Not all ETFs qualify for the zero-commission deal. Most of the 46 funds on the list are from Claymore Investments, although a few iShares and Horizons products are also included. Any investor will be able to build a well-diversified portfolio of Canadian and international equities, bonds, real estate and commodities from this list.

The announcement could also prompt other discount brokerages to follow suit. Qtrade Investor looks to be the first to compete: “We expect to have an offer that meets or beats the Scotia offer,” says vice president Joel Bernard.

We’ll get to the gory details in a moment, but first let me explain why I didn’t suggest that she simply build her own portfolio of index funds. I used to assume that the first step in becoming a Couch Potato was to fire your adviser, but I’ve changed my tune over the years. Many investors can do just fine on their own, as long as they learn the basics of financial planning and have the discipline to ride out the rough patches. Problem is, that’s more difficult than it sounds, and I’ve come to realize that most investors would do better with professional advice.

Besides, Natalie has no interest in being a DIY investor. “I’m not going to manage a $100,000 portfolio on my own,” she told me bluntly. What’s more, she has little confidence in passive investing. “The idea that I’ll just put money in the whole market and only look at it once a year—I’m not sure that’s right for me.”

I’ve spilled a lot of ink trying to convince people like Natalie that index funds offer the best chance of long-term investing success. But the whole “index funds versus active management” debate often misses the most glaring problem with the financial services industry in this country. The big issue here is not that Natalie is using actively managed mutual funds, or even that she is paying too much. When the mutual fund industry’s spokespeople defend high fees, they point out that part of that money pays for ongoing advice. True enough, but as Natalie’s situation demonstrates, that advice is often terrible. Here’s what I mean:

There’s no planning. Natalie is 42 years old and plans to retire in 20 to 25 years. I asked her how much money she thought she needed in retirement, and what rate of return she needed to get there, based on her current savings. She didn’t know, because her adviser had not created a financial plan for her. For him, “advice” meant picking mutual funds and not much else.

Imagine a doctor prescribing medication without a diagnosis—and then collecting commissions from the drug companies. Building a portfolio without a plan makes just as much sense.

The portfolio is poorly designed. Natalie’s RRSP includes 10 mutual funds. There is no reason why a portfolio of $100,000 needs that many, especially since many of her funds have redundant holdings. I asked Natalie what her overall asset mix was, and she thought it was 50% stocks and 50% bonds. (This should appear on her statements, but it doesn’t.) It took me over an hour with a spreadsheet to figure out that the actual mix was 64% stocks, just 19% bonds, and 17% cash.

Choosing an appropriate asset allocation is one of the most important services a good adviser will provide. Your mix of equities and fixed income is hugely important to your risk management and your expected long-term returns. Yet Natalie’s adviser just picked a handful of hot performers, threw them in a blender, and called it a portfolio.

He’s gambling with her money. Natalie describes herself as “very conservative” and says she endured the dot-com meltdown and the 2008 financial crisis because her former adviser had her in a low-risk portfolio. However, when she moved to the new adviser, the first thing he did was sell all her bonds, as well as three well-diversified equity ETFs. Then he put 20% of her money in two highly speculative small-cap stocks that have since lost almost half their value. This is gambling, not investing. How such stocks could ever be considered suitable for a conservative investor’s RRSP is impossible to imagine.

A professional adviser will create an Investment Policy Statement (IPS) that sets the ground rules. One of those rules should be: “The portfolio will avoid all speculative stocks, such as junior mining companies.”

She’s locked in. The overall fee (MER) on Natalie’s mutual funds is 2.31%, which is far more than anyone needs to pay for their investments. Worse, her new adviser made sure that all her mutual funds had deferred sales charges (DSCs), which means Natalie must hold them for at least six years or face hefty redemption fees. She would love to fire her adviser tomorrow, but if she does, she’ll pay over $3,000 in DSCs to get out of the funds he chose for her.

I am the first to argue that investors who need financial advice need to be prepared to pay for it. Even fee-only advisers (who do not receive commissions) typically charge 1% to 1.5%, which is a significant cost. My point is not so much that Natalie and others like her are paying too much for financial advice: rather, they’re paying too much for bad advice.

