Investment Workshop 3: Picking Your ETFs

Wanderer
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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.

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Just a quick note to all our Workshop participants, by now you should be (hopefully) done setting up your Questrade or TD Ameritrade accounts and funding them. Again, we’ll be using Personal Capital as our UI front-end since both these brokerages support linking with Personal Capital. Once you ‘ve set up your account and linked them, you should be able to see your trading account in Personal Capital when you log in, as well as any money you’ve put in. Here’s what my dashboard looks like, showing the first $1000 I’ve put into the account as cash. If you can see something similar, you are all set.

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Last week, we went over how to pick our overall top-level asset allocation: equities and fixed income. This will generally determine your long term investment gains as well as your overall portfolio volatility. For this workshop we will be using the same 60% equity/40% fixed income portfolio we used to retire, but based on your own investment timeframe and spikiness-tolerance, you may choose to go more or less aggressive than this.

The Trump Effect

As we’ve mentioned previously, all rosy everything-will-be-fine economic scenarios have been tossed out the window courtesy of incoming President-Elect Donald Trump. The impact of a Trump presidency is unclear because he himself has been so unclear on the campaign trail. As Seth Meyers said on Late Night, Donald Trump has held every possible position on every possible issue. And there’s a ton of negative stuff coming down the pipe for the rank-and-file American citizen such as the elimination of Obamacare, the sharp increase in violent hate crime across the country, and uncertainty in America’s future participation in military alliances such as NATO.

However, the Millennial Revolution is a finance blog so we will focus on the economic impacts. Specifically:

  • Drastically cut the corporate income tax, from 35% to 15%
    • Impact: Positive for stock markets as this would increase corporate profitability
  • Push the Fed to raise interest rates faster
    • Impact: Posssibly Negative as a too-rapid rise in interest rates would cause a recession
  • Rip up and renegotiate NAFTA
    • Impact: Negative as the imposition of tariffs would increase labour costs and decrease corporate profitability
  • Label China a currency manipulator and start a trade war using punitive tariffs
    • Impact: Negative for the same reason as above, but with a much bigger impact

So basically, all eyes are on those trade deals. If those policies get implemented the way Trump yelled about on the campaign trail, look out below because the US will get hit with a triple whammy: Job losses, Crashing Stock Markets, and Higher Inflation since the cost of imported goods will rise.

Right now, stock markets seem to be relatively calm, indicating that Wall Street is expecting to get the first line item relatively easily (since tax cuts are easy to pass through a Republican Congress), but are expecting the NAFTA/China trade wars to get stalled by Republicans weary of tanking the stock market and therefore their own investment accounts. I hope they’re right.

Nevertheless, we should assume the worst and invest accordingly, meaning through a portfolio of low-cost Index ETFs that cannot go to zero, no matter how badly Trump screws up the economy. This is the same portfolio that survived 2008/2009, and will survive Trump as well.

Canada

For our fellow Canauckistans, when we were first starting off we used www.canadiancouchpotato.com as our go-to resource for model portfolios. Here’s a link to their most up-to-date page.

Since we last checked in with Canadian Couch Potato, they seemed to have changed their ETF model portfolio. A few years ago, they used to track each individual index (S&P500, EAFE, etc.) using a separate ETF for each, but now they’ve converged all those holdings into a single ETF called VXC which is an “All-World Ex-Canada ETF,” meaning that it covers all global equity indexes minus Canada.

I actually prefer the old approach because it gave us the ability to shift allocations between countries while this one is one giant monolithic black box. Fortunately, they still have the old portfolio still linked on that site (go to the Model Portfolio’s page, scroll to the bottom, click the link that goes to the “Canadian Portfolio Manager” blog run by one of the contributors to Canadian Couch Potato, then click “Model ETF Portfolios (with broad-market bonds)“. Here’s the model portfolio we’re going to be using as a starting point.

pwl-model-etf-portfolios-broad-market-bonds-2016-06-30

Source: Canadian Couch Potato Model Portfolios

So since we’re targeting a 60% equity/40% fixed income portfolio, we want to scan over and look at the column labelled “40FI-60EQ.” This is the ETF mix we will be starting with.

