Over the years, however, we’ve come to appreciate that the Couch Potato strategy isn’t always so easy to execute. That’s why we asked our index investing expert Dan Bortolotti to write the MoneySense Guide to the Perfect Portfolio. This new guide will help you navigate the process step by step, even if you’ve never invested on your own before.

Our guide starts by showing you how to set financial goals and determine how much risk you need to take to reach them. After that, it describes how to design a simple, low-cost, diversified portfolio that’s suited to your objectives. Then it takes you through the maze of investment funds and shows you how to pick the right ones. It explains how to open an account with a discount brokerage so you can build and maintain your portfolio on your own. Finally, it shares some wisdom about the most difficult part of investing: sticking to your plan when the media, market gurus, your brother-in-law and your own self-doubt are threatening to sabotage all your hard work. Along the way, we include personal stories from real Canadians who have succeeded with index funds, offering tips on what to do—and what to avoid.

The Couch Potato strategy, also called index investing or passive investing, is not new. Some of the world’s most respected financial thinkers—several of whom have Nobel Prizes on their mantels—have been recommending it for decades. If you’re not happy with the returns you are getting now with mutual funds or stocks, consider giving it a try. For $9.95—the cost of a single online trade—you can read about how to reduce your investing costs, lower your risk, boost your returns and build your wealth faster. You can order the MoneySense Guide to the Perfect Portfolio online here or pick it up today at top retailers, including Chapters, Indigo, Shopper’s Drug Mart, Walmart and Loblaws.

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

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.”

Passive Couch Potato investors don’t try to beat the market, they simply track stock and bond indexes at low cost. Our Couch Potato strategy beats 80% of the money managed by professionals over the long-term and requires only 15 minutes of your time each year.

Step-by-step instructions on how to become a Couch Potato are available here.

I admit it: I’m an ETF geek. My bedside table usually holds a well-thumbed book on exchange-traded funds, and I routinely bore people with meditations about the merits of cap-weighted indexes. My wife recently asked, in her charming way, if I would love her more if she were an ETF. I answered yes, since she’d be less expensive, more transparent and easy to trade. Then I ducked.

Given my own enthusiasm, I shouldn’t be surprised when I hear from readers who have sold their dreary, high-fee mutual funds and want to know which ETFs to use in their first Couch Potato portfolio. (For the uninitiated, Couch Potato investors don’t try to beat the market, they simply track stock and bond indexes at low cost.) Some are new to do-it-yourself investing and are still fuzzy on what exchange-traded funds are. Others are keen to cover every asset class, but have only a few thousand bucks in sav­ings. It pains me to say it, but for these investors, ETF port­folios usually don’t make sense. Luckily, though, they can still become Couch Potatoes.

ETFs are not the best way to start out, because they trade on an exchange, like individual stocks. That means you need a discount brokerage account to buy and sell them—and if you have no experience managing your own money, this can make you nervous.

As well, if you’re investing less than $30,000 or so—or if you’re making small regular contributions—ETFs may not make sense when you add up the trading fees. As with stocks, every time you buy or sell shares in an ETF you pay a commission: about $29 at the bank-owned brokerages, or $9.95 at independent ones such as Questrade and Qtrade. If you’re periodically rebalancing your portfolio or diligently tucking a couple of hundred dollars a month into an RRSP, RESP or Tax-Free Savings Account, those commissions will eat you alive. (One exception would be a portfolio of ETFs from Claymore Investments, which offers free pre-authorized cash contribution plans—but such plans are not yet available through the big bank discount brokerages.)

For newbie Couch Potatoes, or those saving in small accounts, low-cost index mutual funds are a more sensible choice, as you can set up regular contribution plans and you don’t have to pay each time you add money. Here are three ideas for the simple spud:

Less than $5,000
If you’re starting from scratch, you won’t find anything easier than ING Direct’s Streetwise Funds. Launched in 2008, the Streetwise Funds are one-stop Couch Potato portfolios. They hold a mix of Canadian, U.S. and international stocks, as well as Canadian bonds, all passively managed and tied to well-known indexes. The Streetwise Funds come in three flavors: the Balanced Fund, the Balanced Income Fund, and the Balanced Growth Fund. All work fine in an RRSP, but RESP versions are not yet available.

