There’s money in your couch

Couch Potato Guide Overview Couch Potato Selector 3 Ways to Build a Couch What about Robo-Advisors? Couch Potato Performance

Do you think spending your evenings studying annual reports and researching mutual funds is the recipe for building wealth? If you’ve spent any time with MoneySense you know there’s a different way: the Couch Potato strategy. For those new to the idea, it’s a simple method of building a diversified, low-maintenance portfolio of index funds designed to deliver the returns of the stock and bond markets with minimal cost. Instead of trying to beat the market, index funds simply try to match it—and by doing so they’ve consistently outperformed the vast majority of actively managed funds over the long term.

While the premise of the Couch Potato remains the same, a lot has changed since the magazine brought the strategy to Canada 17 years ago. The portfolios have long included the same four components—bonds, Canadian stocks, U.S. stocks and international stocks—but there are many more fund options than there were at the turn of the millennium. As a result, our recommendations have evolved. While investors now have more ways to assemble a Couch Potato portfolio that suits them best, the variety has also caused confusion for those looking to get started with indexing.

The most attractive feature of the Couch Potato strategy has always been its low fees, especially when compared with actively managed mutual funds. But the truth is, fees are only one part of the decision. To appreciate this point, imagine you’re trying to decide what to do for dinner. You could take the family to a restaurant and let someone else do the cooking. Or you might grab a prepared meal to serve at home. Finally, you could buy all the ingredients and whip up a dinner from scratch. Of course, the home-cooked meal is the cheapest, but that doesn’t mean it’s the best option for everyone. If you work long hours, or don’t know how to cook, or are afraid of slicing open your hand with a chef’s knife, one of the other options makes more sense despite the added costs.

Index investing involves similar trade-offs. You can simply use a balanced fund that holds all the stocks and bonds in a single product. This is the “restaurant” option: it’s as easy as it gets, but you pay more for the convenience. You can also build your portfolio from individual index mutual funds, a “heat and serve” option that is a bit more work, but provides more flexibility and lower costs. Finally, you can cook from scratch using ETFs, which offers ultra-low fees and enormous variety that you can tailor to your tastes, but with significantly more complexity and some risk of injury.

In Canada, the choices are surprisingly limited in the first two categories. You might think balanced index funds would be common, but they’re not—likely because offering low-cost, simple solutions is not how fund companies make buckets of money. The only products that fit this bill come from Tangerine, the well-known online bank. There are five Tangerine funds, but only three are balanced portfolios (the other two don’t have a bond component). They range from the conservative Balanced Income Portfolio, which is 70% bonds, to the aggressive Balanced Growth Portfolio, which holds 25% in each of the four asset classes. The Balanced Portfolio comes down in the middle, with 40% bonds and 20% in each of the three equity indexes—the classic Couch Potato mix. All three funds have the same management expense ratio (MER) of 1.07%.

As for individual index mutual funds, all of the major banks offer them, but only grudgingly. Many bank-sponsored index funds have fees of 1% or more. The exception is TD’s e-Series funds, which stand out for having the lowest fees in Canada: their MERs range from 0.33% to 0.51%. You can select an individual fund for each of the four main asset classes and combine them in any proportion, from cautious to aggressive. The biggest limitation of the e-Series funds is the only effective way to buy them is through a self-directed account with TD Direct Investing.

Finally, we come to ETFs, the darlings of the industry. Their primary appeal is their rock-bottom cost: You can build a portfolio for less than 0.15%. ETFs are also available in enormous variety from several providers—including Vanguard, iShares and BMO—and through any online brokerage. Rather than limiting yourself to the basics, you can find ETFs that zero in on specific categories of bonds or stocks: Short-term or long-term bonds, government or corporate bonds, large companies, small companies, dividend payers and many others. You can also expand your portfolio to include asset classes like emerging markets, real estate or preferred shares, none of which are available with the other options we’ve discussed.

So, which option is right for you? The answer depends on several factors:

How large is your portfolio?

Costs are always important, but if you’re just starting out, they aren’t the most crucial factor. Consider a young investor with $10,000. She might look at the Tangerine funds with their 1.07% MER and think they’re too expensive compared with ETFs at about 0.15%. But in dollar terms that difference is just $92 a year—and that’s before you factor in any trading costs you’ll incur buying ETFs (but more on that later). For a new investor who may be overwhelmed by the variety of ETFs available or intimidated by the idea of placing trades on an exchange, that’s a reasonable price for the user-friendliness of a single balanced fund. On a $200,000 portfolio that fee difference becomes $1,840 a year, which is probably too much to pay for convenience; investors with portfolios that large will be rewarded for learning to use ETFs.

