My main source for that column was Timothy Nash, president of Strategic Sustainable Investments, a company that helps institutions and individuals create portfolios aligned with their values. Tim also has a blog called The Sustainable Economist and recently wrote a post called The Organic Couch Potato, where he shared his ETF suggestions.

Tim is a thoughtful, articulate advocate for SRI and I thought readers would like to hear more from him, so here’s an excerpt from our interview. I’ll run another in a few days, and next week I’ll go into more detail about specific investment products that combine passive investing with SRI principles.

In many ways passive investing and SRI seem incompatible. One of the fundamental ideas behind indexing is that you don’t pick individual companies. But with SRI, that is often what you’re doing.

TN: I actually see a lot of overlap between the two strategies, primarily in the sense that both are about long-term investing.

When it comes to choosing individual companies, I don’t think that’s what socially responsible investing is about at all. There are different approaches, and by far the most popular is negative screening. This started with religious communities that would exclude “sin stocks” like tobacco, firearms, and things like that. That has evolved to the point where the majority of socially responsible funds rank every company according to a sustainability score—the lingo we use is ESG, for environmental, social and governance. So every company will get an ESG score, and then the fund will drop the bottom 20% in each sector. This is the methodology used by the Jantzi Social Index, for example, and most of the SRI funds use a similar approach to that.

In some cases, rather than just dropping the bottom 20% they will have black list: if there has been a controversy, they will exclude that company. For example, Enbridge is excluded from the Jantzi Social Index because of the big oil spill that happened in Michigan in 2010. BP is another classic example: in fact, that company was in a number of SRI portfolios before the Deepwater Horizon oil spill, but as soon as that happened it was excluded.

Another strategy, which is important to many passive investors, is shareholder engagement. With traditional mutual funds you don’t go to the shareholder meetings yourself: you’ve got proxies, and the default policy is to simply vote with management. Let’s say there’s a shareholder resolution that would require the company to report their carbon emissions, and management says that’s a burden. Traditional investors will have their votes go with management against the resolution. Whereas with socially responsible investments, if they do shareholder engagement your vote will be used to push that company toward greater transparency, greater disclosure, greater sustainability.

Not all index funds do shareholder engagement: the iShares Jantzi Social Index Fund (XEN) doesn’t do it, but the US-listed iShares SRI funds do [These are the iShares MSCI Socially Responsible (DSI) and iShares MSCI Select Socially Responsible (KLD).] I’m really shocked the Canadian one doesn’t, because they are all iShares, and it’s all the same company, but the two funds in the US have a voting policy statement that says they will vote for any measure that promotes transparency and sustainability. I can’t tell you why the Canadian Jantzi ETF doesn’t.

What other strategies are used by SRI index funds?

TN: Another strategy is positive screening. With negative screening you get rid of stuff you don’t want: the worst of the worst. Positive screening is about including companies in sectors you do want. For passive investors there are a number of ETFs that follow what I would call green themes. There is a solar ETF, a wind ETF, and also a couple of water ETFs—as we move forward in a world that is experiencing climate change, I think water is going to become a huge issue. The one I put in my own Couch Potato portfolio is the PowerShares Cleantech Portfolio (PZD), which is diversified across a number of green themes.

The last strategy is called impact investing. This is a really hot topic right now in certain circles, but it hasn’t really made it into the mainstream yet. Impact investing involves going outside of financial markets and investing directly in projects that have both a positive financial return and a positive social or environmental impact.

One example is microcredit financing: that has been around for the longest. Another is community bonds, which are usually are centered around non-profit real estate. There’s a website called socialfinance.ca that follows a lot of these trends. They’re still very new and there aren’t many available, but it’s a very cool option for socially responsible investors because instead of SRI meaning you’re not going to invest in tobacco, military, and firearms, this is a way for investors to have direct impact and generate a financial return.

Transaction costs. It will cost you two trading commissions to sell an ETF and buy a replacement, and you’ll also lose a little more on the bid-ask spread with each trade. If the new ETF is only a few basis points cheaper, the cost of switching may not be worth it.

