The ETF: A giant box of assorted LEGO

Building an investment portfolio is a lot like building with Lego. Using a variety of assets (bricks), a plan, and some time, you can really create something to be proud of. Just like your latest Lego creation, a lot depends on the types of bricks you start with.

Individual Stocks: Picking stocks individually is like buying Lego bricks one type at a time. Imagine having to buy 1000 4x2 Red Bricks at a time, or worse, 1000 4x4 Grey Plates. You might run out of funds before you can buy enough types of bricks needed for your project.  Also, when investors only own a few different types of stocks (less than approximately 25), they are vulnerable to business risk. Business risk is present in individual stocks due to changes in the conditions relative to that business. For example, RIM (Blackberry) saw it's stock go from $165/share on the day the iPhone was released to less than $10/share 10 years later.

Mutual Funds: Like that premium Star Wars Death Star themed Lego building set, mutual funds may offer all the pieces you need for that project, but at a premium price. Mutual Funds are actively managed by portfolio managers who charge extra fees known as Management Expense Ratio (MER) , and are often bound by some other terms that make it more difficult to adjust or dismantle. It is also unlikely that you would “uncragle” that Death Star to build something else without some effort (or tears).

An example of a Portfolio built with ETFs can be something like this:

Growth Investment Portfolio
1. Canadian Equity Index ETF 25%
2. US Equity Index ETF 25%
3. International Index ETF 25%
4. Canadian Bond Index ETF 25%

ETFs, Exchange Traded Funds: (Spoiler alert – This one is my favourite). One of the easiest ways to achieve a diversified, balanced, and cost efficient building experience is to start with that giant box of classic assorted LEGO pieces. One of the easiest ways to achieve a diversified, balanced, and cost efficient investment portfolio is to start with buying ETFs, or specifically INDEX ETFs. An ETF is a basket of individual stocks that are lumped into one tradeable asset on a given index (TSX, S&P500 etc.). An INDEX ETF is a basket of stocks that mimics the movement of that given Index.

Here are 5 reasons why I love Index ETFs:

1)      ETFs are diversified. Because many Index ETFs own hundred or even thousands of different stocks, they are pretty much eliminating business risk from the equation and only subject to market risk. Rather than owning individual stocks in a particular market, each carrying its own business risk and therefore heightened volatility, why not own ALL of the stocks in a particular market. For example, Vanguard Total US ETF has 3613 different US stocks in its portfolio. If one stock were to tank or go bankrupt (like Enron), the ETF would generally be insulated by the remaining 3612 stocks. 

2)      ETFs give Canadians access to other global markets. Building on the previous theme of diversification, the ability to buy a US Equity ETF or an International Equity ETF with relative ease allows us to diversify away from just the Canadian markets. Many Canadian investors have most of their investments in Canadian stocks/mutual funds which is often called ‘home-country bias’. Canada makes up only 3% of the world markets and the TSX is heavily weighted in financial and resource companies. Investors can achieve more balance and diversification by looking outside Canadian markets. In any given year, Canadian, US, and International Equity ETFs may have a different rate of return. However, it is very difficult to predict which market will do better in each time period. That is why I recommend owning all three of them! That is a more balanced approach than having all your eggs in one basket (or market).

3)      Index ETFs are “passive”. Their goal and purpose is to mimic the ‘market’ or a ‘benchmark’. They do not try to beat the market with “active strategies”. Recently, many studies suggest that “active strategies” that many hedge funds or mutual funds are based on, as an aggregate, do not beat the market over the long term after fees. By moving to a “passive” portfolio, you can get close to market returns, a historically upward trend over the long term (see below graph). A “passive” strategy also helps to reduce FOMO (fear of missing out) or regret. “I should have invested in X stock - it’s up a lot”, or “I shouldn’t have invested in Y because it plummeted”. It also takes out the stress of trying to pick which mutual fund will actually beat the market, which is next to impossible to determine. 

*assuming an investment of $6000 per year for 40 years, earning a little over 5% per year.

*assuming an investment of $6000 per year for 40 years, earning a little over 5% per year.

4)   ETFs are low cost. MER’s(Management Expense Ratio) can be as low as 0.2%. Many Canadian mutual funds have an MER of 2.4%. Did you know that the MER fee is charged on your ENTIRE value of your portfolio year after year, whether it’s up OR down? In my mind, getting ‘the market’ at 0.2% is better than paying 2.4% to a mutual fund to try to ‘beat the market’. To put this in perspective, the mutual fund has to BEAT the market by over 2% in order to give you market returns. Kudos to any mutual fund that can do that over 25-30 years.

5)      ETFs are liquid and easy to buy. You can sell them at any time, buy them easily. You don’t have to get your ‘guy’ do it for you. They are not locked in like GICs or locked in like Real Estate. With a click of a button, you can have access to your investment without having to wait for your advisor, or paperwork, or sell a real asset (like a house or car). Trading fees can be less than $10 per trade so the transactional costs are low compared to other investments.

In summary, I love ETFs because they form the basis of a low-cost, balanced, and globally diversified portfolio that is also liquid (easy to access and trade), just like that box of assorted LEGO bricks is a great start to a creative and fulfilling project. That doesn’t mean you won’t add other more specific pieces to your investment strategy down the road, but starting with a good foundation is key to a healthy financial plan. For more information on how ETFs can be the building blocks for a balanced and diversified portfolio, see my article on “Passive Investing Solutions”.