Taking ETFs to the Next Dimension

This month I began writing what I hope will be a regular series of articles in Canadian MoneySaver. For those who aren’t familiar with the magazine,  MoneySaver features articles on personal finance and investing, primarily written by industry professionals and knowledgeable do-it-yourselfers. Contributing editors include value hunter Norm Rothery, fixed-income specialist Hank Cunningham, preferred share guru James Hymas, and Canada’s self-proclaimed youngest retiree. The magazine contains no advertising and is entirely supported by its membership.

My first article, An ETF Portfolio With Added Dimension (PDF format), explains how do-it-yourselfers can follow the investment strategies of Dimensional Fund Advisors. DFA is based in the US, though it has operated a Canadian subsidiary, DFA Canada, since 2003. It’s a unique firm whose passively managed equity funds are designed to capture the returns of entire asset classes. However, Dimensional funds do not track any index. Instead, they weight companies according to a formula that gives more prominence to small-cap and value stocks, which have historically provided higher returns than the broad market. The screens are purely rules-based—that is, the managers do not pick and choose any individual stocks based on their own analysis.

DFA funds are ridiculously well diversified. For example, the DFA Canadian Core Equity Fund holds 578 stocks. No other Canadian mutual fund comes close to that — indeed, the entire S&P/TSX Composite Index includes just 229. The DFA International Vector Equity Fund holds 2,759 stocks, about three times more than funds that track the MSCI EAFE index. All this for management fees in the range of 0.40% to 0.70%.

So what’s the catch? Only that Dimensional primarily serves institutional clients, not retail investors like you and me. Individuals can invest in these funds, but they must purchase them through a select group of advisors, all of whom have received extensive education in the Dimensional strategy. These advisors typically add their own 1% fee on top of the fund MERs, and most only accept high-net-worth clients. I have found a couple that will take people with $100,000, but a minimum account size of $200,000 to $500,000 is more common.

In the article, I describe the Dimensional strategies in more detail and assemble a portfolio with ETFs that come closest to mimicking DFA funds. Readers who have visited my Model Portfolios page will recognize this as the Über-Tuber, so named because I think of it as the ultimate Couch Potato portfolio:

If you’re thinking about adopting this strategy, I’ll offer a couple of caveats:

• There are 11 ETFs in the portfolio, most of which have small allocations of 4% to 8%. Maintaining a portfolio like this can get complicated and expensive: it is unlikely to be cost-effective for anyone with less than $100,000 or so, and probably shouldn’t be rebalanced more than every two or three years. You definitely want to use a low-cost discount brokerage if you’re holding this many ETFs.

• The portfolio is very heavily weighted toward value stocks. While these have rewarded patient investors, they have a tendency to fall even more than the broad market during bear markets like 2008–09. If that’s too much volatility for you, replace Claymore’s CRQ with iShares XIC for the Canadian core holding, and use Vanguard’s VTI instead of PowerShares PRF for the US core holding.

In next month’s Canadian MoneySaver, I’ll reveal Canada’s cheapest ETF portfolio and explain why MER isn’t the only factor to consider when weighing costs. New readers can check out a sample issue of the magazine or sign up to receive two free online issues before subscribing.