Name Ticker Allocation MER
Vanguard Canadian Aggregate Bond Index ETF VAB 40% 0.13%
Vanguard FTSE Canada All Cap Index ETF VCN 20% 0.06%
Vanguard U S Total Market Index ETF VUN 20% 0.16%
iShares Core MSCI EAFE IMI Index ETF XEF 16% 0.22%
iShares Core MSCI Emerging Markets IMI Index ETF XEC 4% 0.26%

The majority of these Index ETFs are run by Vanguard which is great as they have the lowest fees out there, running at 0.06-0.16%. iShares is not far behind, with their EAFE and Emerging Market funds charging 0.22-0.26%. Total MER of this portfolio is a scant 0.14%, compared to the average 2% of actively traded mutual funds.

Remember what we keep saying on this blog: Every time you buy an ETF you are making a statement. This portfolio is composed of index ETFs, with Canada, USA, and International Indexes weighed equally, so by investing in this portfolio, we are stating two things:

  1. We believe that it’s impossible to pick individual stocks from each index, so we are simply purchasing the entire index
  2. We believe that Canada, the USA, and International stocks will perform roughly equally

So this portfolio is basically a region-neutral allocation. Canada, USA, and International (meaning EAFE and Emerging combined) are all equal. So by sticking with this allocation, we are basically saying that no particular region will outperform the other.

Now, you’re probably wondering with my USA-will-doom-us-all talk that I would lighten up or eliminate our US exposure, right? Actually, no. We’ve gone through a US-led economic collapse before, and when that happened all stock indexes fell together at the same rate. Trying to guess which country will crash less didn’t help at all because when the US crashes, the world crashes. However, when the US eventually did rebound, they led the charge. So a significant portion of our portfolio should still be allocated to the US despite our deep misgivings about the current President.

This will be the Canadian portfolio we will build in the Investment Workshop. As always, feel free to disagree and design your own portfolio based on your own beliefs. For example, if you’re bullish on President Trump and believe that the US will outperform other countries, you may want to shift equity towards the US index, like so:

Name Ticker Allocation
Vanguard Canadian Aggregate Bond Index ETF VAB 40%
Vanguard FTSE Canada All Cap Index ETF VCN 15%
Vanguard US Total Market Index ETF VUN 30%
iShares Core MSCI EAFE IMI Index ETF XEF 11%
iShares Core MSCI Emerging Markets IMI Index ETF XEC 4%

However, please know that any guess about any particular region’s outperformance over any other is just that. A guess. So if you want to stake out a position on a particular region, don’t shift any asset class too much off a neutral stance or you risk being caught off guard and getting blown up if you turn out to be wrong.

And now let’s move on the Americans…

USA

The American equivalent of a Canadian Couch Potato portfolio would be the Three Fund Portfolio pioneered by none other than John Bogle, founder of Vanguard and the pioneer behind Index Investing as an investment strategy. This guy knows what he’s doing, so for our American readers, we will be following his guidelines.

The Three Fund Portfolio basically states that you only need 3 funds tracking 3 asset classes: Bonds, US Equities, and International Equities, with the US and International Equities split equally between them. So for a 60/40 equity allocation, this is what our portfolio would look like:

Name Ticker Allocation MER
Vanguard Total Bond Market ETF BND 40% 0.06%
Vanguard Total Stock ETF VTI 30% 0.05%
Vanguard FTSE All-World ex-US ETF VEU 30% 0.13%

Total MER: An even more astoundingly low 0.08%!

Note that these are the Vanguard ETF versions of funds that many FI-ers like Jim Collins use (VTSAX being the most famous one). The only difference is that VTSAX requires your balance to be at least $10,000, but other than that they’re the same thing.

This allocation is, once again, a region-neutral allocation that doesn’t make any strong statement about US performance vs. International equities. And because we have no idea what’s going to happen under a Trump presidency, we will be going with this region-neutral allocation for our Workshop.

