As a DIY investor, you will need to choose what to buy. I am not a certified investment advisor and cannot make specific recommendations for you. However, I will present information that you may find helpful in deciding or seeking out more information first. Asset allocation, or “All-In-One” exchange traded funds (ETFs) are a simple, cost efficient, and effective way to build a globally diversified portfolio. An excellent option for someone starting out on their DIY journey. Or for anyone who doesn’t want to spend much time managing their portfolio.
The evolution to easy, low-fee, diversified investing.
Investment returns are related to the risk taken. However, the best way to mitigate uncompensated risk without sacrificing returns is diversification. That used to mean picking and buying a wide variety of stocks and bonds. Time consuming and expensive. Mutual funds made that easier by bundling them, but still suffered the costs and risks of active management. The advent of passive index ETFs dropped the cost and manager risk. Now, even the rebalancing aspect is taken care of with the all-in-one asset allocation ETFs.
What is an ETF vs a mutual fund?
An ETF is a fund that holds a bundle of assets, like stocks or bonds. The main difference from a mutual fund is that you can buy/sell directly using a discount online brokerage, like Qtrade. In contrast, mutual funds are sold via dealers. Additionally, most mutual funds are actively managed. Dealers and managers cost a lot, and the fees and commissions are baked into the management expense ratio (MER) of the fund. The MER for active retail mutual funds is about 1.5-3%/year. An advisor may use discounted mutual funds with MERs in the 0.5-2%/yr range, but their advisor fees (usually ~1%) are added onto that.
A passive index ETF simply buys the stocks in the proportion to emulate the index that they track. That is simple and costs little. So, the MER of ETFs are typically much lower, ranging from 0.03-0.60%/yr. The more niche the ETF, the higher the fee and less diversified it usually is. There are also some actively managed ETFs with fees on the higher end of the range, but still much lower than a mutual fund since they don’t need a dealer.
Why do MER fees matter?
Data of 10-year rolling time periods consistently show that actively managed funds lag their comparable index. For Canadian mutual funds, 90-95% lag their index. It is impossible to know in advance, who the 5% that will beat the index moving forward are. SPIVA data also shows that the top performers are likely to underperform in the following five years. At a rate worse than random chance. So, are there managers that do beat the market net of their fees? Yes, but they are extremely rare. Can you readily pick them out for their future performance? No.
There is a plethora of reasons for that underperformance over time. However, one of them is fees. They must consistently outperform (hard) by more than their fees (super-hard). Previously, I analyzed a Morning Star report, and it showed that higher fees were strongly related to worse performance. While the gap between active and passive management narrows briefly during market downturns, it still favors lower-fee passive strategies over active ones. Plus, the market spends much more time going up than down.
You cannot predict or control market returns, but you can predict and control fees. They will cost you whether the market goes up or down. This is the rationale behind low-cost passive index investing. You won’t beat the market, but you will beat the vast majority who try to. Fees may sound small as a percentage, but the impact over time is huge, and the dollar amount is large with a large portfolio. Unfortunately, many people don’t realize that until they have a large portfolio, later in life when they are staring the impact to their cashflow straight in the eye.
Potential behavioral advantage of asset allocation ETFs.
There is no Canadian data showing better investor behaviour for those using asset allocation ETFs. However, it does make empiric sense that something simpler to use may help people to invest more consistently. There is also some US data that we can make inferences from.
In the US Mind The Gap Study for the 10 year period ending in 2019, asset allocation funds showed a positive behavioural gap. That means investors did not lag due to buying and selling at bad times due to timing attempts. Most other funds targeted to separate asset classes had about a 1%/yr lag due to bad investor market timing for buying and selling.
The bundling of stocks and bonds into one fund dampens the volatility that provokes bad behaviour. So, a smaller behavioral drag on performance is not surprising. However, their return was actually boosted slightly. Rebalancing can boost returns during periods where stocks and bonds move in opposite directions (like in 2009-2019). However, that is not always the case. Regardless, the behavioural component was better than separate equity funds.
Another confounder is that the asset allocation funds in that study are often used by employer-sponsored retirement plans. Automatic deduction and investment from people’s paychecks with limited ability to trade, makes for good consistent investor behaviour. So, that makes the data a bit more of stretch to extrapolate to a DIY investor who doesn’t have a fully automated process.
Potential disadvantages of asset allocation ETFs. And Solutions.
Added fee for the convenience of rebalancing for you.
Asset allocation ETFs have a slightly higher fee than if you were to hold the underlying ETFs individually. It is usually <0.1% more. That may be an excellent price for your time, hassle, and better behaviour.
Worse tax-efficiency in RRSP accounts than holding the underlying ETFs directly.
Since the asset allocation ETFs are Canadian-listed, but hold some US-listed ETFs inside, there can be a slight loss of foreign withholding taxes (FWT) in an RRSP, compared to holding the US-listed ETFs directly.
That inefficiency works out to 0.1-0.2%/year. Of course, to be more tax-efficient and hold US-listed ETFs directly you would need a US-dollar account. Even using Norbert’s Gambit to minimize currency exchange fees, you would likely lose 0.1-0.2% per transaction due to the bid-ask spread. Much more if exchanging via a bank or brokerage. So, using an all-in-one ETF would be a wash for the first year of a purchase, but have a slight tax drag advantage over the subsequent years.
What if your risk tolerance changes later?
As people get closer to needing their money, their risk tolerance and risk capacity usually drop. So, they may want a higher bond allocation later than they do now. That can be addressed by adding a separate bond ETF later on, as that time approaches.
Loss of ability to choose to sell or donate holdings with different unrealized capital gains.
If you have a personal taxable account with multiple ETF/stocks and need some money, you could sell from the ETF/stock with the lowest capital gain. That would defer more tax until later. In a corporation, donating stock/ETFs with large unrealized capital gains to a charity results in the ability to move money out of the corporation tax efficiently into personal hands. Harvesting capital gains in a corporate account can also be a way to tax-efficiently move money out.
This potential downside could be addressed by adding an asset allocation ETF from a different company later. For example, if 20 years from now you have a large unrealized gain on VGRO, you leave that and start buying XGRO moving forward. Then you have two to choose from, but still convenient.
Loss of the ability to attempt asset location optimization.
Some investors try to match different holdings to the accounts where they are most tax efficient. This is a vety complex process. It may be worthwhile with a large portfolio (millions) and a high-income tax rate, particularly if incorporated. However, the benefit is small compared to the other aspects of investing, and potential for problems executing it are significant. So, not being able to do this should not be a deterrent for the average person starting DIY investing.
More sophisticated investors with a large tax-exposed portfolio could always shift gears to asset location tax optimize later. I have made tools to help make it easy, but basic knowledge and comfort is required first.