If you’re comfortable managing your own index portfolio, I encourage you to do so. If you’re not, then a good adviser is worth the fee if she can help you achieve financial goals that you can’t reach by yourself. A bad adviser, on the other hand, does little more than turn your wealth into his own

But when it comes to investing, the possibilities are vast once your portfolio grows beyond $100,000. Problem is, much like Bertie Bott’s Every Flavour Beans (a devilish Harry Potter confection) the investing flavour you choose might wind up tasting like earwax. Alas!

That’s why the advice in Where to invest $10,000 still applies. If you aren’t intensely interested in the markets, you should probably stick with a good low-fee balanced mutual fund. After all, much like grilling a nice steak, if you poke and prod your portfolio too much then you’re likely to obtain less than desirable results.

But if vanilla really isn’t for you, let’s check out some other tasty ways to invest now that you have a more sizeable portfolio.

The lazy way to riches
In the “Where to invest $1,000” story, we introduced the idea of investing using passive index mutual funds such as the TD e-Series Funds, which rise and fall in tandem with the large market indexes. Long-time MoneySense readers will know that we call a portfolio of such funds a “Couch Potato portfolio,” as it’s so easy to execute, you rarely have to haul yourself up from the couch to tend to your investments. The goal is to take the returns the markets give you while keeping your investing costs as low as possible. This allows you to enjoy a big advantage versus high-priced fund managers who, far too often, fail to earn back the fees they charge investors.

Now that your portfolio is larger, we have some good news. You can implement the exact same strategy with a new type of fund that has even lower costs: the exchange-traded fund or ETF. These funds are much like index mutual funds in that they passively follow a market index such as the S&P 500, but instead of being sold like mutual funds, you buy them on the markets, just like a stock. The ETFs you choose depend on your investment goals, your time horizon and your tolerance for risk, but we find that plonking 40% of your money into a good bond fund, and spreading the remaining 60% among Canadian and U.S. stock funds is the simplest way to start. If you do it through ETFs, you can reduce your fees to very low levels. For example, if you use the iShares S&P/TSX60 ETF (XIU), the Vanguard Total Stock Market ETF (VTI), and the iShares DEX Universe Bond ETF (XBB) for the Canadian stock, U.S. stock, and Canadian bond components respectively, then the annual fee on your portfolio will be a minuscule 0.19% a year.

Just remember, because ETFs are traded like stocks, you do get dinged with a brokerage commission when you buy and sell them. The commissions can really add up for small portfolios but, by $100,000, the big Canadian discount brokers usually offer online trades for $9.95 a pop, or less.

Much of the appeal of Couch Potato investing lies in its simplicity, so you don’t want too many funds. Still, if you’re up for it, expanding beyond just U.S. and Canadian stocks is a sensible thing to do. As a result, I suggest the Global Couch Potato variant with international stocks added via the Vanguard FTSE All-World ex-US ETF (VEU). Here you’d put 40% of your portfolio in the XBB bond ETF, 20% in Canadian stocks via XIU, 20% in U.S. stocks via VTI, and the final 20% in international stocks via VEU.

Don’t want to go it alone? If the thought of opening a discount brokerage account and buying ETFs on your own fills you with fear and trepidation, don’t worry. You wouldn’t be the first to feel daunted by the task. I still remember that my first trade, back in the day when you had to phone a real trader, was rather nerve-wracking.

Besides, if you’d like a little guidance you’re in luck: when your portfolio moves above $100,000, advisers will start to take an interest. Problem is, their advice often comes at a steep price. To help you out, I’ve sleuthed out a few ways you can get the basics without spending an arm and a leg. You might not get expensive wine and cheese service, but you will get core asset allocation advice and a friendly hand to help you build a customized portfolio.

One good choice is to enlist the services of investment management firm Phillips, Hager & North. PH&N is the granddaddy in the field and it still represents good value. The firm offers a very broad line of low-fee funds and when you sign up directly with them, you can get a dedicated adviser, portfolio planning, and a long-term investment strategy. All of which is included in the already low cost of their funds.

Another option is Steadyhand, a new entrant run by PH&N alumni Tom Bradley. You get the benefits of his experience, but you also get advisers who are still hungry and thus likely to work harder for you than others who may have had a few too many ice cream cones. Portfolio strategy is included with the low cost of their funds, and Steadyhand’s fees fall as your portfolio grows. At $100,000 you already get a discount and there are more discounts to be had at higher levels. In a break from usual practice, their fees also decline based on how long you’ve held their funds.