Again, if you are bullish on President Trump go ahead and shift some allocation away from VXUS towards VTI. Another argument for a higher allocation towards US equities comes from fellow Early Retiree Jim Collins, who writes that because so many US companies are multinationals, you are getting more International exposure than you think through VTI. You can read his very good article on it here: http://jlcollinsnh.com/2012/09/26/stocks-part-xi-international-funds-2/

If you buy either argument, you may want to pivot towards US equities like so:

Name Ticker Allocation
Vanguard Total Bond Market ETF BND 40%
Vanguard Total Stock ETF VTI 40%
Vanguard FTSE All-World ex-US ETF VEU 20%

But again, if you take a position one way or another don’t move too far away from a neutral stance so you don’t get blown up if you’re wrong.

Next Week

OK so now that we have our ETF picks ready to go, next week we will discuss our buying schedule. Namely, we will discuss the impact of lump-sum investing versus Dollar-Cost-Averaging as it relates to the current investing environment, after which we will schedule our first purchase.

Questions? Comments? Let’s hear it in the comments below!

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39 thoughts on “Investment Workshop 3: Picking Your ETFs”

  1. Nice workshop post Wanderer.

    Do you believe currency exchange rates will have a significant affect on your U.S. asset purchases?

    From an American’s perspective, the CAD looks pretty cheap right now. Canadian dollars haven’t been this cheap in a decade.

    But that also means U.S. based assets are expensive for Canadians.

    1. My response to your question about the future direction of CAD/USD is a qualified “I have no idea.” Forex is a whole other ball game that I don’t have much experience with, so I maintain a neutral position on that. For that reason, none of the ETFs I picked are currency-hedged, because that would be taking a position on CAD over-performance that I’m not prepared to take.

    1. No. That portfolio is the one I’m using now that I’m retired, in which I deliberately pivoted towards riskier but higher-yielding fixed income assets. The portfolio we’re building in the Workshop is for people in the Accumulation phase of their journey, meaning people who are still working and trying to build up their portfolio as quickly as possible. We can expect a yield of around 2% for this.

  2. For the Canadian portfolio, why did you choose a US etf that was not hedged? Also, do you keep any of your investments in US dollars at all? Thanks.

    1. Great catch. Boy, we’ve got some smart cookies on this blog 🙂

      Because the underlying assets are priced in the currency of that country, adding CAD hedging is taking a position of “I believe the CAD will outperform the USD.” I have very little forex experience so I’m deliberately taking a neutral stance on which currency will outperform the other. Therefore, all ETFs are currency-unhedged.

  3. Something is concerning me about your allocations, and that is that you haven’t diversified your “bond” exposure more. Is it that you wanted to keep it simple or that you really wouldn’t have spread out your 40% further?

    The Canadian portfolio appears to have all Canadian bonds, no bonds from the US (VBU) or anywhere else (VBG) and they largely appear to be government bonds. No corporate bonds (XCB), no REITs (VRE or CGR), and no Preferreds (CPD or PFF).

    The US Portfolio is similar though the ETF there has a slight diversification of territories the bonds come from.

    1. If you live in a politically & economically stable economy, a bond is a bond is a bond. Canada’s bond yields are not that different from the US’s, so investing in US bonds is taking on a foreign exposure risk for no good reason. Higher risk bonds like corporates and preferred are fine too, but for someone still working and building their portfolio for the first time, simple is better.

      That being said, if you happen to live in a country whose bonds are really different than the US’s, investing in more foreign bonds may make sense. If I were a Greek investor, I wouldn’t be going domestic any time soon.

    2. IMO, it is important to remember that the purpose of the “bonds” portion of your portfolio is to provide stability and reduce volatility–the purpose is generally NOT to increase return. Therefore diversification is really not necessary (and as Wanderer mentioned, could expose you to currency risk which actually increases volatility, exactly the opposite of what you want it to do). It’s easier just to keep the fixed income portion as simple as possible.

  4. Miscellaneous notes:

    1. I wish they had a class like this back when I was in college. Granted, college students usually don’t have any money to invest. But this is an important skill to learn.