Tracking error on new products. When an ETF is created, its start-up costs are often borne by investors. As a result, a new ETF can take a year or more before it starts tracking its index closely. A low-fee fund may still have a larger tracking error until it builds some economies of scale.

Taxes. If you’re planning to switch ETFs in a non-registered account, selling your existing fund might generate a significant taxable gain. It doesn’t make sense to pay a lot in taxes to save a little in fees.

Different risk exposure. Two ETFs in the same broad asset class may track quite different indexes. For example, if you’re comparing corporate bond ETFs you may look only at the fee and not realize some funds include only short-term bonds, while others include all maturities. One equity fund might track the broad market while a similar-sounding one includes large caps only.

It’s not about products. Successful index investing is not about selecting the best ETFs and squeezing every last basis point from the cost of your portfolio. If you’re a disciplined saver who invests in a low-cost, broadly diversified portfolio that’s appropriate for your risk profile, it really doesn’t matter whether you’re paying 0.30% or 0.28%, especially if your portfolio is small.

A minor tweak

With that preamble out of the way, I’ve made only a single change to my ETF recommendations: I’ve replaced the iShares S&P/TSX Capped Composite (XIC) with the BMO S&P/TSX Capped Composite (ZCN). The BMO fund changed its benchmark in September and now tracks the same index as XIC. It has also surpassed $1.1 billion in assets, making it essentially the same size and scale as its competitor, but with a management fee 10 basis points lower.

I’m constantly asked why I haven’t added Vanguard Canada’s ETFs to the model portfolios, since their fees are among the lowest around. I think almost all of the Vanguard ETFs would be good choices, but I’m taking a wait-and-see approach this year as they make the transition from MSCI indexes to new benchmarks from FTSE and CRSP.

It’s also worth pointing out the Vanguard Aggregate Bond ETF (VAG) costs 10 basis points less than the iShares DEX Universe Bond (XBB), but the latter outperformed it by 26 basis points last year. And as it happens, the BMO Aggregate Bond (ZAG), which recently dropped its management fee to match Vanguard’s, beat them both. This should be a reminder that investors don’t need to switch ETFs every time one appears with a slightly reduced fee, because a lower MER does not guarantee a correspondingly higher return.

A bigger change

After much thought, I’ve also removed the Yield-Hungry Couch Potato from the model portfolios page. I’m expecting some negative feedback about this decision, so allow me to explain the reasoning:

• I continue to be concerned about the emphasis many investors put on yield rather than total return, a subject I wrote about recently in MoneySense. The emails I received about this portfolio made it clear that many readers were so “yield hungry” they were ignoring far more important factors like risk, diversification and tax-efficiency. I don’t want to contribute to these biases by suggesting a portfolio designed to maximize yield.

• The more I learn about effective tax management, the less enthusiastic I become about complicated products like the iShares (formerly Claymore) Advantaged ETFs, which comprised about 45% of the Yield-Hungry portfolio. The forward structure used by these ETFs adds a significant cost (0.50% to 0.75%) and I’m not convinced of the benefits. I’ve come to appreciate the best way to manage taxes is with careful asset location and attentive tax-loss harvesting, not using exotic products.

• I was routinely asked for long-term performance data for the Yield-Hungry Couch Potato, and I could not provide it. Many of the funds track exotic indexes with no meaningful track record. Moreover, some of the Advantaged ETFs show a surprisingly large discrepancy between their market price and net asset value (NAV), which makes even one-year reporting problematic.

If you happen to use the Yield Hungry Couch Potato, I’m not recommending you abandon it. But monitoring and tracking the model portfolios takes more time than many readers appreciate, so given the above concerns I’ve decided to focus on the other three: the Global Couch Potato, the Complete Couch Potato, and the Über-Tuber.

Note these returns use actual ETF performance wherever possible. However, none of the funds has a 15-year track record (a few have been around for less than five years). So we have filled in the gaps using index data, minus the MER of the relevant ETF. It’s certainly not a perfect measure (no backtest is perfect), but it’s a reasonable proxy. Full details are provided in the PDF document, which is also linked on the model portfolios page.