Getting started with stocks
At the other end of the spectrum, you might want to take a more active approach and start picking your own stocks. While it might not be the right thing to do for many investors, it would be hypocritical of me if I didn’t say that it can be great for some.

If you’re just starting to buy your own stocks, I suggest moving slowly for the first few years. The experience will likely to be educational and you don’t want to make mistakes with the bulk of your money.

Thus at first you should keep the core part of your portfolio in a good low-fee balanced fund, or a Couch Potato portfolio, and then supplement that with a handful of stocks. Put at least 80% of your money in the core and at most 20% in individual stocks.

Which stocks should you start with? I suggest large Canadian dividend stocks, preferably in different industries. While you can go wrong with big dividend stocks—I’m looking at you Yellow Media—they’re generally less volatile than their smaller brethren. Large businesses with good credit ratings also tend to have more staying power than smaller outfits. To whet your appetite, I’ve highlighted five in 5 great stocks to start out with, which show promise at the moment.

Start slowly when learning the ropes to figure out if buying individual stocks is something you really want to do. As your portfolio and experience level increases, allocating more money directly to stocks becomes reasonable. Just be warned, successfully picking your own stocks is harder than it looks and requires a great deal of patience and discipline. But if you have some aptitude for it, the returns can be most gratifying.

But as student Vince Sweeney discovered, there are plenty of options for those who are just starting out. In 2009, Sweeney read about the introduction of Tax-Free Savings Accounts and thought they sounded like a good deal. The markets were still in the dumps after the meltdown of the previous fall, and he saw it as a buying opportunity. “I did some research, and my first purchase was a dividend fund from my bank, which had a $500 minimum,” says Sweeney, who was just 19 at the time. “Then I just started contributing every month.”

After about two years with his bank adviser, Sweeney opened a self-directed account and started managing his own money. Now in his fourth year at the University of Waterloo in Ontario, where he’s studying math with the goal of becoming a teacher, Sweeney will graduate with a portfolio worth about $5,000. When he retires decades from now with a comfortable nest egg, he’ll be able to trace it all back to that first $500 contribution.

“It can be really powerful starting young,” says Neil Jain, founder of Money Life Skills in Toronto. It doesn’t matter if you have just a few bucks. “It’s about cultivating the habit. The value is in the process of learning about the types of accounts, understanding your time horizon and risk tolerance—all of those things are more important than the actual amount you’re investing.”

If, like Sweeney, you’re keen on growing your wealth but you’re not sure how to get started, these tips can help you get the most out of your first grand:

Pay off your debt first
One quick note before we look for a place to invest that extra $1,000. Jain stresses that you first need to make sure you’re routinely spending less than you earn, and that you have no high-interest debt. “If those two conditions are not met, then don’t even consider investing,” he says. “One of my recent clients had credit card debt of over $5,000, and he was asking me whether he should put money into a Tax-Free Savings Account.” Jain explained that paying off a typical credit card gives you a risk-free 19% return—that’s something you can’t get from any investment.

Stash some cash
Once you’re free of credit card debt, Jain recommends that your first couple of thousand dollars go into a savings account earmarked as an emergency fund. “That gives you some peace of mind, so if you suddenly lose your job you will at least have the next month’s rent covered.” Online banks such as Ally and ING Direct pay the highest rates, and you can withdraw the funds any time without a fee.

Give your money some context
Once your emergency account is set up and you have an extra $1,000 or so available to invest, ask yourself what the money will be for. “It’s really important to be clear about your purpose,” says Jain. “Are you investing for the very long term, or are you saving up for something in five to 10 years?” If your time horizon is measured in decades, you can afford to invest all your money in equities—assuming you can stomach the risk. But if your goal is just a few years away, you need to be more conservative.

Sweeney will graduate in 2012 and expects to tap his investments in about five years, perhaps to buy a home. With that in mind, he’s not willing to put it all at risk in stocks. After opening an account with a discount brokerage, he split his money equally among the TD Canadian Index Fund, the CIBC US Broad Market Index Fund and the TD Canadian Bond Index Fund. For now, most of his future contributions will go to the bond fund. “I’m young, but a loss of even a couple of hundred dollars is a lot for me now. I’ll sleep better knowing that there is a smaller chance of losing money.”

