How to Build an ETF Portfolio Around the Vanguard S&P 500 Index ETF (VFV)

The Vanguard S&P 500 Index ETF (VFV) is a staple in many Canadian investors' portfolios, as evident on forums like r/CanadianInvestor where it's frequently discussed.

It's no surprise why – after all, offering exposure to the S&P 500 at a mere 0.09% MER makes it an enticing choice. This is even after dealing with a 15% withholding tax on dividends and the inherent FX volatility from an unhedged Canadian domiciled U.S. equity ETF.

Yet, putting all your investment eggs in the VFV basket isn't ideal, particularly if you're aiming for international exposure beyond U.S. equities. And while it might be tempting to pair VFV with a comprehensive asset allocation ETF like the iShares Core Equity ETF Portfolio (XEQT), this strategy often results in unnecessary overlap and redundancy.

So, how should you complement VFV to forge a more rounded, robust ETF portfolio? Let's look at a strategy that enhances diversification without duplicating your existing investments.

iShares Core S&P/TSX Capped Composite Index ETF (XIC)

When diversifying beyond VFV, Canadian investors should first consider incorporating a domestic equity ETF into their portfolio, allocating about 10-30% to such assets.

A slight home country bias has its advantages, including reduced currency risk, lower historical volatility, and greater tax efficiency, as noted in Vanguard's research.

A prime candidate for this role is the iShares Core S&P/TSX Capped Composite Index ETF (XIC). XIC offers broad exposure to approximately 220 large, mid, and small-cap companies listed on the TSX.

The "capped" in its name means no single holding can make up more than 10% of the portfolio, ensuring no excessive concentration even though the ETF is otherwise market-cap weighted. Predominantly, XIC's composition mirrors the classic Canadian market sectors, heavily skewed towards financials and energy.

For those who appreciate regular income, XIC also sports a respectable trailing 12-month yield of 2.67%. It's also very affordable with a 0.05% MER.

BMO MSCI EAFE Index ETF

Expanding your investment horizons beyond North America is a smart move, and the EAFE region, which stands for Europe, Australasia, and the Far East, is a stellar choice for geographic diversification.

My top pick for accessing this market is the BMO MSCI EAFE Index ETF (ZEA), which captures around 85% of the market capitalization in these areas, focusing primarily on large-cap stocks.

A glance at ZEA’s sector and country distribution reveals a significant emphasis on Japan and the UK, alongside substantial allocations to other European nations like France, Switzerland, and Germany, and Oceania countries such as Australia.

The ETF includes well-known international companies like Novo Nordisk, Nestlé, ASML Holdings, AstraZeneca, Shell, LVMH, and SAP.

While ZEA is slightly more expensive than some domestic options, its expense ratio of 0.22% remains quite competitive within the sphere of international developed equity funds.

Putting it together

You can slice and dice it any way you prefer, but I like an allocation of 60% in VFV, 30% in ZEA, and 10% in XIC. This setup mirrors the composition of the MSCI World Index but adds a slight home country bias. Without this bias, a more typical global allocation might look like 70% in VFV, 27% in ZEA, and 3% in XIC.

With annual rebalancing and reinvested distributions, this portfolio strategy would have delivered an annualized return of 12.15% from February 14, 2014, to August 23, 2024, turning an initial $10,000 investment into $33,427.16.

I think that's quite impressive for a straightforward approach using just three low-cost index ETFs. With commission-free brokerages like WealthSimple, there's no reason why the average Canadian investor can’t easily implement this strategy.