Fees on small accounts are another consideration. The bank-owned brokerages often charge $100 a year on RRSPs that don’t meet their minimum account requirements—typically $15,000 or $25,000 depending on the brokerage. Some may charge higher trading commissions if your balance is below a certain threshold. It’s almost never worth paying these account fees: If your portfolio is small, choose a no-fee option (Tangerine or one of the independent brokerages), or look for ways to have the fee waived. For example, TD Direct charges $25 per quarter on accounts under $15,000, but will waive this fee if you set up automatic contributions of at least $100 a month—which is a smart habit anyway.

How much of your portfolio is taxable?

The Couch Potato strategy is straightforward if you’re investing in tax-sheltered accounts such as RRSPs and TFSAs. But if you have a large non-registered (taxable) account, the simplest solutions don’t work as well. Now you need more flexibility to ensure your portfolio is built in a tax-efficient way.

Consider the Tangerine funds: they’re a perfectly good choice in your RRSP or TFSA, but they hold a significant percentage in bonds, which are not very tax-efficient. If you use the e-Series funds, you can hold the bond fund in your RRSP while keeping the more tax-efficient Canadian equities in your non-registered account. ETFs give you even more options, including specialty bond funds designed to minimize tax if held in non-registered accounts. Experienced investors can also use U.S.-listed ETFs, which can also be more tax-efficient.

How will you be adding new money?

All good investment strategies begin with regular savings, and if you’re contributing with every paycheque, index mutual funds are ideal. Both Tangerine and TD make it easy (and free) to set up systematic plans that ensure your dollars get invested immediately. While you can arrange for cash to go into your brokerage account every month, you’ll have to make the trades manually. And unless you’re able to take advantage of a commission-free offering, it’s not cost-efficient to make frequent small trades. If you’re paying $10 every time you buy or sell an ETF, you should wait until you have at least $2,000 or so before you make a transaction.

Are you disciplined enough to rebalance?

Couch Potato portfolios are very low-maintenance, but you do need to rebalance from time to time. The idea here is to keep your asset mix close to its long-term target, and that can mean selling whatever has recently gone up and using the proceeds to buy what’s gone down. That sounds easy in theory, but very few investors do it with discipline. In a year when bonds have fallen sharply and stocks have delivered double-digit returns, which do you think your lizard brain will tell you to buy?

One of the great benefits of balanced funds is that they’re rebalanced automatically: The Tangerine funds do it quarterly. A report by Vanguard found that investors who held balanced funds were less likely to make changes to their portfolios during the financial crisis of 2008 and the five years that followed, which means they weathered that event far better than most. The authors pointed out that these one-fund options “may actually help to insulate investors from one of the most insidious risks their investment portfolios face: their own behaviour.”

Are you prone to tinkering?

There’s a well-known idea in psychology called “the paradox of choice.” While most of us think we want as many options as possible, the truth is that too much choice is paralyzing, and it can lead to deep dissatisfaction. That’s why the limited selection of index funds from Tangerine and the TD e-Series is a blessing in disguise because it’s hard to screw up.

ETFs, on the other hand, are available in such variety that investors often find it overwhelming. Too often they build a nicely diversified portfolio and then immediately second-guess themselves. They wonder if they should switch to a different ETF that is a bit cheaper, or add a 5% allocation to some exotic asset class. Inner peace only comes to ETF investors once they realize there is no optimal portfolio, and that constantly making changes is more likely to be a bigger drag on performance than fees.

How much do you enjoy investing?

Some people consider investing a fun hobby—and then there’s everyone else. Indeed, if you’re attracted to the Couch Potato strategy it’s probably because you don’t want to spend a lot of time managing your portfolio: You simply want to enjoy the benefits of diversification and low fees. You can get most of that benefit with simple solutions like Tangerine or the e-Series funds, with a lot less effort than building and maintaining an ETF portfolio.

In the end, there’s no single Couch Potato that’s right for everyone. The best solution for you isn’t necessarily the cheapest: it’s the one that will allow you to comfortably and confidently manage your portfolio for the long term.