Get with the plan
Before opening a self-directed investment account, first pay a visit to your HR department at work, Jain recommends. Many employers have group RRSPs that make saving easy, even if you’re starting from zero. The contributions come right off your paycheque, and some companies even match them.

Diversify
Jain likes to show his clients a chart of three stocks he bought in 2000. One of the companies went bankrupt in 2002, while another has lost 95% of its value. The third—Microsoft—is down more than 20% over the last 11 years. His lesson is simple: putting all of your money in a small number of stocks can easily destroy your savings.

While it’s easy to build a diversified portfolio of individual stocks if you have a six-figure sum, it’s almost impossible to do it with a few thousand dollars. Better to follow Sweeney’s example: he gets access to the equity markets through his index funds, each of which holds hundreds of stocks.

Don’t get locked in
Jain suggests that new investors simply visit their bank and ask about opening a mutual fund account, but he stresses that you shouldn’t sign anything during your first meeting. “The bank always wants to get you set up immediately, but the act of not making that decision right away is helpful, because it makes you think twice and ask more questions.”

One of the questions you should ask is whether the mutual funds you’re offered have deferred sales charges (DSCs), which are triggered if you sell the funds within six or seven years. You don’t want to be locked in to any fund—or any adviser—for that long, so you should insist on no-load mutual funds, which do not carry these sales commissions. (See “Where to invest $10,000” on the right for more on picking mutual funds.)

Keep fees in perspective
Savvy investors know that high mutual fund fees quickly erode your returns. However, when you’re investing a small amount of money, keep these fees in perspective. ING Direct’s Streetwise Funds, for example, are a convenient way to get a diversified index portfolio in a single fund: you can get them online without an adviser, and without opening a brokerage account. The funds charge a management fee of 1.07%, which is high by index fund standards, but works out to less than a dollar a month on a $1,000 investment. That’s a lot less than you’ll pay for most actively managed mutual funds, and it’s a perfectly good starting place for small investors who should be primarily concerned with developing the right investing habits.

TFSA or RRSP?
The usual advice is that young people with small amounts to invest should opt for a Tax-Free Savings Account rather than an RRSP. The reason is that RRSPs don’t offer much in the way of tax breaks to people in a low tax bracket. Indeed, as a future teacher who expects a generous pension in retirement, Sweeney figures his tax bracket is as low as it will ever be. “I will probably never be making less than $10,000 a year again,” he says. “So there’s no point in contributing to an RRSP now.”

However, Jain argues that small investors shouldn’t discount RRSPs altogether. “If the goal of your investing is retirement, the RRSP is often the better choice. The risk of using a TFSA is that you may be tempted to take money out for another purpose. With an RRSP you’ll think hard before you withdraw from it.” Early withdrawals from an RRSP are subject to withholding taxes, and you never get the contribution room back.

Wherever you decide to start your investing journey, you can be sure of one thing: you’ll make some missteps along the way. But it’s far better to make mistakes when you’re young and investing small amounts. For now, worry less about specific funds in your portfolio and more about good habits.

“It’s all about discipline,” Sweeney says. “Save regularly, save often. As a mathie, I know the power of compound interest, and I know I’ve got time on my side.”

Check out other stories in this series:
Where to invest $10,000
Where to invest $100,000
Where to invest $500,000

Why the doomsday predictions? Because most people think that after two decades of trending downward, interest rates are due to start edging up. And if they do, bond prices could crash. Since bond index funds simply deliver the returns of the overall market—and there’s no fund manager trying to forecast interest rates—they would crash too. The critics are saying that the passive approach to bond investing that worked wonders during the last 20 years has run its course. They think investors should run, not walk, to the markets to dump their bond index funds. But will Couch Potatoes really face a fixed-income disaster?

Don’t confuse different rates
To find out, I turned to Norbert Schlenker of Libra Investment Management in Salt Spring Island, B.C. He explained that when you talk about interest rates you have to be specific: there are many different rates, and they don’t all behave the same way.

