as an emergency fund in a high-interest savings account. And don’t forget to add a workplace defined contributions or defined benefits plan, if you have these.

Investment considerations

Understanding these three considerations will help determine your asset allocation and the type of investments that will work for you. 

1. Your objectives: Are you saving for retirement, a down payment on your first home, your child’s tuition? Include your goals here.
2. Your time horizon: This is when you need the money to be accessible. It’s essentially the target date for your objectives. 
3. Your risk tolerance: You need to consider how much volatility and unrealized losses (a loss in market value of an asset that isn’t yet sold) you are willing to bear. 

Asset allocation

This is a breakdown of what asset classes you want in your portfolio (this isn’t a wish list, so be realistic). It can be a mix of stocks, bonds, cash or alternatives. You also log which accounts you’ll hold them in. For example, you may want to keep bonds in an RRSP due to their tax-inefficiency. And, lastly for asset allocation, include your preferred proportions relative to each other (e.g. 60/40 portfolio mix of stocks and bonds). 

Your rules: This is a list of dos and don’ts for how you want to manage your portfolio. Note when you want to rebalance your portfolio, and when you want to make contributions or reinvest dividends. You will also want to include types of funds you’ll be avoiding, such as assets with fees above a certain level or riskier ones like cryptocurrencies. And to keep yourself in check, write out any behaviours to avoid, such as panic-selling or timing the market. Add your fee-only advisor’s contact info here, too, as a gentle reminder to check in when you feel you might be sliding into those actions.

Canadian ETFs versus U.S.-listed ETFs

Once you have your IPS complete, decide on whether you’ll buy Canadian-, or U.S.-listed ETFs. 

Generally speaking, Canadian ETFs are preferable due to their accessibility, as you do not need to convert currency to purchase them. 

U.S.-listed ETFs can be especially useful for Canadians investing in an RRSP. This is because U.S.-listed ETFs that hold U.S. stocks or bonds are not subject to a 15% foreign withholding tax (FWT) on their distributions if held in an RRSP. In a TFSA, this doesn’t apply, so consider holding Canadian ETFs there. 

However, the FWT cost savings often outweigh currency conversion costs charged by brokerages. While you could use techniques like Norbert’s gambit, it might not be worth the time and commissions. If you are set on using U.S.-listed ETFs, consider a brokerage with low currency conversion fees, like National Bank Direct Brokerage or Interactive Brokers. 

How to choose ETFs: The basics

If you decide to use Canadian-listed ETFs, a great way to get started is with ETFs tracking an external benchmark index of stocks and bonds, such as the S&P/TSX 60. These work in contrast to actively managed ETFs that attempt to beat index benchmarks using proprietary strategies.

There is substantial research showing that, over the long term, passive index funds nearly always outperform their active counterparts. For example, the latest SPIVA Scorecard from S&P Dow Jones Indices found that, over the last 15 years, as of December 2022, 93.4% of U.S. actively managed large-cap equity funds underperformed the S&P 500 index. 

For many Canadian investors it makes sense to stick to passive index ETFs. When it comes to choosing ETFs, consider these two factors: maximum diversification and low fees. Both are easily controllable sources of risk that can make a substantial difference in long-term returns.

How to choose equities ETFs

The goal should be to diversify equity holdings globally, across U.S., international developed (Europe and Asia Pacific) and emerging market equities, based on their market-cap weights. Equity holdings should ideally span all 11 stock market sectors, and include large-, mid-, and small-caps based on market-cap weightings. 

There is a caveat—consider an overweight of Canadian equities of around 20% to 30% of our equity allocation. This, in the industry, is called a “home-country bias” and according to Vanguard has historically helped reduce volatility, lower currency risk and improve tax efficiency. It’s a good thing!

Also keep management expense ratios (MERs) as low as possible, ideally under a 0.20% weighted average for the portfolio. This would make a portfolio competitive with the existing asset allocation ETFs, which mostly charge between 0.20% to 0.24%. 

How to choose fixed-income ETFs: 

Finally, consider an allocation to bonds and cash. A 100%-equities portfolio is considered a highly aggressive allocation, too volatile for every Canadian, but suitable for the most risk-tolerant investors. It may have higher than expected returns, but that’s of no use if you panic-sell. 