The Streetwise Funds have a management expense ratio of 1%, which is higher than you’d pay for a portfolio of ETFs (but less than half the MER of most actively managed funds). And that’s the all-in cost. There’s no fee to open or maintain an account, no minimum account size, no trading commissions, and the fund automatically rebalances every quarter. Once you set up an automatic contribution from your chequing account, you can safely lapse into a coma.

Between $5,000 and $30,000
If you’ve accumulated some savings and you’re comfortable managing your own portfolio, consider TD’s e-Series mutual funds. There are 10 funds in the e-Series family, but a Couch Potato needs only four: TD Canadian Index, TD U.S. Index, TD International Index and TD Canadian Bond index. These are the cheapest mutual funds in the country: you can build a diversified portfolio for less than 0.5% a year. It costs nothing to buy and sell new units, and you can set up automatic contributions from your bank account.

The only drawback is that you must buy them online through TD. You can do this with a TD e-Series Funds account, or you may want to consider opening a brokerage account with TD Waterhouse, which will give you access to ETFs further down the road.

More than $30,000
As your portfolio grows, the low management fees of exchange-traded funds become more attractive. Here’s an idea for moving into ETFs in a cost-efficient way: build a Global Couch Potato portfolio with four ETFs in a discount brokerage (see the Canadian Couch Potato blog for instructions). Then set up automatic monthly contributions to a money market fund in the same brokerage account. Once a year, use the cash in the money market fund to rebalance your portfolio. Assuming four trades a year at $29, the commissions would be $116, but that’s offset by the lower annual fees on the ETFs.

Compared with the e-Series funds, this only makes sense for portfolios approaching $100,000. But if you’re currently using pricier index mutual funds, or if your broker charges just $9.95 for trades, this technique will work for accounts as small as $30,000.

Do the math and figure out what works best for you. Just don’t forget that while costs are important, saving regularly and sticking to the strategy are the most important ingredients in the Couch Potato formula.

If I want to add new money to an existing couch potato portfolio at rebalancing time, should I rebalance first, and then split the new money in the original ratio and add to each component?
Or should I just split and add the new money directly to an existing potato to bring the value of each component back to the original ratio without selling anything, i.e. add less new money to the well-performed components and more to the under-performed components?

What about when I want to withdraw money? Do I rebalance and take same ratio out, or take out correct amount from each component to bring back to orignal ratio?

Will the RRSP contribution room (Line A from Notice of Assessment) be reinstated if a person contributed to RRSP, then later determined he/she could not use the RRSP deduction at all and withdrew the unused contribution (Line B of Notice of Assessment, or the amount show on RRSP receipt) using Form T3012A or T746 from the RRSP either in the same year, or in future years? — W.H.

Karin Mizgala: The simplest way to rebalance is to add new monies to the funds that need topping up to bring them in line with the target ratio. If the ratio is still out of balance after adding the new monies, you can then make further adjustments by moving monies between accounts as needed. Do the same when you withdraw funds. Take monies first from funds where you are too heavily weighted, then withdraw the remaining funds in the same proportions as the target ratio.

Your RSP contribution room would not be affected if you made a contribution, did not deduct it against income and later withdrew it using Form 3012A.  For further clarification call Canada Revenue Agency at 1-800-959-8281.

Next question: Using funds to purchase an income producing property

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Share your thoughts on this answer in the comments below.

I like the couch potato concept. I’m confused or misunderstanding something. If I follow the advice and invest in 60% stocks (20% divided into each of the suggested allocations) and 40% in bonds, and if each cost about .5%, doesn’t that equal about 2%? Isnt 2% around the MER for an actively managed fund?

How do I go about making contributions using this strategy if I want to make pre-authorized monthly payments, as I do not have a large lump sum to invest? —Believe10

Karin Mizgala: The Management Expense ratio (MER) is the fee to manage a fund calculated as a percentage of the amount of money you invest.  If the management fee on an actively managed fund is 2% and you have $10,000 invested, you would be paying $200/year in fees.  If the MER is only .5% you would only be paying $50/year in fees.  Even if you are investing in several different funds, you would be applying the MER only on the amount of money you have in each fund.  So if you have $2,500 invested in 4 different funds with MERs of .5%, then you would be paying $12.50/year in fees per fund – the same amount you would be paying if you invested $10,000 in one fund with an MER of .5%.