The media tend to focus on what’s called the overnight rate, which is set by the Bank of Canada. It’s the shortest of short-term rates, and it has a big influence on lenders: banks use it to set their prime rate, so it affects what we pay on variable mortgages and lines of credit. But here’s the important point: the overnight rate doesn’t drive what happens in the bond market.

Central banks have little control over the yields on 5- and 10-year bonds, Schlenker explains, and those rates march to different drummers. “The short end of the yield curve doesn’t act like the middle or the long end,” he says. For example, the Bank of Canada lowered the overnight rate three times in 2009 and raised it three times in 2010. But the yields on 5- and 10-year government bonds trended the other way: they rose in 2009 and declined in 2010.

Know your numbers
So which interest rates will have the greatest effect on a bond index fund? To answer that question, Schlenker explains that you need to know two important numbers, both of which you can learn by looking at the fund’s fact sheet or its website.

The first is the “average term to maturity” of the bonds in your fund. The index mutual funds and exchange-traded funds we recommend in the Couch Potato portfolios track the broad DEX Universe Bond Index, which includes a wide range of maturities, from one year to more than 25 years. The average term, however, is between nine and 10 years. That tells you that your fund will behave much like 10-year bonds, and won’t be affected by short-term rates at all.

The second important measure is the fund’s “duration.” This number indicates a bond fund’s sensitivity to interest rate movements: the longer the duration, the more value your fund will lose if rates rise. Funds tracking the DEX Universe have a duration of about six years. That means if the rate rises by one percentage point—and it has to be the rate that corresponds to the correct average term to maturity—then the fund will fall in value by six percentage points.

Stay in for the duration
The key message for investors is to make sure your time horizon is at least as long as the duration of your bond fund. “If you do that, everything will wash out in the end,” Schlenker explains.

In other words, if you need your money in three years—to pay for a child’s education or a down payment, for example—then you should not be holding a broad-based fund with a duration of six. You should be in a short-term bond fund with a duration less than three—perhaps even a three-year GIC—or you risk losing some of your capital. “But if you have an investing horizon of 10 years, or 20 years, then investing in something that tracks the DEX Universe is perfectly fine,” says Schlenker.

Fixed-income investors often forget that there’s a silver lining in the black cloud of rising rates: new bonds have higher coupons, which means more interest income down the road. In any bond fund, the manager is constantly collecting interest payments and cashing in bonds as they mature. He then invests that money in new bonds with higher yields. “If you can hang on for the whole duration, the increased coupon will bail you out. You will be no worse off than if you invested in T-bills.”

Does that mean Couch Potatoes should expect their bond funds to deliver 8% annualized returns, as the broad-market bond index has done since 1991? Absolutely not. But bond index funds should still be part of any long-term portfolio, even if there is a risk of short-term pain.

“It would be wonderful if everyone could invest in a portfolio where everything only went up in value,” Schlenker says. “But that happens to absolutely nobody. If we own a diversified portfolio of stocks, some of them will be down in a year’s time, but in most cases we’re comfortable that they will come back. That holds true for bonds as well.”

The Permanent Portfolio was created in 1981 by Harry Browne, an American investment adviser, writer and politician who died in 2006. It’s dead simple. You put your money into four equal buckets: stocks, long-term government bonds, cash, and yes, gold. In the 30 years since Browne first wrote about it, the Permanent Portfolio has delivered an annualized return of more than 8%. Even since 2000, the start of the worst decade for stocks since the Depression, it has hovered around that 8% mark. No wonder it’s attracted a new generation of disciples.

One of the most articulate of these is Craig Rowland, a start-up and technology consultant in Portland, Ore. Rowland, who hosts a forum about the strategy at CrawlingRoad.com, encountered the Permanent Portfolio about five years ago. “My background is computer security,” he says. “So I always test ideas by trying to break them. When I looked at traditional index fund portfolios, there were periods when they broke—they had significant declines, or extended periods where they did not have real returns over inflation.”

Rowland says that Browne hit on a better way to diversify. “He didn’t pick the four asset classes because they had some past positive or negative correlation with each other. He picked them based on economic cycles, and that was really the genius of his approach.” Browne argued that economies alternate between prosperity and recession, inflation and deflation. So he chose stocks for periods of prosperity, cash to keep you afloat in a recession, gold as a hedge against inflation, and long-term bonds as a safety net in times of deflation. And since you can never tell what’s on the horizon, Browne recommended holding equal amounts of each asset all the time, rebalancing when the allocations stray well off target.