    2. Could you discuss how the dividend/distribution from these funds is reinvested?

    3. I would suggest including MER info here as well, though that info can be found easily. And also discuss exactly how they deduct those fees from the account.

    4. I (in the USA) have a Scottrade account instead of TD Ameritrade account. But I guess that doesn’t matter, as those funds are also available through Scottrade. (Coincidentally, Scottrade just merged with TD Ameritrade. Not sure when the deal will get finalized.)

    1. I’m invested 100% in VUN. I’ve lost about $50 since I invested. So much volatility. Should I pull my money out? Just kidding haha. Keeping it in there for years. I wouldn’t be shocked if my investments tank for the next 4 years. Will keep addding to it monthly, regardless.

    2. Dividends will be deposited into your account as cash.

      As for MER’s, they will be paid for from whatever you make from your fund. If the ETF made 1%, and the fee was 0.1%, you will see 0.9%. That’s why you want to make sure the MERs are as low as possible.

      Don’t know a thing about Scottrade, but make sure you won’t pay any commissions to trade. I don’t want your money to disappear in fees.

  5. VTSAX doesn’t require “each purchase” to be $10,000. You just need to have a minimum of $10,000 invested in the Vanguard Total Stock Market Index funds before you get access to the lower cost Admiral Shares. You can get started with the Investor Shares with a minimum investment of $3,000 (VTSMX). The only difference between VTSMX and VTSAX is the expense ratio. The “Investor” class has a expense ratio of 0.16% and the “Admiral” class has an expense ratio of 0.05%.

    So, if you’re just getting started, you can put $3,000 into VTSMX and then add as much as you can (in any increment, $400, $1000, $10, etc.) until you reach $10,000 when Vanguard will automatically switch you over to the cheaper version “Admiral” class (VTSAX). From there, you can continue to add to your investment in any increment.

      1. An ETF you normally have to pay commissions to buy/sell while the mutual fund you don’t. And VTSAX requires at least $10k invested.

        Of course, since we’re using Questrade and TD Ameritrade as our brokers who don’t charge commissions for trading these ETFs, you get no advantage from using VTSAX over the ETF.

  6. I like your argument that lessening exposure to the US isn’t useful/possible in The Time of Trump.
    But what about decreasing exposure to stocks, and increasing to bonds? Maybe not if inflation goes nutty?

    1. You base your equity/fixed income allocations based on timeframe and individual risk tolerance. That’s it. If you try to swing in/out of equities based on the news, you’re actively trading and that shit doesn’t work.

  7. I am trying to follow along from Australia and these after some research I found the following ETFs to mirror your portfolio:

    Bonds (40%) VAF – Vanguard Australian Fixed Interest Fund
    Australian shares (20%) VAS – Vanguard Australian Shares Fund
    US shares (20%) VTS – Vanguard U.S. Total Market Shares Index ETF
    International shares (16%) VGS – Vanguard MSCI Index International Shares
    Emerging markets (4%) IEM – iShares MSCI Emerging Markets Fund

    Is there a way to check if the products by Vanguard and iShares in different countries track the same indexes? i.e. is there a way to check if the VTS offering by Vanguard in Australia tracks the same US companies as the VUN you are using in Canada? I want to try to find the equivalents of what you are going to buy in your Canadian portfolio and I’m wondering if there’s a way to check this?

  8. 2 Questions:

    1) Why did you decide to go with 3 ETF portfolio (for the International portion) as opposed to just owning VXC (Global ex Canada)?
    I understand that,that way, you’re more flexible in terms of rebalancing and can increase/decrease your exposure to the US/Developed/Emerging Markets the way you want (as opposed to owning a big black box).
    But other than that, does it really make a difference?
    I ve been thinking about this over the last few weeks and I m still not sure.
    I know that CPP is pro-VXC and that Justin (PWL) prefers the 3 ETF model.

    2) What do you think of the experts who pretend that the 60/40 is dead?
    I know you had this 60/40 portfolio and it worked fine for you over the last few years. But with the current Bond and Stock markets, don’t you think it would make more sense to increase the equity exposure. Basically, wouldn’t the 60/40 of yesterday be a 80/20 or 70/30 today?

    Thanks!

    1. Additional flexibility is the only reason we’re not using VXC. If you look at the regional holdings of VXC, it’s 55% US/45% international, so not too different from a region-neutral portfolio. Feel free to use it if you’re fine with this blend, but if you do you’ll lose the ability to adjust those allocations in the future.

  9. Hey! Looking over the PWL Model ETF Portfolio table at the top of the article, one thing strikes me as particularly crazy and out of sync with the basic principles of risk/return – over 20 years, the 30% equity 70% bond portfolio delivered a GREATER annualized return than the 100% equity portfolio. In fact the whole table doesn’t seem to illustrate that basic principle very well (on the longer-term investment time frames), it all looks kinda off in terms of the risk/return ratios…am I missing something entirely?!

  10. Yeah that’s because those are the results for a single 5/10/20 year investment period ending in June 2016. You see the variance in effects if you were to take a 20 year window and slide it backwards through history and see how the ending balance changes depending on time period.

    The efficient frontier graph I had in the last post shows this, but for another view we can use FireCalc.

    Here’s the results of a 30-year sliding investment window with a 60/40 portfolio.
    http://tinyurl.com/z93mqpk (click “Submit” on the right, I’ve already filled in the parameters with that link)

    You can see with a starting $100k portfolio, the ending balance at 30 years varies between around $100k (if you were unlucky) to around $850k (if you were lucky), with an average of $428k.

    But with a 100% equity portfolio, you get a much wider range: http://tinyurl.com/grp3mka
    Now, the min/max is $100k to $1.6M, with an average of $667k.

    Play around with that calculator and you’ll see the effects of higher equity allocations.

    1. Great tool – and thanks for sharing all of this – I’m really learning a lot. It’s really generous and awesome of you! Thanks :))

  11. I love this, Wanderer.
    I appreciate the Canadian Couch Potato’s simplicity of VCN & VXC, but our VXC’s took a long time to break even and show a profit. (We have multiple portfolios for our family, and our kids’ RESP is mostly VXC.)
    Meanwhile, VUN skyrocketed as the engine of our collective portfolio.
    I believe there are a few things going on. First, the US market is super hot right now. That happens. It doesn’t mean it’ll go on forever. Andrew Hallam, author of Millionaire Teacher, pointed out that overseas markets were more profitable for one decade, and the US has been more profitable for the following decade, so you need to be ready to capture the wave, no matter where it rises, and the way to do that is to have a balanced portfolio, as you do.
    Secondly, VXC has a higher MER. It’s a drag on profits.
    So I have a print-out of the PWL portfolio, and it does guide my buying, although I don’t follow anything slavishly.
    I have to admit, I trimmed our VUN the summer before the US election, so we have too much cash right now, and we missed out on some of the wave. Now I’m more a believer in “Timing IN the market is more important than timing OF the market.” But I’m someone who has to try things out first instead of only reading about it.
    Thanks for doing this. You two ROCK.

    1. Yeah that’s another advantage of splitting out the regions. You can see which region is outperforming the other, and you can decide to do something about it instead of just staring at the monolithic VXC and tapping your foot impatiently.

      And everyone who tried to play the US election got surprised. Even we were surprised it didn’t plummet after Trump won. Guess that shows you how hard it is to market time, huh?

  12. Ok, today was payday and I’m ready to start my contributions!! I just had a question; I have lots of contribution room in both my RRSP and TFSA (which I have recently opened on Questrade). Based on your article, “How to Pay No Tax on Your Investments” I assume that the ideal way to allocate my purchases would be such:

    RRSP
    Vanguard Canadian Aggregate Bond Index ETF
    Vanguard US Total Market Index ETF

    TFSA
    Vanguard FTSE Canada All Cap Index ETF
    iShares Core MSCI EAFE IMI Index ETF
    iShares Core MSCI Emerging Markets IMI Index ETF

    Cheers!

  13. Do you recommend Canadians to hold US ETFs? Or is it much better if we buy the Canadian equivalent?

    Ah I like the 3 fund better just because it’s only 3 haha

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