A few observations about these numbers:

• As I’ve discussed before, start and end dates mean an awful lot. Unlike the returns for the decade ending in 2010, the 10-year returns now look quite good—so much for the “lost decade,” which only applies when your start date is during the tech wreck of 2000–01.

• Five-year market returns are disappointing, since they start just prior to the disaster of 2008. But barring a terrible 2013, the next batch of five-year returns will probably look outstanding, since they start with 2009, one of the all-time best years for equities.

• The Global Couch Potato lags the other two portfolios significantly over all periods longer than three years. This is largely because the last 15 years have seen strong returns in several asset classes that are absent in the Global Couch Potato: real-return bonds (9% annualized since 1998), Canadian REITs (13% since 1998), emerging markets (8.8% since 1999).

Dividend ETF webinar Thursday

On Thursday, January 17, at 11 a.m. EST, I’ll be participating in a webinar at ETF Insight. I’ll be joined by Vinit Srivastava of S&P Dow Jones Indices, Craig McGee of Morningstar CPMS, and moderator Yves Rebetez. The topic is Canadian dividend ETFs.

Specifically we’ll be looking at these ETFs tracking indexes from S&P Dow Jones and Morningstar:

iShares Dow Jones Canada Select Dividend (XDV)

iShares S&P/TSX Canadian Dividend Aristocrats (CDZ)

iShares S&P US Dividend Growers (CUD)

First Asset Morningstar Canada Dividend Target 30 (DXM)

First Asset Morningstar US Dividend Target 50 (UXM)

iShares Morningstar Dividend Yield Focus (XHD)

If you’re interested in learning more about dividend ETFs, I hope you’ll join us for the webinar.

We are currently working with a financial adviser from a large mutual fund company. Our portfolio is worth about $500,000 and we have no mortgage or credit card debt. We have been considering the Couch Potato Portfolio but we are afraid to make the change, plus we are unsure what steps we need to take or fees we would pay if we go this way. We also wonder if we should have this decision looked over by a fee-only adviser?

Answer

Did you know that you are paying about $12,000 per year for financial advice?

Hello? Are you still there?

Yeah. I know. It is a huge amount of money. But if we say that your mutual funds have a management expense ratio (MER) of 2.4%, on average, then that is what the cost works out to ($500,000 x 2.4%) for a portfolio of that size. And that doesn’t include any other front or back end commissions that might be applied to your mutual funds.

Here’s the thing: you can save most of that money. You could save big by moving to a fee-based or fee-only financial adviser, or by managing your money yourself. The question is, what is the best fit for you?

I’ll get to that in a second, but let me first answer your specific questions.

How much is a Couch Potato?

The Couch Potato Portfolio is a super simple way to attain performance that mirrors a benchmark index by purchasing low-fee investments, like exchange-traded funds (ETFs). Click here for Couch Potato 101. The only direct fees involved are the commissions you pay to a discount broker to buy and sell the ETFs. You’ll pay no more than $10 a trade because of your asset level. The indirect fee is the MER on the ETF itself, which will be around 0.5% versus a mutual fund at 2.4%.

How to set up a Couch Potato Portfolio?

The steps to set up a Couch Potato Portfolio are pretty simple. Start by opening an account at a discount broker, ideally one associated with your bank for simplicity sake. Then have them transfer over your assets from your current adviser. Once the money is in your account you can purchase a small number of ETFs that fit with your goals.

Are you getting value from your financial adviser?

The hardest part about making the switch to the Couch Potato Portfolio will likely be breaking up with your financial adviser. (Click here for details on how to navigate that process). But before you do, it is worth assessing the value that you’re getting out of that relationship. Right now your gut says it may not be worth it, but take the time to answer this question properly.

Is a fee-only adviser worth consulting?

At a minimum you should have a fee-only adviser review your portfolio to provide a second opinion. You’ll pay for their time—somewhere between $200 and $500 per hour—but I think it will be worth it. And, given your fear about making changes to your portfolio, I think a fee-only adviser might make more sense than a do-it-yourself approach. They will give you some guidance and be able to complete a full financial plan for a few thousand dollars. Click here for some tips on how to find a financial adviser.

Who’s the boss?

