ROB CARRICK

Saturday, October 14, 2000

It's time you got up close and personal with the product that could eventually end the mutual fund industry's reign as the investment choice of the masses.

Exchange-traded funds are simple to understand, a cinch to buy and cheaper to own than almost all mutual funds. Most importantly, history suggests they'll give you better performance than the majority of mutual funds over the long haul, and more flexibility in constructing a portfolio.

Still, there's a problem with exchange traded funds. Although they're relatively new and unknown to most people, there has been an exponential increase over the past year in the number of funds available.

Picking your way through this selection is incredibly time-consuming, if not baffling. Will that be an S&P 500 fund to track the U.S. market, or perhaps a Dow Jones U.S. Total Market Index fund, a Russell 1000 fund or, for that matter, a Russell 2000 or Russell 3000 fund? The selection of Canadian funds isn't nearly as varied, although many new choices are coming in the months ahead.

What you'll find below is some advice on how to cut through the newly grown forest of ETFs. There are suggestions about which funds to use to track the most important markets and sectors, and some model portfolios to give you an idea of how to use these funds. (See N5 for details).

For your own portfolio, it's recommended that you diversify your index holdings with some actively managed funds, or individual stocks.

Some ETF basics

ETFs are index investments, which means they more or less give you the return of a target stock index. Index funds charge less in management expenses than traditional mutual funds, and they tend to perform better as well over time.

Another important characteristic of ETFs is that they trade on a stock exchange, generally the Toronto Stock Exchange and the American Stock Exchange in New York. Where you'd deal with a bank or fund company to buy an index mutual fund, you buy ETFs exactly like a stock -- quote the symbol, say how many shares you want and you're away.

If you use an on-line broker, you can buy virtually any exchange-traded fund for as little as $35 to $45. And don't worry about having to buy in board lots of 100 -- in many cases, you can buy as little as one fund unit if you want.

There are dozens of global stock indexes that are tracked by exchange-traded funds, ranging from widely followed benchmarks like the S&P 500 stock index and Dow Jones industrial average to sectoral and national indexes that focus on technology, for example, or the stock market of Taiwan or Germany.

If you're familiar with index mutual funds, you know they give you access to only a small fraction of the indexes available through ETFs.

The three criteria used here to select ETFs from among the dozens available are:
1. Management expense ratio: Index funds basically make whatever their target index makes, minus management expenses. That's why low MERs are crucial.
2. The underlying index: ETFs often give you the choice of several differently constructed indexes that track the same market. Indexing experts recommend the broadest possible index, but this can mean buying an obscure, opaque index that's totally unfamiliar to you. How comfortable are you going to be putting money in a fund that tracks an index that never appears in the newspaper and has no long-term performance history you can check? Not very. That's why the ETFs suggested here strike a balance between broad market coverage and high visibility.
3. Liquidity: Investors haven't taken to all the ETFs out there -- some funds may go a whole day without a single share trading. This lack of liquidity could present a problem if you had to sell at a given moment, or if you wanted to place an order for an odd lot of shares, as opposed to a board lot of 100.

Now, let's go through the major markets and economic sectors to pick the most suitable funds:
Canada

Several new Canadian market funds will be available by year-end, but for now there are two choices: The iUnits S&P/TSE 60 Index Participation Fund (XIU--TSE) from Barclays Global Investors and the SSgA Dow Jones Canada 40 Index Participation Fund (DJF--TSE), which is managed by rival State Street Global Advisors. Both i60s and DJ40s are large-cap funds with roughly 40 per cent of their assets allocated to Nortel Networks Corp., which means you're assuming a fair bit of risk if Nortel tanks.

You have two choices on how to address the Nortel factor, the first is to cross your fingers and buy these funds. Choose DJ40s if you go this route -- their 0.08-per-cent MER is cheaper than the 0.17 per cent charged for i60s.

Another option is to wait until the end of the year, when we'll see a new ETF based on the S&P/TSE 60 Capped Index called the i60C. This fund will limit individual stocks to no more than 10 per cent of the total, which is a lot more comfortable. Other new funds arriving around the same time will offer exposure to medium-sized Canadian companies, as well as the energy, information technology, gold and financials sectors. A pair of fixed-income funds are coming in the next few weeks.
The United States

The S&P 500 and the Dow Jones industrial average are the most widely followed U.S. indexes, so let's stick with them for the most part when selecting ETFs.

Soon,Canadian investors will be able to buy an S&P 500 fund developed by Barclays that is fully eligible for registered retirement savings plans. The MER hasn't been set for the iUnits S&P 500 Index RSP Fund, but no more than 0.25 per cent seems about right. That's half of what's charged by the cheaper index mutual funds offering RRSP-eligible exposure to the S&P 500.

