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Do-it-yourself ETF may not be worth your time

Special to The Globe and Mail

Is the war against money management fees going too far? Investors - the more enlightened ones anyway - have battled high fees for years, forcing the industry to parry with low-cost index mutual funds and exchange-traded funds as well.

Now, spurred by ultra-low trading commissions, some investors and financial planning pundits are aiming their guns at ETFs, arguing that you can dispense with them and create your own index funds, under certain circumstances, such as having a big enough portfolio. The arguments make sense on paper, but they're not without their shortcomings. The reality is that ETFs are pretty hard to beat if you want to invest in an index.

Here's how the strategy works, in theory: An ETF is a pool of money that, generally speaking, is built to resemble an index or subindex as closely as possible. The most popular ETFs are iShares, offered by Barclays Canada, which sport management expense ratios ranging from 0.17 to 0.55 per cent. That compares nicely with your typical mutual fund MER of more than 2 per cent (although most fund firms also offer lower-cost versions of the same funds, but in any case they're considerably higher than ETFs).

That said, the argument goes, ETF fees don't compare well to just buying the shares in the index yourself. A simple example goes like this: Take a $50,000 investment in, say, the iShares energy ETF (XEG-TSX). Using a low-cost broker to execute the trade, you'll pay a $5 commission to buy it and the same to sell it. Assume you hold on for seven years, the average holding period for a stock mutual fund.

In the meantime, you'll pay the 0.55-per-cent MER annually. A simplified calculation that assumes constant 8-per-cent capital appreciation yields a total management fee of about $2,600, plus $10 for trading in and out of the ETF, for a total of $2,610.

Now compare that to buying all the shares in the index individually. The energy ETF owned, at last count, about 60 companies. Buying them all today would cost $300. Selling them all in seven years, assuming the portfolio is the same, would cost the same, for a total cost of $600, less than a quarter what you pay with an ETF.

And you don't necessarily have to buy all of the stocks in the ETF. The top five companies make up half its weight and fully half of the stocks have weightings of less than half a percentage point, meaning you could get 90 per cent of the ETF's portfolio by buying half the shares in it. (EnCana, the largest holding, makes up 16 per cent of the index fund itself.) So you could pay $300 to buy and sell the 30-stock portfolio, saving $2,300 over the ETF over a seven-year period.

That sounds like time well spent, but there are wrinkles. The first is that you'll incur more trading expenses than that if you want to truly shadow the index because company weights change over time. ETFs are regularly rebalanced to keep them current in terms of composition, and the cost of doing so is included in the MER.

As a do-it-yourself ETF investor, you'll pay these trading costs.

On average, from 2003 to 2007, the energy subindex turned over at a rate of 60 per cent annually, with the number ranging from 6 per cent in 2003 to 120 per cent in 2007. Turnover is a proxy for the amount of trading in the fund. It's a sign of how much rebalancing you'll have to do. Even assuming our above example of owning half the names in the index, annual rebalancing commissions will add to your costs if you want to be faithful to the index. In the interests of simplicity, let's assume the rebalancing costs are $75 annually. That puts the total cost at about $1,125 if you buy all the shares. That's still lower than an ETF by a country mile.

However, a drawback of ignoring half the index is that you will be ignoring the smaller half, which has a better chance of doing well. Small stocks double, triple or quadruple easier than big ones. A stock with a half-point weight that quadruples adds 1.5 percentage points of return. That's a lot compared with the average annual historical return. Smaller stocks also falter more often of course, but on average, especially in bull markets for commodities, they come out ahead.

And then, says Barclays' executive in charge of iShares, "what about the spread?" What Heather Pelant is talking about is the cost of buying shares on the open market. Simply put, Barclays can buy in large blocks, which can mean a better price than buying retail. On a trade-by-trade basis, the difference is small, but it adds up.

Despite these drawbacks, the do-it-yourself portfolio can have a small advantage over the ETF, notably flexibility, says fund analyst expert Dan Hallett. With an ETF, you don't control the timing of sales and capital gains.

For example, suppose you own a lot of a mid-capitalization ETF, and a company that has done well is to be sold because it's no longer a mid-cap. You'll have to pay tax on that sale. If you own the index yourself, you can avoid selling.

But if you avoid selling when the index does, or if you only buy part of the index or choose not to rebalance in the same way, you're not really investing in the index, you're starting to actively manage a portfolio. The difference between that and buying an index is that with the latter, you are buying stocks that are going up and selling stocks that are going down - usually a proven strategy. By introducing some active management, you have less reason to invest in the index.

It should be noted that this do-it-yourself approach will work better if the index in question has only a few names in it and the ETF fee is high.

In any case, if you want to follow an index, do so. If you want to manage a portfolio, do so. But doing something in between to save a few bucks is not necessarily the best move. It will take up a lot of time and energy and it might produce inferior results.

At the end of the day, ETFs do a decent job compared with the alternatives. What's your time worth?

Fabrice Taylor is a chartered financial analyst.

Top 20 holdings of the iShares Cdn. Energy Sector index fund (XEG-TSX)

EnCana Corp.ECA15.9$89.85
Suncor Energy Inc.SU13.2$59.40
Canadian Natural Resources Ltd.CNQ12.6$100.46
Petro-CanadaPCA6.2$55.25
Canadian Oil Sands TrustCOS.UN5.8$53.20
Talisman Energy Inc.TLM5.3$22.25
Nexen Inc.TRP5$39.39
Imperial Oil Ltd.IMO3.5$54.75
Penn West Energy TrustPWT.UN3$34.25
Husky Energy Inc.HSE2.8$47.86
Enerplus Resources FundERF.UN1.8$47.49
ARC Energy TrustAET.UN1.5$32.45
Pengrowth Energy TrustPGF.UN1.2$20.33
Crescent Point Energy TrustCPG.UN1.2$40.28
OPTI Canada Inc.OPC1.1$23.73
Niko Resources Ltd.NKO1$98.64
Addax Petroleum Corp.AXC1$48.47
Oilexco Inc.OIL0.9$18.77
Harvest Energy TrustHTE.UN0.8$23.79
Petrobank Energy and ResourcesPBG0.8$51.83

SOURCE: iSHARES.CA

© 2007 The Globe and Mail. All rights reserved.

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