You can set up the Coach Potato strategy with monthly pre-authorized payments at most banks or financial institutions that sell index funds. Most bank issued index funds are set up to allow you to invest with as little as $25-$50/month.

Next question: What’s the best way to rebalance my Couch Potato Portfolio?

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Have another idea? Let us know in the comments.

This proven strategy (sometimes called “index investing”) has exploded in popularity over the last decade thanks to the arrival of exchange-traded funds, or ETFs. These funds are similar to mutual funds in that they are pooled investments that hold a number of stocks or bonds. However, unlike mutual funds, ETFs trade on a stock exchange, so you can buy and sell them throughout the day. And rather than being run by a high-priced manager who tries to beat the market by picking winning stocks, most ETFs deliver returns similar to the overall market by buying virtually every stock in an index. As one proponent of the strategy puts it, instead of looking for the needle, you’re buying the haystack.

I’m pleased with my new portfolio, but I have to admit that building it wasn’t as easy as I expected. Until about three years ago, choosing ETFs was dead simple, because one company, iShares, had the Canadian market largely to itself. Today, there are three additional ETF sponsors in Canada:Claymore Investments, BMO Financial Group and Horizons’ and the four companies together offer more than 100 different funds. There are also more than 800 other ETFs available on American exchanges. The variety is welcome, but it makes things more confusing for investors, including me. At least half a dozen times, I bought an ETF that looked good, only to sell it weeks later when I discovered one that followed a better index, was more broadly diversified, or had a lower fee. As a result, I blew a few hundred bucks on trading commissions. But just because I wasted my time and money, that doesn’t mean you have to.

I’d like to walk you through the important questions you need to ask when choosing the right ETFs for your investment goals. You’ll learn how each fund chooses the stocks or bonds it holds, and why you should consider fees, diversification and the effect of foreign currency exchange. Some of this information is complicated, but we’ve organized it into easy-to-follow sections, so you can get all the detail you want, or simply skip ahead to our model ETF portfolios (see “Ready to build your own portfolio?” on page 51), where I’ve done the heavy lifting for you. Ready to go? Then let’s begin with the first question.

Which index do you want to follow?

Indexes have been around since Charles Dow created the famous Dow Jones Industrial Average in 1896. Simply put, an index is a group of stocks or bonds used to measure the performance of a particular market. For instance, the Dow includes just 30 large American companies from various sectors, but it is considered a barometer of the entire U.S. stock market. The S&P 500 and the Russell 1000 which include 500 and 1,000 stocks, respectively are much broader indexes of large American companies. The S&P/TSX Composite Index, which includes about 200 companies, is the most popular benchmark for Canadian stocks. Other indexes measure the fixed-income market, such as the widely used DEX Universe Bond Index, which covers both government and corporate bonds.

An ETF attempts to deliver the same return as its underlying index, and it does this in a straightforward way: by owning all (or almost all) of the stocks or bonds in that index. Whereas a mutual fund manager might pick the 15 or 20 Canadian stocks he thinks will outperform the S&P/TSX Composite, an ETF would simply buy all 200.

This was easy to understand when there were just a few ETFs and they all used well-known indexes. But today there are thousands of indexes tracking every region, asset class, market segment and investment style. You can find indexes and ETFs that track Vietnamese stocks, the wind power sector, the Indian rupee, and the price of corn.

It’s easy to learn which index an ETF tracks: just visit the sponsor’s website (see ‘The ETF Marketplace’ on page 47) and find the section devoted to that fund. The index is always listed prominently, usually with a full explanation of what it includes. The more difficult question is whether the index is of any value to investors.

“People can use common sense for the most part. If it sounds weird and wacky, it probably is, says Mark Yamada, president of PUR Investing, a Toronto firm that builds custom ETF portfolios for its clients. One recently deceased ETF included only Wal-Mart suppliers. There was another one for suppliers to the Beijing Olympics. Somebody must have thought these were good ideas.