Provided Barclays doesn't get greedy with the management expenses charged on its new fund, it'll be an ideal choice for people who want to go beyond the 25-per-cent foreign content limit.

For non-registered accounts, choose the iShares S&P 500 Index Fund (IVV--Amex) over SPDRs (SPY--Amex), or Spiders, which is the street name for S&P Depositary Receipts. The iShare fund has a cheaper MER -- 0.09 per cent, compared with 0.12 per cent.

You can track the Dow with Diamonds (DIA--Amex), a popular ETF with an MER of 0.18 per cent. Remember, though, that the S&P 500 has been the better performing index over time.

There are several indexes that let you invest in the smaller-sized companies that don't make the S&P 500. If this appeals to you, then choose the iShares S&P MidCap 400 Index Fund (IJH--Amex) over MidCap Spiders (MDY--Amex). Again, the iShares will save you money in the long run with a lower MER -- 0.20 per cent to 0.25 per cent.

Want to add a growth or value slant to your portfolio? The iShares series includes funds that let you track the Russell 1000, 2000 and 3000 indexes in both value and growth versions. The value indexes include companies with lower price-to-book ratios and lower forecast growth values, while the growth index does the opposite.

Wondering which Russell index to choose? The best-performing over time is the 1000, which is made up of large-cap stocks (the 2000 is smaller-cap, while the 3000 combines the other two).

An ideal global index to track with an ETF would be the Morgan Stanley Europe, Australasia and Far East (EAFE) Index because it's basically an anywhere-but-the-Americas product.

Strangely, the only way to buy this index is through a regular index mutual fund, or the RRSP-eligible iUnits International Equity Index RSP Fund that will shortly be introduced in Canada by Barclays. With a reasonable MER, this new fund will be an ideal candidate for RRSP portfolios.

The U.S. selection of ETFs includes some 20 country-specific funds, a couple of Europe funds and a fund that comprises 50 of the largest-cap companies in the world.

A Europe fund is a good candidate for your portfolio and one to consider is the iShares S&P Europe 350 Fund, which includes stocks from 15 European markets. Be warned that the MER for this fund is 0.60 per cent, which is high for an ETF. By comparison, TD Asset Management's Green Line European Index eFund has an MER of 0.47 per cent, though it's only sold over the Internet.

Another option for adding a global component to an ETF-based portfolio is the new streetTracks Dow Jones Global Titans Index Fund from State Street. This fund tracks an index of 50 globally dominant companies drawn mainly from the United States but also from France, Britain, Germany, the Netherlands and Japan. The MER is high for an ETF at 0.50 per cent.

Then again, it's a bargain when compared with the 0.84 per cent and higher charged for the iShares MCSI country-specific funds. Save these funds for times when you want to make a small side-bet on a specific country's stock market.
Technology

Here's where ETFs get really interesting, especially given the recent selloff of technology stocks. There are seven technology-focused ETFs, plus another eight flavours of an ETF cousin called HOLDRs, for Holding Company Depositary Receipts.

For most investors, the best tech choice happens to be the most popular ETF in the world by far. It's called the Qube (QQQ--Amex) and it lets you invest directly in the performance of the Nasdaq 100, an index of the 100 largest non-financial stocks listed on the Nasdaq Stock Market. The MER on this fund is a reasonable 0.18 per cent, which compares with 0.60 per cent for the iShares Dow Jones U.S. Technology Sector Index Fund (IYW--Amex), 0.50 per cent for the new streetTracks Morgan Stanley High Tech 35 Index Fund (MTK--Amex) and 0.27 per cent for technology Select Sector Spiders (XLK--Amex).

If you've got a large amount of money to invest and feel comfortable about plunking it down in a high-risk sector, then definitely look at the HOLDRs that focus on biotechnology, broadband, the Internet, business-to-business Internet, Internet infrastructure and so on.

Traded on the Amex, HOLDRs are based on a basket of stocks chosen by analysts at Merrill Lynch. Problem is, they can only be purchased in board lots of 100. Biotech HOLDRs traded at $172 (U.S.) this past week, which means you'd have to put down roughly $25,000 (Canadian) to buy a position. Ironically, HOLDRs are ultra-cheap to own. No MER is charged, only an $8 annual fee per 100 units.
Other sectors

If you're in a league where you can afford HOLDRs, you can zero in on regional U.S. banks, utilities and pharmaceuticals. Regular ETFs let you play about a dozen different sectors of the U.S. market.

Select Sector Spiders are your best bet for playing a sector. There are nine varieties -- basic industries, consumer services, consumer staples, cyclicals/transportation, energy, financials, industrials, technology and utilities -- and MERs are around 0.27 per cent.