The idea has held up remarkably well. Rowland backtested the portfolio to 1972 and found that in almost every year, if one or more of the asset classes got clobbered, another picked up the slack. Both stocks and bonds were negative in inflation-plagued 1977, but gold was up over 23% and the portfolio returned 5.6% for the year. In 1988, gold fell by almost 16%, while equities were up 18%. And in the chaos of 2008, when stocks plummeted 37%, long-term bonds returned 33% and the portfolio eked out a 1.9% gain.

Many investors like the idea of the Permanent Portfolio, but wonder why there’s so little allocated to stocks. Rowland asked the same question when he first picked up Browne’s books. “When I read about the 25% in gold, I thought he was nuts. And then I read about the 25% in long-term bonds and I thought he was really nuts. But you can’t look at the assets in isolation: you have to consider the portfolio as a whole.”

Here’s what Rowland means. Stocks, gold and long-term bonds can all have double-digit gains or losses in a single year. But look what happens when you combine them: over the last four decades, the portfolio would have lost money exactly twice (in 1981 and 1994), and both of those declines were less than 4%. “It’s like in chemistry,” Rowland says. “By themselves, sodium is explosive and chlorine is toxic. But if you mix them together you get salt, which is benign. It’s the same thing with this portfolio.”

It would be easy to adopt the Permanent Portfolio using exchange-traded funds. You might split the stock portion between the iShares S&P/TSX Capped Composite (XIC) and the iShares MSCI World (XWD). You can get long-term government bonds through the BMO Long Federal Bond (ZFL) and gold with the iShares Gold Trust (IGT). For the cash component, a savings account will do fine.

I’m not ready to adopt the Permanent Portfolio myself, but I do think it can teach index investors some valuable lessons. The first is the value of sticking to your asset allocation regardless of market conditions. Trying to predict whether this will be a great year for stocks, or whether interest rates will go up, or whether gold is overvalued—it all amounts to guessing. Many people predicted 2010 would be a terrible for the Permanent Portfolio, yet it went on to return over 14%.

The other lesson is that discipline is crucial to any strategy. In the 1990s, stocks returned over 20% five years in a row, while gold lost money every time. How many people would have rebalanced from a huge winner to a massive loser for five straight years? After the carnage of 2008, would you have the nerve to put more into stocks? The Couch Potato strategy presents similar challenges, and you need to be prepared for the short-term pain that rebalancing can cause.

Rowland the computer security specialist says he still hasn’t been able to break through the Permanent Portfolio’s firewall. “I’ve looked into every criticism, because it’s my own money at stake. But I sleep like a baby following this strategy.”

Well, those results are now in. I recently collected 10 years’ worth of data and calculated the returns of the Global Couch Potato using TD’s e-Series index funds. I assumed that you made a lump-sum investment at the beginning of 2001 and rebalanced the portfolio back to its target asset allocation at the beginning of each year. Had you done that annually through 2010, the Global Couch Potato would have delivered — drum roll, please — just over 4% a year.

I don’t imagine that you’re jumping for joy right now — I know I wasn’t when I learned the results. A 4% annualized return sounds dismal for a balanced portfolio of 60% stocks and 40% bonds. As one of my blog readers wrote to me: “I can get 3.5% from a five-year GIC with no risk and no fees. So why do you advocate investing instead of saving?”

It’s a fair question. But does a 4% return mean the Global Couch Potato was a miserable failure? Does it mean that mutual fund managers are right when they scoff that indexing delivers mediocre returns? Not so fast: the sad truth is that even with a 4% return, the Global Couch Potato still outperformed the vast majority of its peers. Before you mash the Potato, consider these facts that put its performance in context.

The markets performed terribly. During the last 85 years, portfolios with a mix of 60% stocks and 40% bonds have averaged well over 8% a year before costs. But during the period I looked at, from 2001 through 2010, market returns were nowhere near that. Canadian equities and bonds did reasonably well, with both delivering more than 6%. But U.S. and international stocks were a train wreck: both had negative returns during that period (as measured in Canadian dollars).

