Sunday, November 21, 2010

My ETF Picks for Asset Allocation

One of the basics of investing is understanding what the breakdown of your various asset classes will be. Most investors will want a mix of canadian bonds, canadian stocks, along with foreign stocks.

In this post I'll explain what ETFs I picked to represent each of those asset classes. I use ETFs  exclusively for my investments because they cover a broad range of assets, and have low management fees.

For reference my own target asset allocation is:

  • 30% Canadian Bonds
  • 35% Canadian Stocks
  • 15% US Stocks
  • 20% International Stocks

I don't try to have cash in my portfolio, but I essentially accompish the same thing by keeping a reasonable amount of cash in my savings account.

Canadian Bonds - TSX: XSB (iShares DEX Short Term Bond Index Fund)
XSB is a Canadian ETF that includes a wide range of Canadian bonds with maturity dates of 1-5 years. I chose this ETF because:

  • It has a low 0.275% Management Expense Ratio
  • Short term bonds are less inflation sensitive than other bond options
  • Short term bonds are less correlated with equities than long term bonds.

Returns on Bonds are classified as income and do not benefit from capital gains tax credits. Accordingly, I only hold XSB in my RRSP or TFSA where gains will not be taxed.

Canadian Equities - TSX: XIC (iShares S&P TSX Capped Cmpst Indx Fnd)
XIC is a Canadian ETF that tracks a broad range of Canadian stocks. I chose this ETF because:

  • It has a low 0.25% Management Expense Ratio

XIC produces both dividends and capital gains. Since both dividends and capitalare taxed favorably I try to keep my holdings of XIC outside of my RRSP.

US Stocks - NYSE: VTI (Vanguard Total Stock Market ETF)
VTI is a US index that tracks the entire US stock market. I chose this ETF because:

  • It has a low .07% Management Expense Ratio. Yes, .07%! Can't get much lower.
  • I prefer a total stock market index to one that tracks the S&P 500 because the holdings are more diverse.
  • Many US stock ETFs are hedged to the canadian dollar, but I prefer unhedged investments

Hedged investments are more stable, while unhedged investments are more efficient. I chose unhedged because:

  • I am investing for the long term, and the common concensus is that in the long term currency fluctuations will average out.
  • Hedged investments have a significant drag in performance over unhedged

Returns from this fund are classified as Dividends or Capital Gains, but because this is a foreign stock things get a little more complicated:

  • There is a 15% US witholding tax on Dividends. If this stock is held in a Canadian RRSP the witholding tax is waved. Note - if you invest in a Canadian fund that holds US stocks there is no way of avoiding this witholding tax.
  • Note witholding tax is still charged on dividends earned on US stocks held in a TFSA
  • Tracking capital gains on foreign owned stocks is a bit of a pain compared to Canadian stocks, so that in itself is a good reason to hold these stocks in an RRSP.

I choose to hold VTI in my RRSP to avoid the witholding tax. This means I don't benefit from favorable treatment of capital gains. Holding this ETF outside of an RRSP would also be good choice but will make doing taxes more complicated.

International Stocks
I hold two major ETFs to represent international stocks. I weight my holdings 3:1 for MSCI Europe vs MSCI Emerging markets. I hold these ETFs in my RRSP for the same reason that I hold US stocks in my RRSP - avoid some dividend taxing and simpler book keeping.

NYSE:VEA - Vanguard Europe Pacific ETF

  • Tracks the Morgan Stanley Capital International (MSCI) Europe, Australasia, Far East (EAFE) Index
  • 0.15% MER

NYSE:VWO - Vanguard Emerging Markets ETF

  • Tracks the MSCI® Emerging Markets Index
  • 0.27% MER

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