Earlier this week I published an excerpt from my interview with David Nugent, portfolio manager of the online investment service Wealthsimple. In this second part of our interview, Nugent goes into more detail about the firm’s investment strategies, including the individual funds they use in their portfolios.

Let’s say you’ve determined an investor’s appropriate asset mix is 60% equities and 40% fixed income. Can you describe how you would divide that across various asset classes?

DN: Our asset classes are Canadian equities, US equities, foreign developed market equities, emerging markets, dividend stocks and real estate, and then there is a component of tactical stocks. The fixed income piece is Canadian investment-grade corporate bonds, Canadian government bonds, US high-yield bonds and cash.

When it comes to choosing ETFs, we try to get the broadest exposure in each asset class. We’re looking to try to capture large caps, mid caps and small caps because we believe that over the long term there is value in having some exposure to that small cap space: they tend to outperform large caps over extended periods. So for Canadian, US, foreign developed and emerging market equities we use total-market cap-weighted ETFs.

iShares Core S&P/TSX Capped Composite (XIC)
Vanguard Total Stock Market ETF (VTI)
iShares Core MSCI Emerging Markets ETF (IEMG)

We are using US-listed ETFs wherever possible. As you have written about on your blog, the tax efficiency is better. We have been able to negotiate institutional currency pricing. The typical investor pays 100 to 150 basis points on top of whatever the foreign exchange rate is through their discount brokerage or their advisor. We have been able to negotiate a rate of 0.2%, and that will come down as we scale the business.

I understand that you don’t use cap-weighted funds for the other equity asset classes.

DN: With the real estate and dividend stocks we use a fundamental methodology. We really want to make sure the underlying fundamentals are considered when looking at income-producing stocks. Obviously the risk to a dividend-paying stock is that the dividend will be cut, so the highest yield is not necessarily the best, especially given a rising interest rate environment. We want companies that are paying solid income and growing their distributions over time, so we have gone with a more fundamental methodology there.

For real estate we’re using the Purpose Duration Hedged Real Estate Fund. When you look at the real estate products on the market, the iShares product has a third of the portfolio in two stocks, so arguably you’re taking a lot of company-specific risk there. We prefer the BMO fund because of the equal-weight structure, but even there you’re missing out on the US. So Purpose gave us the ability to get exposure to both Canada and the US, and it looks at the underlying fundamentals of the businesses. The other interesting thing is the income received from the US is recharacterized as Canadian dividends for tax purposes: it’s part of the corporate class structure Purpose uses.

We actually use the mutual fund versions with Purpose, rather than the ETFs. Mutual funds in Canada have been associated with very high management fees, and that’s why people generally don’t like them. But one of the beneficial things about the mutual fund structure is that you are not paying a bid-ask spread like you would with an ETF: you are getting it at net asset value every day. Because we buy our securities once a day the mutual fund structure is actually cheaper, because we are not paying that bid-ask spread. And at Purpose the management fees on the mutual fund and ETF versions are exactly the same. So we just made that call based on efficiency.

The dividend fund also has a North American focus. The problem with Canadian dividend ETFs is simply that you have a massive overweight to financials, and obviously you miss out on the US market completely. So we have elected to go with the Purpose Core Dividend Fund, which has a sector cap of 20%. It also has that ability to recharacterize US income as Canadian dividends through the corporate class structure.

The tactical stock piece is really interesting, and we’re excited about it. The Purpose Tactical Hedged Equity Fund uses a US fundamental methodology for the individual stock selection, but the ETF itself can go anywhere from 75% to 25% long the market. It’s all rules-based: they look at technicals from two weeks to one year. When we add a sliver of that to the portfolio it really dampens the volatility and provides what we believe to be superior risk-adjusted returns, because you’re systematically trimming that equity exposure when markets start to fall. So we have about a 10% weighting to that fund, and we think that’s going to help us on downside protection.

The flexibility we have by owning a few of the Purpose products is the tax deferral mechanism within the corporate class structure. If we need to rebalance by reducing our equities and buying more fixed income, for example, instead of selling the equity exposure we can just roll it over into the fixed income fund within the corporate structure and defer capital gains. So from a tax-efficiency standpoint it’s a huge advantage.

OK, that’s the equities looked after. Now let’s talk about the fixed-income side of the portfolio.

DN: For Canadian investment-grade bonds we’re using the iShares 1-5 Year Laddered Corporate Bond (CBO), and then we overlay that with the Purpose Total Return Bond Fund, which is more tactical in nature: it can have a weighting of up to 66% in any one of four categories: high-yield, investment-grade corporates, governments, or cash.

We are heading into a new paradigm of interest rates. We’re not going to make a call on interest rates on a short-term basis, but given the record low rates, they really have only one place to go, which is up. So for the fixed-income piece it’s important to keep the duration low. We’re not going to make any active duration calls, because we think that could become very volatile, similar to last year when interest rates spiked and no one really saw it coming. So we’ve elected to stay short and be a little more tactical.

On the equity side, nothing is hedged to the Canadian dollar. But the US bonds are all hedged: we own the iShares U.S. High Yield Bond CAD-Hedged (XHY). The reason we go to the US for that exposure is simply because there is a very small high-yield market in Canada and it’s just much more robust in the US.

So for a typical balanced portfolio, what would you estimate is the weighted MER?

DN: It’s about 0.25% to 0.30% across the board. We’re never going to be the lowest cost, but we want to provide people with a sophisticated investment solution at a reasonable cost. And given where management fees are on mutual funds and active management today, we feel we’ve achieved that.