The iShare series offers a slightly larger menu of U.S. sector funds, but the MER is high at 0.60 per cent. Also, some of these funds are wallflowers that some days attract little or no trading interest.

Why ETFs?

The average U.S. equity mutual fund posted an average annual gain of 17.5 per cent in the 10 years to Aug. 30, while the S&P 500 made 19.5 per cent. Now you understand why more and more people are getting fed up with actively managed mutual funds and turning to index investing.

With an index fund you make what the index does, minus management fees. Clearly, then, you want a fund with the lowest fees. That's where exchange-traded funds shine. Their management expense ratios, a comparison of a fund's expenses against its total assets, are far lower than index mutual funds.

Say you want to buy the S&P 500 index. With an ETF called the iShares S&P 500 Index fund, you'd pay an MER of 0.09 per cent. With index mutual funds, you'd pay anywhere from 0.30 per cent to 0.90 per cent or more.

Now, imagine $10,000 was invested in the iShare S&P ETF and an index mutual fund (MER of 0.5 per cent) for 20 years and both made an average gross return of 10 per cent annually. At the end of the 20 years the iShare fund would give you an additional $5,218, or 52 per cent of your initial investment.

Another advantage of ETFs: You can buy them at any time of day to take advantage of price fluctuations, and you can short-sell them if you like. Mutual funds can only be bought at end-of-day prices.

Still another advantage: Tax efficiency. Index funds adjust their portfolios only to reflect changes in their target index, which means fewer taxable distributions of taxable gains.

A disadvantage: Unlike mutual funds, ETFs don't give you the option of having your dividends and capital gains distributions reinvested in new fund units. It may be possible at some brokers to set up a dividend reinvestment plan for a widely traded ETF like the i60s.
Rob Carrick

Related Web sites

These Web sites offer all the
information you'll need to find the right ETFs for your portfolio:
http://www.iunits.com: Details on ETFs offered in Canada by Barclays Global Investors, including the popular i60.
http://www.ishares.com: Barclays' site for its 60-odd U.S. funds, called iShares.
http://www.holdrs.com: Details on the 11 holding company depositary receipts created by Merrill Lynch.
http://www.streettracks.com: Details on new ETFs run by State Street Global Advisors.
http://www.amex.com: Information on all ETFs listed on Amex, including top holdings and MERs, plus quotes and graphing tools. A great site.
http://www.spdrindex.com: Data on select sector SPDRs.
http://www.indexfunds.com: News and views on U.S. ETFs and index funds in general.

Portfolios

Here are some ideas for building a foundation of exchange-traded funds for your portfolio.
Basic RRSP portfolio

55% -- a Canadian ETF (DJ40s, symbol DJF on the TSE, if you love Nortel; the          soon-to-be-released i60C if you're leery of Nortel).

20% -- iShares S&P 500 Index Fund (IVV -- Amex).
20% -- *iUnits International Equity Index RSP Fund (no symbol assigned yet).
5% -- Qubes (QQQ -- Amex).
Basic non-RRSP portfolio
45% -- a Canadian ETF.
30% -- iShares S&P 500 Index Fund (IVV -- Amex).
10% -- iShares Euro 350 Fund (IEV -- Amex).
10% -- Dow Jones Global Titans (DGT -- Amex).
5% -- Qubes (QQQ -- Amex).
Aggressive RRSP portfolio
40% -- a Canadian ETF.
20% -- *iUnits International Equity Index RSP Fund (no symbol assigned yet).
20% -- *iUnits S&P 500 Index RSP Fund (no symbol assigned yet).
10% -- Qubes (QQQ -- Amex).
10% -- iShares S&P MidCap 400 Index Fund (IJH -- Amex).
Aggressive non-RRSP portfolio
40% -- a Canadian ETF.
25% -- iShares S&P 500 Index Fund (IVV -- Amex).
15% -- S&P Europe 350 (IEV -- Amex).
10% -- streetTracks Dow Jones Global Titans Index Fund (DGT -- Amex).
5% -- iShares Dow Jones U.S. Healthcare Sector Index (IYH -- Amex).
5% -- Energy Select Sector Spiders (XLE -- Amex).
Super-aggressive non-RRSP portfolio
30% -- a Canadian ETF.
20% -- iShares S&P 500 Index Fund (IVV -- Amex).
20% -- Qubes (QQQ -- Amex).
10% -- iShares S&P SmallCap 600 Inces Fund (IJR -- Amex).
10% -- S&P Europe 350 Fund (IEV -- Amex).
5% -- IShares MCSI Japan Fund (EWJ -- Amex).
5% -- Energy Select Sector Spiders (XLE -- Amex).
-*provisionally included here pending announcement of MER

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