Couch Potato investors accept market returns, minus only small costs. But indexing cannot conjure returns out of thin air, and for the first time since the Great Depression, global market returns were negative for a decade.

Most actively managed funds did worse. Critics of the Couch Potato argue that active strategies work best during periods when the markets sputter. Money managers can get out of stocks during the worst periods, and they can identify opportunities to outperform the indexes. Sounds great, but is it true?

I contacted Morningstar to ask for the 10-year returns of comparable Canadian mutual funds, and here’s what they found: the 54 funds in the Global Equity Balanced category had an average annualized return of 1.76%. Just five funds earned more than 4%, meaning that the Global Couch Potato outperformed the other 91%. In the similar Global Neutral Balanced category, the average fund earned 2.98% and the Couch Potato beat 81% of them. So, yes, you might have picked an actively managed fund that did better. But your odds were rotten.

In addition, most of the individual TD e-Series funds were top-quartile performers over the last 10 years, which means they beat at least 75% of their peers. Active managers claim they can add value during difficult markets, and yet the humble TD U.S. Index Fund outperformed a shocking 93% of its category during a period when even my chequing account beat the S&P 500.

The winner is never obvious in advance. It’s easy to identify the best performing asset class in hindsight. If you could travel back in time to 2001, you would clearly have put all of your equity allocation in Canada, which blew away the rest of the world during the following 10 years. But you could never have been able to predict that at the time.

Everyone loves Canadian stocks today, but from 1991 through 2000, the S&P 500 returned almost 20% annually, and international stocks delivered almost 11%, while Canada brought up the rear with 9% returns. And don’t forget that our loonie — which is “obviously” a long-term winner today — was worth an embarrassing 65 cents U.S. in 2001 and was despised by investors. Could you have made a big bet on the previous decade’s loser? Absolutely. But few people did.

The future looks even brighter. Back in 2001, index funds and ETFs in Canada made slim pickings. With all of the excellent new products now available, investors can harness the returns of other asset classes, and they can do so at even lower cost. While we still love the simplicity of the Global Couch Potato, knowledgeable index investors can now build efficient portfolios that also include emerging markets, real-return bonds, real estate and small-cap stocks.

We have no way of knowing whether the next decade will see higher returns, but we do know that index investors are better equipped than ever to capture everything the markets have to offer.

]]> http://www.moneysense.ca/2011/07/14/a-cure-for-potato-performance-anxiety/feed/ 3 http://www.moneysense.ca/2011/06/15/beat-the-market-without-even-trying/ http://www.moneysense.ca/2011/06/15/beat-the-market-without-even-trying/#comments Wed, 15 Jun 2011 16:17:01 +0000 Dan Bortolotti http://www.moneysense.ca/?p=15528 Only a few years ago, the term “actively managed ETF” was an oxymoron. When exchange-traded funds first appeared, they simply tracked well-known stock indexes and made no attempt to beat the market.

Today there are dozens of actively managed ETFs, and they seem to offer a lot of promise: with lower costs and better tax-efficiency than mutual funds, ETFs with active managers should have a greater chance of earning above-market returns.

However, Greek researcher Gerasimos Rompotis has just published a pair of studies that turn that idea on its head. He found that once you adjusted for risk and other factors, it was the traditional passive ETFs with no money manager that outperformed.

In one recent paper, Rompotis examined the performance of 14 actively managed ETFs using three statistical methods to see whether the managers delivered “alpha,” or a risk-adjusted “premium” that beat the S&P 500. Some of the ETFs did outperform the index slightly, but the alpha was statistically insignificant, so it wasn’t likely to last.

On the other hand, an earlier study by Rompotis found that most passively managed ETFs have outperformed the S&P 500 when he ran them through similar tests. His results covered a five-year period and suggested that the outperformance wasn’t a short-term fluke.

How is that possible? It’s because most of the individual ETFs in the study did not use the S&P 500 as their benchmark, Rompotis stresses. So the funds may have been able to deliver better risk-adjusted returns simply by tracking different indexes, without active management. “Even though investors follow a passive investing strategy,” Rompotis wrote, “they still stand chances of achieving greater returns than the market.”