Couch Potato investors looking to build a basic portfolio should steer away from niche products and stick to indexes that follow the major asset classes, such as Canadian stocks, U.S. or international stocks, and government or corporate bonds. If you’re including only three or four funds in your portfolio, each should be as broadly based as possible.

How does the index choose its holdings?

The most important things to understand about an ETF’s index are how it chooses the stocks or bonds it includes, and what proportion of the index each will comprise.

Traditional stock indexes select the largest and most frequently traded companies, and then weight them by their market capitalization. (You can find a company’s market cap by multiplying the number of outstanding shares it has by the current price of each share.) This method produces what’s called a cap-weighted index, where the bigger the company, the greater its influence. This is the method used by most of the indexes you’ve heard about, such as the S&P/TSX Composite or the S&P 500. iShares uses cap-weighted indexes for almost all of its equity ETFs, including its Canadian Composite Index Fund (TSX: XIC) and the Canadian S&P 500 Index Fund (TSX: XSP).

Cap-weighted indexes are the simplest to create (and the cheapest to buy), but critics point out an inherent flaw: if a stock is overvalued, it gets a bigger share of the index, while undervalued stocks get underrepresented. That makes cap-weighted indexes vulnerable to bubbles: during the 1990s, technology companies went from 5% of the cap-weighted S&P 500 to almost 30% as their stock prices ballooned, and here in Canada, Nortel alone grew until it made up more than 36% of the S&P/TSX Composite. When it turned out that tech companies were wildly overvalued, the bubble burst and ETFs tracking cap-weighted indexes were hammered.

To avoid such situations, a newer strategy called fundamental indexing was introduced a few years ago. In this method, companies are chosen not by their size, but according to other characteristics, such as their dividend payments, cash flow, sales and book value. The fundamentally weighted FTSE RAFI Canada Index is the benchmark for Claymore’s Canadian Fundamental Index ETF (TSX: CRQ). Using this methodology makes a big difference: the mining company Teck Resources, for example, makes up about 1.3% of a cap-weighted index, but more than 8% of Claymore’s. In general, this strategy places greater emphasis on smaller companies and those that appear to be underpriced.

Fundamental weighting has become a hot topic among ETF investors. Its proponents argue that between 1984 and 2007 using such a strategy would have added an extra 2% to returns in the U.S., and an extra 2.7% in Canada, with lower risk to boot. (If you’re interested in learning more, read The Fundamental Index, by Robert D. Arnott.) So far, that advantage has continued. Since Claymore launched three fundamental ETFs in 2006 and 2007, all of them have outperformed their cap-weighted counterparts from iShares.

Still, not everyone is convinced. I appreciate the critique of cap-weighted indexing, but it doesn’t follow that weighting by company fundamentals is necessarily better, says Norbert Schlenker, president of Libra Investment Management in Salt Spring Island, B.C. It’s always possible to identify a strategy that worked in the past, but there’s no guarantee it will hold up in the future, he says. “I certainly wouldn’t want people to expect an extra 2% or 3% a year by investing this way.

There are other weighting strategies, too. BMO has an exchange-traded fund that follows the Dow Jones Industrial Average, which is weighted by price: a stock trading at $20 per share has twice as much influence as one trading at $10. Claymore offers an equal weighted ETF whose index tracks the financial sector by allotting 10% each to 10 banks and insurance companies.

There’s no simple answer to which methodology is best, but keep in mind that cap-weighted ETFs are almost always the cheapest, so you should pay more for a different strategy only if you are confident it will deliver higher returns.

How well diversified will you be?

An ETF should give you wide exposure to the asset class you want in your portfolio. To see if it does, start by looking on the fund’s web page to see how many securities it holds.

You’ll find that the number of holdings varies a lot. For instance, if you look at the iShares Canadian Composite ETF (TSX: XIC), which is pegged to the S&P/TSX Composite Index, you’ll find it includes 204 stocks. On the other hand, the Claymore Canadian Fundamental Index (TSX: CRQ) holds only 65. But don’t be fooled into thinking that makes XIC radically more diversified. Because XIC is cap-weighted, 20 large companies make up close to 60% of the index, and all of these are included in CRQ. So even though the iShares ETF includes three times more stocks than its Claymore counterpart, most of those stocks won’t have a huge effect on performance.