The most important thing to remember in all of this is that you’re the boss. You have the power to hire and fire. I know that your confidence level in this area is low right now, but don’t let that stop you from doing what needs to be done to get a handle on your money.

Not really. While there’s a deep divide between investment extremists—ardent Couch Potatoes on one side and those who defend active management on the other—most people don’t see things in such black-and-white terms. There are shades of grey in between, and we don’t have to feel guilty about that. It’s entirely possible—and increasingly common—to combine both indexed and active strategies in a portfolio. In fact, while I’m a committed indexer myself, a small portion of my portfolio is actively managed. In what follows I’ll help you decide whether you should consider a so-called “core and explore” strategy, too.

The base case

Before we consider how you might combine indexing and active strategies, I must emphasize there is a mountain of theoretical and empirical support for the superiority of “passive” index investing. All the investment managers and private investors in the world are competing against each other. Together, they make up the market, and therefore passive and active investors collectively earn the market return before costs. But because active investors incur higher costs (due to management fees, transaction commissions, trading costs and taxes), as a group passive investors will always outperform their active counterparts. This holds true in both bull and bear markets. Hence, Couch Potato investing is incredibly appealing.

Note I said passive investors will always outperform as a group. This in no way precludes the possibility of outperformance by individual investors or fund managers. No one is denying that market-beating returns happen, and will continue to occur. The problem is they are extremely hard to identify in advance.

A long track record of good performance can be a predictor of future success, but the consensus of the many academic papers studying the matter is that the track record needs to be very long indeed. We don’t mean five or 10 years. The research suggests you need 20 years or more before you can draw meaningful conclusions. Managers who’ve enjoyed that kind of long-term success have little incentive to stick around another 20 years—because they’re filthy rich by then. So for all practical purposes, history is no guarantee of future outperformance. To quote Warren Buffett, “If past history is all there was to the game, the richest people would be librarians.”

So why do active investment strategies continue to be so popular? Mostly because it’s human nature to shoot for outsized returns. And while active investing may be something of a gamble, it’s not as reckless as playing the lottery with your life savings. If you’re prudent about active investing, the worst outcome is lagging the indexes by a few percentage points a year, which seems to be an acceptable trade-off to many investors.

A world to explore

“Core and explore” investing—or “core and satellite,” as it’s also called—isn’t new, but the basic idea has evolved over the years. Before index investing became as popular as it is today, core-and-explore portfolios were often 100% actively managed. You might have held 75% in a conservative fund of blue-chip stocks, for example, and 25% in aggressive, high-turnover, small-cap funds or emerging markets.

Today, however, the term generally refers to using a core of index funds for cheap access to the overall market (so-called “beta”), coupled with more expensive actively managed products and strategies designed to capture outperformance (“alpha”).

One method is to use a fully diversified Couch Potato strategy for the majority of your portfolio—think 70% to 90%. The explore portion would then be a go-anywhere, do-anything strategy with the simple goal of outperforming your starchy core. In fact, that’s sort of the point. Core and explore proponents usually seek out active strategies that are as different from the index as possible in order to avoid overlap with their inexpensive core holdings. That could mean hiring a specialized fund manager who deals in precious metals, or a hedge fund that focuses on mergers and acquisitions. Or you could pick your own stocks, if that floats your boat.

Another common strategy is using passive products actively: for example, you might use sector ETFs to move from defensive utilities to aggressive technology stocks when you think the timing is right. The sky’s the limit.

Another option is to index the most liquid asset classes and actively manage less efficient ones. So you might use index ETFs for your bonds and large-cap stocks, complemented with active strategies for small caps and emerging markets. Your assumption here is that skill matters more in less liquid asset classes, so it should be easier for active managers to beat their indexes. Emphasis on “assumption.”

To continue reading the “Best of both worlds” by Preet Banerjee, including sections on counting the costs of core and explore, what the pros do, when core and explore is best and what mix is right for you, download the full Retirement 100 | Fall 2012 package. The download includes a spreadsheet of Norm Rothery’s top dividend-paying stocks. Or pick up a copy of the November 2012 issue of MoneySense magazine on newsstands now through mid November. You can also buy digital editions of the magazine for the iPad.