Many Canadians have been concerned about bonds, given the recent losses as interest rates rose. It’s important to keep in mind that historically, bonds provided protection during numerous economic downturns and market corrections like the March 2020 COVID-19 crash and the 2008 Great Recession. 

Bonds have also beat stocks during long-periods of stagnant market returns, like during the “lost decade” of 1999-2009 where U.S. bonds outperformed U.S. stocks dramatically. While some might assert that “2022 is different,” there is ample historical evidence to suggest that bonds remain an indispensable part of a diversified portfolio. 

Therefore, adding high-quality government and investment-grade corporate bond ETFs can help smooth out volatility and reduce drawdowns. When all else fails, cash is used to help in situations where bonds fall along with stocks, which is usually during a rising interest rate environment as we saw in 2022. 

For bonds, the same considerations as with equities apply—ensuring the lowest possible fees, a Canadian home-country bias, and a global focus. Some Canadian investors prefer to only hold Canadian bond ETFs, but as Vanguard suggests, global bond ETFs can provide additional diversification benefits. 

Here’s a sample model portfolio

With that in mind, here’s a model portfolio that incorporates these suggestions, using a 70/20/10 allocation of stocks, bonds and cash:

• 50% iShares Core MSCI All Country World ex Canada Index ETF (XAW)
• 20% Vanguard FTSE Canada All Cap Index ETF (VCN)
• 10% Vanguard Global Aggregate Bond Index ETF (VGAB)
• 10% iShares Core Canadian Universe Bond Index ETF (XBB)
• 10% Horizons High Interest Savings ETF (CASH)

The weighted average MER of this portfolio works out to exactly 0.176%. For a $10,000 investment, that’s roughly $17.60 in fees. This portfolio is diversified across global market-cap-weighted equities, has a Canadian home-country bias, and includes an allocation to high-quality bonds and cash to help lower volatility and drawdowns. 

Over time, the asset allocation of this portfolio will drift from its 70/20/10 target. For example, if equities go on a bull run, the 70% stock allocation might quickly grow to become 80%. When this happens, investors would “rebalance” by selling overweight assets and buying underweight assets.

There’s no hard-and-set rule on frequency; quarterly, semi-annually or even annually may work. The key is to stick to a systematic and mechanical schedule (and add that to your IPS!). By doing so, Canadian investors can avoid the urge to tinker or time the market, which can negatively impact long-term returns. Rebalancing periodically helps ensure your portfolio maintains its desired risk-return profile.

Finally, Canadian investors should take note of the distribution schedule for each ETF, which can be annual, quarterly or monthly. When distributions are received, they should be reinvested promptly to help compound returns faster.

Building an all-ETF portfolio for Canadians

“When there are multiple solutions to a problem, choose the simplest one,” John Bogle, the late founder and chairman of Vanguard, wrote in his book The Little Book of Common Sense Investing (Wiley, 2017). 

While Canadians can DIY a portfolio of four to five ETFs to create a complete investment portfolio, there is also beauty in the simplicity of an asset allocation ETF.

For investors with smaller accounts (five or less ETFs), it’s hard to justify the additional time spent on managing and rebalancing five different ETFs for what amounts to a 0.07% annual decrease in cost savings. This can easily be eaten up by bid-ask spreads from the increased amount of trading required. 

In addition, the asset allocation ETFs offer a powerful psychological advantage—the ability to deter tinkering. Because they’re managed on your behalf by a professional, investors won’t be tempted to do things like overweight Canadian stocks too much, ditch their bonds or panic-sell to cash.

In short, if you’re disciplined and like to stay hands-on with your portfolio, then the DIY five-ETF portfolio could be a viable option. If you prefer to keep your investments on autopilot, then there’s nothing wrong with sticking to an asset allocation ETF.

Regardless of your choice, the main tactics for investment success remain the same: making consistent contributions, reinvesting dividends, keeping fees low, and always staying the course. 

Read more about ETFs:

• What are ETFs?
• Best U.S. equity ETFs
• Best fixed-income ETFs for Canadian investors
• Making sense of the markets this week