Another measure of diversification is the percentage that each fund holds in the various business sectors. Here you’ll notice some significant differences: about half of CRQ is made up of banks and other financial institutions, while XIC is more heavily tilted to energy and materials. That will have a greater effect on performance than the overall number of stocks in each fund.

Does your ETF actually hold what’s in the index?

Some of the most popular ETFs in Canada track the price of natural gas, crude oil, gold and silver. If you decide to invest in one of these commodity funds, it’s important to understand how they work.

Say, for example, you want to add a gold ETF to your portfolio and you spot three possible choices: Horizons BetaPro Comex Gold (TSX: HUG), Claymore Gold Bullion Trust (TSX: CGL.UN), and iShares Canadian Gold Sector (TSX: XGD). Look further into these products and you’ll find they hold entirely different things.

Most commodity ETFs do not physically hold precious metals, oil or grains. Rather, they hold futures contracts that give them the right to purchase the commodity at a specified price on a given date. That’s how Horizons’ commodity funds work. Claymore’s Gold Bullion Trust, however, really does hold gold bullion in a vault. (Technically it’s a “closed-end investment trust,” not an ETF, but it trades the same way.) The iShares ETF, meanwhile, isn’t a commodity fund at all: it holds stocks in 28 gold-mining companies in North America.

What are the fees?

ETF management fees are generally a fraction of those charged by mutual funds. But not all ETFs are bargains.

Cap-weighted ETFs usually have the lowest fees because they are the easiest to manage. The cap-weighted iShares Canadian Large Cap 60 (TSX: XIU) charges just 0.17%, while Claymore’s CRQ holds almost all of the same stocks, but has a management expense ratio (MER) of 0.65%. Of course, if you believe that fundamental weighting can add at least half a point in returns, as it has in the past, then the higher fee is good value.

Some asset classes are inevitably more expensive than others. Small-cap ETFs, which often hold more thinly traded stocks, tend to have higher fees than those tracking large companies. ETFs holding international stocks are often pricier than those holding U.S. or Canadian equities.

ETFs that track a single sector often charge high fees despite holding few companies, and may not be worth it at all. The iShares Canadian Tech Sector (TSX: XIT) includes just five stocks, yet charges an annual fee of 0.55%. If you’re planning to invest in this sector for the long haul, you should just buy the stocks directly.

Keeping fees to a minimum is especially important in a bond ETF, where returns are usually lower to begin with. “The link between higher returns and lower expenses on bond funds, including bond ETFs, is close to perfect over the long run,” says Schlenker. “So you always want to look for a lower expense ratio.” Just make sure you compare apples to apples. For example, Claymore’s 1-5 Year Laddered Government Bond (TSX: CLF) is cheaper than the iShares Short-Term Bond (TSX: XSB), but the former holds only government bonds, while the latter also includes corporate bonds. (Claymore has a separate fund, CBO, that holds only corporates.)

If you want rock-bottom fees, take a serious look at the ETFs trading on American stock exchanges. Vanguard’s Total Stock Market (NYSE: VTI), for example, charges a microscopic 0.09% and holds more than 3,300 stocks.

Does it use currency hedging?

Before you buy a U.S. equity ETF on an American exchange, though, you need to understand that you’re adding an extra layer of risk. If the U.S. dollar falls against the loonie, the value of your investment will fall with it. Canadians saw that happen in 2003 and 2004, when the U.S. stock market was on fire, but Canadians who held those stocks had their returns virtually wiped out as the loonie soared. Of course, currency fluctuations work both ways: holding stocks in U.S. dollars would have cushioned your losses during last year’s market tumble.

To reduce the effect of these swings, many Canadian ETFs that hold foreign stocks use a strategy called currency hedging. The managers use complicated financial instruments designed to smooth out currency fluctuations and deliver the full return of the underlying stocks in Canadian dollars.

