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:

Canadian core equity 12% Claymore Canadian Fundamental (CRQ)
Canadian small-cap equity 8% iShares Small Cap Index (XCS)
US core equity 8% PowerShares FTSE RAFI US 1000  (PRF)
US value equity 4% Vanguard Value (VTV)
US small-cap equity 4% Vanguard Small-Cap (VB)
International core equity 8% Vanguard Europe-Pacific (VEA)
International value equity 4% iShares MSCI EAFE Value (EFV)
International small-cap equity 4% Vanguard All World ex-US Small-Cap (VSS)
Emerging markets equity 4% Vanguard Emerging Markets (VWO)
Real estate 4% Claymore Global Real Estate (CGR)
Short-term bonds 40% iShares DEX Short-Term Bond (XSB)

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.

14 Responses to Taking ETFs to the Next Dimension

  1. Mike Bayer, CFP September 17, 2010 at 12:53 pm #

    Great article. I have been implementing many of the DFA strategies with ETF’s since I attended my first DFA advisors training conference back in 2002 and have to say that your model portfolio does incorporate many of the strategies used by some of the worlds most knowledgeable financial professionals.

    However, I would also like to add a couple of points.

    Most people tend to put too much focus on choosing the right investment products. They mistakenly believe that investment success is primarily a result of picking the right stocks, bonds or ETF’s. The fact is that the products you choose are not really that important in the long term.

    In reality, investment success is primarily determined by creating and following a disciplined investment process based on your individual objectives and requirements.

    1 – Create an investment plan – Based on your goals, determine your required rate of return.

    2 – Determine your asset allocation (bonds – equity – cash) based on your required rate of return.

    3 – Re-balance annually or when your portfolio moves too far away from your target allocation.

    Sadly, only a very small number of individual investors have the knowledge and emotional discipline to maintain this process on their own. It seems as though the human brain is simply wired to cause most people make bad investment decisions. I have seen many very intelligent people make poor, emotionally driven and very costly investment mistakes. This is one of the few places a good advisor can add value. Maintaining investment discipline is a skill that very few people have developed and yet is the single most important element in determining a successful investment experience.

    Another point to consider is simplicity. A very well diversified portfolio can be constructed with 4 to 7 ETF’s, adding more funds simply increases complexity and does not necessarily reduce risk or improve returns.

    I think we can all agree in today’s complex and often confusing world, a simple solution of often the best solution.

    Mike Bayer, CFP

  2. Canadian Couch Potato September 17, 2010 at 1:17 pm #

    @Mike: Thanks for the comment, and I completely agree that this portfolio is too complicated for most investors. Those with small accounts and/or a desire to keep things much simpler can certainly lump together some of the US and international equity components. For example, 15% to VTI and 15% to VEA would be just fine. There are lots of simpler alternatives on my Model Portfolios page.

  3. Sean September 17, 2010 at 1:59 pm #

    Very good post and magazine (Canadian Moneysaver). It’s remarkable that only 6% of Canadians use ETF’s vs 53% use mutual funds to invest their savings. Sheep.

    So what were the returns for the model dimension portfolio vs the actual DFA portfolio over the last 5-10 years?

  4. Canadian Couch Potato September 17, 2010 at 2:04 pm #

    @Sean: There is no 10-year track record for many of these ETFs, and indeed, some have been around less than five years. There is also no single “DFA portfolio,” though I am going to try to get historical returns for their Canadian funds. Some US performance data here:
    http://www.dfaus.com/strategies/performance.html

  5. Financial Cents September 17, 2010 at 7:42 pm #

    I look forward to the next MoneySaver article Dan.

    Cheers,
    Mark

  6. Corey September 18, 2010 at 1:28 pm #

    Dan, love Canadian MoneySaver and glad to hear that you’re writing for them – I hope to see many more articles from you!

  7. Canadian Couch Potato September 18, 2010 at 4:31 pm #

    @Mike and Corey: Many thanks! Next MoneySaver hits the stands in about two weeks.

  8. Arjun @ InvestingThesis.com September 18, 2010 at 11:18 pm #

    Dan,
    Great post. Look forward to seeing your articles in Canadian MoneySaver.

  9. Farhan Thawar September 19, 2010 at 10:09 am #

    I love this blog!

    Btw, I don’t think the “Notify” via email feature works, but will look out this time.

  10. Mark September 19, 2010 at 4:07 pm #

    This article was interesting, I am wondering if you did an article in the pass about all the different asset classes, their rate of returns and risks? After reading this article, I scanned the internet to find the average returns of all the different asset classes and was surprised by some of the results, (REITs outperforming large caps with less risks) but I am not 100% sure about the accuracies of these reports so I decided to leave a comment here to see if you know any links/articles that can help me out.

    Thanks.

  11. Canadian Couch Potato September 19, 2010 at 4:53 pm #

    @Mark: Download the “Total returns” spreadsheet here : http://www.libra-investments.com/re01.htm

    This provides annual returns for major asset classes going to 1970, where available. Unfortunately, REITs are not included. But you can go to http://www.iShares.ca and click “Index Return Charts.” Under the Sector/Specialty heading, you can find the S&P/TSX REIT Index and can download a spreadsheet with historical performance info.

    Hope that helps.

  12. Boomer from Grande Prairie September 21, 2010 at 5:10 pm #

    What are your thoughts on Wisdomtree and possibly using their small cap dividend etf’s for small cap international or emerging markets?

  13. Canadian Couch Potato September 21, 2010 at 7:05 pm #

    @Boomer: I haven’t looked deeply in to WisdomTree ETFs, though their indexes are designed to capture some of the same value components. They also have the only emerging markets small-cap ETF that I am aware of (ticker: DGS). That might be slicing the pie a little too thin, but they’re worth a look.

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