Preet Banerjee is an independent personal finance commentator and a former adviser with a bank-owned brokerage. You can follow him on Twitter at @preetbanerjee.

—Scott Misener, Newmarket, Ont.

Trading commissions can really eat into a portfolio if you buy small amounts of ETFs with monthly contributions. But there are ways around this. Low-fee mutual funds like the TD e-Series funds are an option, says CFP Fred Kirby. Or you could save up the contributions and buy the ETFs on a quarterly or annual basis, he adds.

Another option is to go with a discount brokerage that will allow you to buy a selection of ETFs without incurring commissions: Scotia iTrade, Qtrade and Virtual Brokers currently offer this service. The main drawback is that the list of eligible ETFs is not as large as some would like, but for the beginner Couch Potato it’s a good way to start.

Got a question about your finances? Email us at: ask@moneysense.ca

The idea is simplicity itself: it can consist of holding as few as four funds, typically a fixed-income one and three equity funds holding equal parts Canadian, U.S. and international stocks.

Set it and forget it

All you need to do with such a portfolio is add to it over time, perhaps rebalancing yearly, so there’s very little tinkering necessary. No need to check the latest quarterly results of some individual stock you fear you’ve overweighted, no need to worry about over- or under-valuations in particular regions of the world or sectors of the economy. Merely “set it and forget it.”

The term Couch Potato refers to the fact the owners of such portfolios can sit back on the couch and no nothing but fiddle with the remote: get on with living life without fretting about the stock market, interest rates or the economy. The term originated with American columnist Scott Burns. It has been adapted in Canada by MoneySense and especially our Index Investing columnist and editor-at-large Dan Bortolotti, who also writes his own Canadian Couch Potato blog.

The idea also shows up under the similar moniker of the Easy Chair portfolio. In any case, readers may be interested to know that the revised second edition of Bortolotti’s MoneySense Guide to the Perfect Portfolio has just been published and should be available on newsstands shortly if not already. Or you can order it online here. The one-year-old first edition has been sold out for several months now.

Having just edited the guide and written the foreword to it, I think any reader interested in this approach to investing would do well to obtain a copy.

Doing it yourself via discount brokers

At the price of a single discount brokerage trade ($10), it’s well worth it. I mention discount brokerages because this is a major focus of the guide. If you’re new to the idea of online investing—perhaps you still use a full-service brokerage or use an investment advisor oriented to mutual funds—Bortolotti takes you through all the steps necessary to make the change to doing it yourself via a discount brokerage. Then he evaluates the pros and cons of the two main types of building blocks for the Couch Potato: index mutual funds and ETFs.

Those who prefer the complexity, thrills and heartaches of stock-picking might want to read the article in the guide by Andrew Hallam, author of Millionaire Teacher. Hallam describes his own route from stock junkie to Couch Potato enthusiast, despite enjoying relative success at the former activity. He just didn’t feel the odds would remain in his favor.

Both Bortolotti and Hallam are what I’d describe as indexing “purists.” Just as it’s impossible to be “half pregnant” they would argue the benefits of indexing only accrue to investors who fully embrace the philosophy.

That makes it a difficult paradigm to embrace for those with existing portfolios chock-a-block full of individual stocks, actively managed mutual funds and a smattering of ETFs. It can take years to fully transition from one investing mindset to another: those with DSC (Deferred Sales Charge) mutual funds face the barrier of waiting for redemption schedules to wind down while tax considerations make it difficult to convert any non-registered portfolio to a couch potato portfolio.

Core & Explore as interim step

In the interim, though, investors could consider a “core and explore” or “core/satellite” approach that puts index funds at the core of registered portfolios (where tax consequences of switches are minimized), while perhaps retaining existing holdings in non-registered portfolios.

I might add the Guide to the Perfect Portfolio nicely complements what I call the Findependence Day model. Both focus on discount brokerages holding ETFs or index funds. The third element I emphasize is fee-only financial planning, a subject Bortolotti’s guide touches on. He is, however, somewhat skeptical about mutual fund managers and stockbrokers, quipping that “the financial industry, as a whole, is not a Potato-friendly zone.”

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