The problem is that hedging comes with a cost—it can add about 0.15% to 0.5% to an ETF’s expenses. What’s more, hedging is not very precise. When currency fluctuations are gradual it can work well, but if the Canadian dollar rises or falls sharply over a few weeks, investors can take a bath. That’s what happened this year to folks who owned the hedged version of the iShares S&P 500 Index Fund (TSX: XSP). Over the 12 months ending in August, the index fell about 20.5%, but XSP lost close to 27%. Two sharp rises in the loonie caught the managers off guard, and it cost investors a lot. That’s why you should think twice about paying for a feature that may backfire.

Norbert Schlenker encourages investors to consider their time horizon: over long periods, currency fluctuations tend to even out, so investors with 20 or 30 years until retirement may be better off buying a lower-cost ETF in U.S. dollars. Second, having some greenbacks in your portfolio is a good idea if you plan to travel when you retire. “Even if you expect to stay in Canada and spend all your money here, you can’t simply dismiss what might happen if the value of the Canadian dollar declines. You’ll still have exposure to things that are priced in U.S. dollars, so you should have some investments outside Canada.”

How often is the ETF traded?

The cost of an exchange-traded fund is also affected by its liquidity—that is, how often it is bought and sold.

Just like stocks, ETFs have two different prices: the “ask price” is what you’ll pay if you’re buying, while the lower “bid price” is what you’ll get if you sell. The “bid-ask spread” is the difference between the two, and the wider the gap, the greater the loss to investors on both sides of the trade. The bid-ask spread depends on two main factors: the number of outstanding shares and the average daily trading volume. You can find both of these numbers on any website that provides comprehensive stock quotes.

The Canadian large-cap ETFs from iShares and BMO offer a dramatic example. iShares’ XIU, which is the oldest and largest ETF in Canada, has more than 600 million units outstanding, and more than 12 million change hands on a typical day. Its bid-ask spread is usually just one or two cents. On the other hand, BMO’s Dow Jones Canada Titans 60 (TSX: ZCN-T), which debuted in June, has just over 200,000 units in the marketplace and often trades only a few hundred shares a day. The BMO fund’s fee is slightly less than XIU, but that difference may be outweighed by higher trading costs due to the lack of liquidity.

There’s another reason to look at trading volume: ETFs that rarely trade earn lower profits and run the risk of being shut down. A Canadian ETF should be trading at least a couple of thousand shares a day if it is to remain viable.

How closely does the ETF track its index?

Many ETFs do an outstanding job of mirroring the return of their underlying indexes. Since its debut in 2000, the U.S. version of the iShares S&P 500 Index Fund (NYSE: IVV) has strayed from its benchmark by just 0.06% annually. Unfortunately, not every ETF has such a remarkable record.

The difference between the performance of an ETF and that of its index is called the tracking error: if the index is up 8% and the ETF returns 7.2%, the tracking error would be 0.8%. You should expect an ETF to trail its index by at least as much as its management fee, but sometimes the variance is much more significant.

For example, the U.S. version of the iShares MSCI Emerging Markets Index Fund (NYSE: EEM, recently launched in Canada as ticker XEM) has posted large tracking errors over the past three years, lagging its index by 4.8% in 2007, besting it by 3.3% in 2008, and trailing again by more than 9% so far this year. Meanwhile Vanguard’s Emerging Markets ETF (NYSE: VWO) follows the same index with little tracking error. The reason is that the index includes 745 stocks, but the iShares ETF holds fewer than 400 of them. Buying 745 stocks in emerging market countries can be prohibitively expensive, so iShares selects only the largest and most influential ones. The strategy isa trade-off—increasing tracking error, but lowering costs—and over the long term it should even out. If your goal is to simply track the index as closely as possible, however, the Vanguard ETF does a better job.

Admittedly, an ETF’s tracking error isn’t always easy to determine. iShares includes a Tracking Error Chart on its website, while websites such as Google Finance and Yahoo! Finance allow you to enter an ETF’s ticker and the name of some major indexes to create a line graph comparing the two. Another useful resource is the ETF Screener on the PUR Investing website (pur.activebaskets.com/demo/Screen.htm), which compares every Canadian ETF in five categories, including tracking error.

Ready to build your own portfolio of ETFs? Read on…