Revisiting the Couch Potato model portfolios

By Dan Bortolotti and Canadian Couch Potato on January 24, 2013
Estimated reading time: 4 minutes

Before we get too deep into the new year, I've decided it's time to review my model portfolios. Regular readers will know I'm reluctant to tinker with the portfolios, since new ETFs are launched all the time, and jumping from fund to fund is a bad idea for several reasons.

Before we get too deep into the new year, I’ve decided it’s time to review my model portfolios. Regular readers will know I’m reluctant to tinker with the portfolios, since new ETFs are launched all the time, and jumping from fund to fund is a bad idea for several reasons:

Transaction costs. It will cost you two trading commissions to sell an ETF and buy a replacement, and you’ll also lose a little more on the bid-ask spread with each trade. If the new ETF is only a few basis points cheaper, the cost of switching may not be worth it.

Tracking error on new products. When an ETF is created, its start-up costs are often borne by investors. As a result, a new ETF can take a year or more before it starts tracking its index closely. A low-fee fund may still have a larger tracking error until it builds some economies of scale.

Taxes. If you’re planning to switch ETFs in a non-registered account, selling your existing fund might generate a significant taxable gain. It doesn’t make sense to pay a lot in taxes to save a little in fees.

Different risk exposure. Two ETFs in the same broad asset class may track quite different indexes. For example, if you’re comparing corporate bond ETFs you may look only at the fee and not realize some funds include only short-term bonds, while others include all maturities. One equity fund might track the broad market while a similar-sounding one includes large caps only.

It’s not about products. Successful index investing is not about selecting the best ETFs and squeezing every last basis point from the cost of your portfolio. If you’re a disciplined saver who invests in a low-cost, broadly diversified portfolio that’s appropriate for your risk profile, it really doesn’t matter whether you’re paying 0.30% or 0.28%, especially if your portfolio is small.

A minor tweak

With that preamble out of the way, I’ve made only a single change to my ETF recommendations: I’ve replaced the iShares S&P/TSX Capped Composite (XIC) with the BMO S&P/TSX Capped Composite (ZCN). The BMO fund changed its benchmark in September and now tracks the same index as XIC. It has also surpassed $1.1 billion in assets, making it essentially the same size and scale as its competitor, but with a management fee 10 basis points lower.

I’m constantly asked why I haven’t added Vanguard Canada’s ETFs to the model portfolios, since their fees are among the lowest around. I think almost all of the Vanguard ETFs would be good choices, but I’m taking a wait-and-see approach this year as they make the transition from MSCI indexes to new benchmarks from FTSE and CRSP.

It’s also worth pointing out the Vanguard Aggregate Bond ETF (VAG) costs 10 basis points less than the iShares DEX Universe Bond (XBB), but the latter outperformed it by 26 basis points last year. And as it happens, the BMO Aggregate Bond (ZAG), which recently dropped its management fee to match Vanguard’s, beat them both. This should be a reminder that investors don’t need to switch ETFs every time one appears with a slightly reduced fee, because a lower MER does not guarantee a correspondingly higher return.

A bigger change

After much thought, I’ve also removed the Yield-Hungry Couch Potato from the model portfolios page. I’m expecting some negative feedback about this decision, so allow me to explain the reasoning:

I continue to be concerned about the emphasis many investors put on yield rather than total return, a subject I wrote about recently in MoneySense. The emails I received about this portfolio made it clear that many readers were so “yield hungry” they were ignoring far more important factors like risk, diversification and tax-efficiency. I don’t want to contribute to these biases by suggesting a portfolio designed to maximize yield.

The more I learn about effective tax management, the less enthusiastic I become about complicated products like the iShares (formerly Claymore) Advantaged ETFs, which comprised about 45% of the Yield-Hungry portfolio. The forward structure used by these ETFs adds a significant cost (0.50% to 0.75%) and I’m not convinced of the benefits. I’ve come to appreciate the best way to manage taxes is with careful asset location and attentive tax-loss harvesting, not using exotic products.

I was routinely asked for long-term performance data for the Yield-Hungry Couch Potato, and I could not provide it. Many of the funds track exotic indexes with no meaningful track record. Moreover, some of the Advantaged ETFs show a surprisingly large discrepancy between their market price and net asset value (NAV), which makes even one-year reporting problematic.

If you happen to use the Yield Hungry Couch Potato, I’m not recommending you abandon it. But monitoring and tracking the model portfolios takes more time than many readers appreciate, so given the above concerns I’ve decided to focus on the other three: the Global Couch Potato, the Complete Couch Potato, and the Über-Tuber.