Three great ideas for small potatoes

From Dan Bortolotti’s new Index Investor column. Visit his MoneySense blog for more Couch Potato tips.

I admit it: I’m an ETF geek. My bedside table usually holds a well-thumbed book on exchange-traded funds, and I routinely bore people with meditations about the merits of cap-weighted indexes. My wife recently asked, in her charming way, if I would love her more if she were an ETF. I answered yes, since she’d be less expensive, more transparent and easy to trade. Then I ducked.

Given my own enthusiasm, I shouldn’t be surprised when I hear from readers who have sold their dreary, high-fee mutual funds and want to know which ETFs to use in their first Couch Potato portfolio. (For the uninitiated, Couch Potato investors don’t try to beat the market, they simply track stock and bond indexes at low cost.) Some are new to do-it-yourself investing and are still fuzzy on what exchange-traded funds are. Others are keen to cover every asset class, but have only a few thousand bucks in sav­ings. It pains me to say it, but for these investors, ETF port­folios usually don’t make sense. Luckily, though, they can still become Couch Potatoes.

ETFs are not the best way to start out, because they trade on an exchange, like individual stocks. That means you need a discount brokerage account to buy and sell them—and if you have no experience managing your own money, this can make you nervous.

As well, if you’re investing less than $30,000 or so—or if you’re making small regular contributions—ETFs may not make sense when you add up the trading fees. As with stocks, every time you buy or sell shares in an ETF you pay a commission: about $29 at the bank-owned brokerages, or $9.95 at independent ones such as Questrade and Qtrade. If you’re periodically rebalancing your portfolio or diligently tucking a couple of hundred dollars a month into an RRSP, RESP or Tax-Free Savings Account, those commissions will eat you alive. (One exception would be a portfolio of ETFs from Claymore Investments, which offers free pre-authorized cash contribution plans—but such plans are not yet available through the big bank discount brokerages.)

For newbie Couch Potatoes, or those saving in small accounts, low-cost index mutual funds are a more sensible choice, as you can set up regular contribution plans and you don’t have to pay each time you add money. Here are three ideas for the simple spud:

Less than $5,000
If you’re starting from scratch, you won’t find anything easier than ING Direct’s Streetwise Funds. Launched in 2008, the Streetwise Funds are one-stop Couch Potato portfolios. They hold a mix of Canadian, U.S. and international stocks, as well as Canadian bonds, all passively managed and tied to well-known indexes. The Streetwise Funds come in three flavors: the Balanced Fund, the Balanced Income Fund, and the Balanced Growth Fund. All work fine in an RRSP, but RESP versions are not yet available.

The Streetwise Funds have a management expense ratio of 1%, which is higher than you’d pay for a portfolio of ETFs (but less than half the MER of most actively managed funds). And that’s the all-in cost. There’s no fee to open or maintain an account, no minimum account size, no trading commissions, and the fund automatically rebalances every quarter. Once you set up an automatic contribution from your chequing account, you can safely lapse into a coma.

Between $5,000 and $30,000
If you’ve accumulated some savings and you’re comfortable managing your own portfolio, consider TD’s e-Series mutual funds. There are 10 funds in the e-Series family, but a Couch Potato needs only four: TD Canadian Index, TD U.S. Index, TD International Index and TD Canadian Bond index. These are the cheapest mutual funds in the country: you can build a diversified portfolio for less than 0.5% a year. It costs nothing to buy and sell new units, and you can set up automatic contributions from your bank account.

The only drawback is that you must buy them online through TD. You can do this with a TD e-Series Funds account, or you may want to consider opening a brokerage account with TD Waterhouse, which will give you access to ETFs further down the road.

More than $30,000
As your portfolio grows, the low management fees of exchange-traded funds become more attractive. Here’s an idea for moving into ETFs in a cost-efficient way: build a Global Couch Potato portfolio with four ETFs in a discount brokerage (see the Canadian Couch Potato blog for instructions). Then set up automatic monthly contributions to a money market fund in the same brokerage account. Once a year, use the cash in the money market fund to rebalance your portfolio. Assuming four trades a year at $29, the commissions would be $116, but that’s offset by the lower annual fees on the ETFs.

Compared with the e-Series funds, this only makes sense for portfolios approaching $100,000. But if you’re currently using pricier index mutual funds, or if your broker charges just $9.95 for trades, this technique will work for accounts as small as $30,000.

Do the math and figure out what works best for you. Just don’t forget that while costs are important, saving regularly and sticking to the strategy are the most important ingredients in the Couch Potato formula.