The Canadian Three-Fund ETF Portfolio

For beginner Canadian investors, I almost always recommend starting with an asset allocation ETF. Why? Because it's an all-in-one solution that prevents excessive tinkering with your investments and captures market returns in a straightforward and economical way.

However, if you're someone who likes to have a bit more control over your investments and perhaps enjoys the process of "slicing and dicing" the market, there's a solid strategy you can adopt while still keeping costs fairly low.

Enter the "three-fund portfolio," a model championed by the legendary Jack Bogle and widely utilized by passive investors in the U.S. Today, we're going to adapt this approach for Canadian investors.

I'm suggesting an 80/20 stock/bond allocation as it offers a balanced yet growth-oriented strategy, but of course, you can tweak this ratio to suit your personal risk tolerance and investment horizon. We'll aim to keep things simple with just three ETFs.

While it's possible to break this down even further for more cost savings, remember that increased complexity doesn't always lead to better outcomes.

Global Ex-Canadian Equity Market ETFs

Our portfolio starts with a solid 60% allocation to global equities, excluding Canada. This means we're diving into markets across the U.S., international developed countries like the UK, Germany, and Japan, as well as emerging markets including China, India, and Brazil.

To fit this bill, we need ETFs that:

1. Are market cap weighted across small, mid, and large-cap companies.
2. Cover all 11 GICS (Global Industry Classification Standard) market sectors.
3. Offer a blended style with exposure to both value and growth stocks.

After filtering through the options, this narrows our list of Canadian ETFs down to two primary candidates, both of which charge a 0.22% MER:

• Vanguard FTSE Global All Cap ex Canada Index ETF (VXC): This ETF tracks the FTSE Global All Cap ex Canada China A Inclusion Index.
• iShares Core MSCI All Country World ex Canada Index ETF (XAW): This one follows the MSCI ACWI ex Canada IMI.

It's important to note that with both ETFs, you might encounter some tracking error. This means the ETF’s performance might slightly differ from the returns of their benchmark indices. Why does this happen?

Aside from the fees, both VXC and XAW use an "ETF of ETFs" structure. They wrap other Vanguard and iShares ETFs to replicate the index's characteristics, which isn’t executed perfectly all the time and can result in performance that is either slightly better or worse. However, this isn't usually a significant concern.

In terms of performance, both ETFs have more or less moved in tandem, but XAW has pulled slightly ahead. I attribute this to its relative underweight in emerging markets compared to VXC, which has struggled over the past decade.

Canadian Equity Market ETFs

For Canadian investors, a certain degree of overweight in Canadian stocks, relative to their global market cap weight (about 3%), is a common and beneficial practice known as a "home country bias." Why is this beneficial?

According to research by Vanguard, having a home country bias can reduce volatility, minimize currency risk, and enhance tax efficiency. It’s a strategy reflected in the design of their asset allocation ETFs, and similarly adopted by other fund managers including iShares and BMO.

Given these advantages, our focus for the Canadian equity ETF component is on three main criteria: low fees, broad sector exposure, and all-cap exposure. This analysis narrows down our options to three ETFs—two tracking the S&P/TSX Capped Composite Index and one tracking the FTSE Canada All-Cap Index:

• iShares Core S&P/TSX Capped Composite Index ETF (XIC) and BMO S&P/TSX Capped Composite Index ETF (ZCN) both track the S&P/TSX Capped Composite Index. They are highly favored for their high Assets Under Management (AUM), excellent liquidity, low bid-ask spreads, and an economical expense ratio of 0.06%.
• Vanguard FTSE Canada All Cap Index ETF (VCN), slightly cheaper with an expense ratio of 0.05%, is just as liquid as its counterparts. Though it has fewer holdings compared to XIC or ZCN, it is by no means under-diversified. The top holdings across these ETFs are nearly identical.

Which one should you choose? Unless you’re deeply into the nuances of indexing, the choice might as well come down to flipping a coin.

As the historical performance data above shows, the returns are more or less identical across these ETFs, with any minor differences likely attributable to random error rather than any substantial divergence in strategy or management.

Canadian Bond ETFs

If you're aiming to produce better risk-adjusted returns, adding a slice of high-quality bond ETFs to your portfolio can help stabilize your investments and generate some steady monthly income.

And don't let the performance of bonds in 2022 throw you off—historically, bonds have proved to be invaluable as a diversification aid. During the 2008 financial crisis and the 1999-2009 "lost decade" for U.S. stocks, where equities stagnated, bonds actually delivered positive returns.

When it comes to selecting bond ETFs, our focus is on a few key traits:

1. Low fees through passive indexing.
2. Broad coverage among investment-grade corporate and government bonds.
3. A range of maturities, targeting an intermediate duration of around 6-7 years.
4. Canadian exposure only: This is crucial because most ETFs holding global bonds in Canada tend to be significantly more expensive, face drags from currency hedging, and have foreign withholding taxes deducted. These factors can negate any potential diversification benefits from global bond exposure.

For Canadian bond exposure, we have several good options, differing slightly in benchmarks but essentially interchangeable in terms of their core function. As of July 12, here are the leading choices:

• FTSE Canada Universe Bond Index: For this index, we have the iShares Core Canadian Universe Bond Index ETF (XBB) and BMO Aggregate Bond Index ETF (ZAG). Both offer expense ratios of 0.1% and 0.09% respectively, with an average duration of around 7.2 years and a weighted average yield to maturity of 4.1%.
• Bloomberg Global Aggregate Canadian Float Adjusted Bond Index: This is tracked by the Vanguard Canadian Aggregate Bond Index ETF (VAB), which charges a 0.09% expense ratio and offers a similar 4.1% yield to maturity and 7.2-year duration.
• Solactive Broad Canadian Bond Universe TR Index: The TD Canadian Aggregate Bond Index ETF (TDB) uses this index and is the most economical option here, with an expense ratio of 0.07%. It provides a 4.3% yield to maturity and a duration of 6.9 years.

Remember, while these bonds reduce market risk, they introduce credit and interest rate risks. There’s no free lunch in investing, but you are compensated for taking on these risks, and overall, these bonds can reduce portfolio volatility as they are not perfectly correlated to stocks.

Historical Performance

Here's how a portfolio of 60% XAW, 20% XIC, and 20% XBB, rebalanced annually with all dividends reinvested has performed from January 2015 to July 12, 2024: