• the fund’s sales charges, fees, and expenses;
• the taxes you may have to pay when you receive a distribution;
• the age and size of the fund;
• the fund’s risks and volatility; and
• recent changes in the fund’s operations.

So, look at more than the fund’s past performance when making your investment decisions. Read the fund’s prospectus and shareholder reports, and consider these tips:

• Scrutinize the fund’s fees and expenses.Funds charge investors fees and expenses. A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858. It takes only minutes to use a mutual fund cost calculator to compute how the costs of different mutual funds add up over time and eat into your returns.
• Know how the fund impacts your tax bill.The law generally requires a fund to make a capital gains distribution to shareholders if it sells a security for a profit that can’t be offset by a loss. If you receive a capital gains distribution from a fund, you will likely owe taxes on it – even if the fund has had a negative return since you invested in it. For this reason, you should call the fund to find out when it makes distributions so you can time your investment in the fund to avoid receiving a capital gains distribution immediately upon investing and paying more than your fair share of taxes. Some funds post that information on their websites.
• Consider the age and size of the fund. Before investing in a fund, read the prospectus to find out how long the fund has been operating and the asset size of the fund. Newly created or small funds sometimes have excellent short-term performance records. Because these funds may invest in only a small number of stocks, a few successful stocks can have a large impact on their performance. But as these funds grow larger and increase the number of stocks they own, each stock has less impact on the fund’s performance. This may make it more difficult to sustain initial results. You can get a better picture of a fund’s performance by looking at how the fund has performed over longer periods and how it has weathered the ups and downs of the market.
• Consider the fund’s portfolio turnover rate. A fund’s portfolio turnover rate measures the frequency with which it buys and sells securities. A fund that rapidly buys and sells securities may generate higher trading costs and capital gains taxes.
• Think about the volatility of the fund.While past performance does not necessarily predict future returns, it can tell you how volatile a fund has been. Generally, the more volatile a fund, the higher the investment risk. If you’ll need your money to meet a financial goal in one year, you probably can’t afford the risk of investing in a fund with a volatile history because you will not have enough time to ride out any declines in the stock market. Read the fund’s prospectus and annual report, and compare its year-to-year performance figures. These figures can help tell you whether the fund earned most of its returns in a few small bursts or whether its returns came in a steadier stream. For example, over ten years, two funds may have gained 12% per year on average, but they may have taken drastically different routes to get there. One might have had a few years of spectacular performance and a few years of low (or negative) returns, while the performance of the other may have been much steadier from year to year.
  
• Factor in the risks the fund takes to achieve its returns.Read the fund’s prospectus and shareholder reports to learn about its investment strategy and associated risks. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals. For example, a fund that invests primarily in stocks whose prices may change quickly – like initial public offerings or high-tech stocks – will usually be riskier than other types of funds. But remember that all funds carry some level of risk. Just because a fund invests in government or corporate bonds does not mean it does not have significant risk. For example, the fund’s investments could be very sensitive to interest rate changes. Thinking about your long-term investment strategies and tolerance for risk can help you decide what type of fund is best suited for you.
  
• Ask about recent changes in the fund’s operations.Has the fund’s investment adviser or investment strategy changed recently? Has the fund merged with another fund? Operational changes such as these can affect future fund performance. For instance, the investment adviser or portfolio manager who generated the fund’s successful performance may no longer be managing the fund.
  
• Check the types of services offered and fees charged
  by the fund.Read the fund’s prospectus to learn what services it provides to shareholders. Some funds provide special services, such as toll-free telephone numbers, check-writing privileges, and automatic investment programs. You should find out how easily you can buy and sell shares and whether the fund charges a fee for buying and selling shares. You can expect funds that require extra work by their managers, such as international funds, to have higher costs.
• Assess how the fund will impact the diversification
  of your portfolio.Generally, the success of your investments over time will depend largely on how much money you have invested in each of the major asset classes – stocks, bonds, and cash – rather than on the particular securities you hold. When choosing a mutual fund, you should consider how your interest in that fund affects the overall diversification of your investment portfolio. Maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk.

 It’s one thing for retail investors and a few do-it-yourself investors to embrace index funds or ETFs. It’s quite another if advisors are breaking away from the embedded compensation pack and recommending that their clients move from mutual funds to ETFs.

One point I should clarify — when referring to “mutual funds” the headline [which I didn't write] was presumably referring to actively managed mutual funds with high fees. There are of course some actively managed mutual funds (from firms like Phillips Hager & North, Beutel Goodman, Saxon, Sceptre, GBC etc.) which aren’t necessarily sold with embedded compensation. And of course index mutual funds (like some of the bank no-load groups or DFA Canada] resemble ETFs in their passive approach to the markets. The difference is that some index mutual funds also have trailer fees or embedded compensation.

 Then again, as we’ve written in the past, even some ETFs have moved to embedded compensation: Claymore Investments in particular has pioneered trailer fees of 75 basis points paid to advisors, bringing the cost to investors significantly closer to the level Canadian investors have been accustomed to paying for years in their actively managed mutual funds.

 In short, the mutual fund industry and the ETF industry appear to be converging somewhat: some ETFs are actively managed or soon will be; some mutual funds take a passive approach; most mutual funds have embedded compensation but some do not; most ETFs do not have trailer fees but some do. So it’s really not productive to make sweeping generalizations about mutual funds being “shunned” altogether. Nevertheless, young advisors like Banerjee may prove to be the canary in the coal mine for the mutual fund industry. That plus the extensive media coverage of the Tufano et al academic study on how high Canada’s MERs are relative to 18 other nations suggests that the industry needs to continue to drive down costs and to deliver performance and value for those fees.

 I’ll close with the same offer made at the end of the column. Over the coming months, I’d like to hear from more young financial advisors who believe they are part of a new breed. We’ll profile them in the same spot occupied today by Banerjee.  

Even though the dollar remains down on the day, it has moved off of its low. The euro rose to a high of $1.2867 Tuesday, then eased back to $1.2815.

Dave Meger of Alaron Trading said that not only is gold reacting to the dollar’s seesawing, but it also has entered a period of consolidation since breaching the $700 an ounce level last week. On Thursday, it hit a 26-year high above $730 an ounce.

“There have been traders looking to sell into rallies and then buy on the dips,” said Meger of the choppy trading conditions in gold.

Others traders have said that the recent pullback in price attracted a good degree of traditional physical demand from India, Hong Kong and Dubai.

“That type of physical demand is underpinning the market, and now we are also seeing bargain-hunter buying,” said Bernard Hunter of Scotia Mocatta.

A 7.4 percent fall in U.S. housing starts during April contributed to the idea that the Federal Reserve may pause in its monetary tightening, said Frank Lesh of Future Path Trading. Annualized starts were 1.849 million, below the consensus forecast of 1.95 million.

The Producer Price Index was mixed relative to expectations. Overall PPI was up 0.9 percent in April, compared to a 0.8 percent forecast. But core PPI, excluding food and energy, was down 0.1 percent, compared to a 0.2 percent consensus expectation.

Analysts at Barclays Capital in London said that even though gold and silver are higher on the day, further near-term weakness is possible given the large speculative length. On a technical basis, the analysts said, there is little that suggests the trend is actually over.

Looking ahead to the rest of the week, Lesh said the market will get an even more important inflation report Wednesday when the government releases the Consumer Price Index.

Are you happy with how well your mutual funds are doing?

Didn’t think so. Over the long run, two-thirds of stock funds deliver less than the market as a whole - a performance most of us can stomach, barely, when stocks are doing well. But in a market as stingy as the one we’ve endured since 2000, below-average results really hurt.

So are mutual funds doomed to underperform? Not necessarily, and new research shows how you can find better funds more reliably.

Experts have long struggled to explain why pension funds - the big pools of money run for traditional corporate and government retirement plans - tend to outperform mutual funds even when they’re run by the same people investing in the same stocks.

The simple explanation: Mutual funds charge more because they cost more to run. A pension fund doesn’t have to advertise how great it is, maintain a 24-hour toll-free phone bank or mail out tens of thousands of prospectuses.

Mutual funds do, and that gives them higher expenses than pension funds - depending on how you count, between 0.03 and 0.3 percentage points a year, or up to an extra $3 on every $1,000 you invest.

But there’s a lot more at stake here than three bucks. The difference between pension funds and mutual funds goes way beyond what gets recorded as expenses.

A new study led by Rik Frehen, a Dutch finance scholar, looks at the stock-investing records of pension and mutual funds in the U.S. - and the findings are fascinating and alarming.

Comparing the returns of 700 pension funds against those of 4,000 mutual funds between 1992 and 2004, Frehen found that both categories had underperformed the broader market but that pension funds had killed mutual funds.

The former had trailed the market by 0.1% a year, beating mutual funds by at least 1.4 percentage points a year, on average, after adjusting for expenses, risk, the size of the funds and their style of investing.

Now we’re no longer talking about three dollars. Over the period that Frehen and his colleagues studied, $10,000 in a mutual fund would have returned just under 9% a year, giving you $30,000.

But the same amount invested in a pension fund would have grown to $36,000, or 20% more. If the stock market returns an average of 6% annually after inflation, you’ll give up more than a quarter of your gain by being in a mutual fund - and that’s before you pay your annual expenses.

What accounts for this huge gap? Much of it lies in how mutual fund managers are compensated and judged. Managers get paid on the size of the portfolios they run and on the basis of quarterly and annual performance - pressure that pension fund managers don’t generally face.

That incentive scheme can lead to behavior that hurts you. To goose short-term results and make a mutual fund appear to own the “right” companies when it reports holdings to investors, managers trade stocks too frequently. Trading doesn’t cost the manager anything, and it’s not reported as an expense to the fund, but the resulting brokerage costs erode your return by up to 1% a year.

Also, some funds allow big investors to put in and yank out tens of millions of dollars at a time, maximizing the funds’ assets but also raising trading and tax bills. Finally, funds pay brokers for “shelf space,” or preference in sales campaigns. One way or another, that also comes out of your pocket.

Your behavior can hurt performance too. Research shows that when tons of money pour into a hot fund with a great recent track record, the stocks it then buys go on to underperform the market; meanwhile, when a fund goes cold and money flows out, the stocks it sells to cash out investors subsequently outperform.

In short, investors often force their mutual fund managers to buy expensive stocks and sell cheap ones. The only real solution is for managers to close their funds to keep “hot money” out - something most are reluctant to do. Pension funds, on the other hand, get a steady and stable inflow of cash, so they don’t have these kinds of problems.

But all is not lost. Some funds do outperform over time. To increase your chances of finding them, look for ones offered by the small and mid-size fund companies I call owner-operators, where the portfolio managers invest heavily both in their own funds and in the company that runs them.

Trading too much, churning up tax bills or shooting for short-term gains will hurt these managers almost as much as it will hurt you. They’ll close hot funds to new investors; they’ll try to keep a lid on fees. Their interests are aligned with yours, helping them stay focused on the long term.

Among such firms are Ariel, Bridgeway, Davis, FPA, Longleaf, Numeric, Oakmark, Third Avenue and Tweedy Browne.

Finally, you can buy a whole-market index fund from a low-cost firm like Fidelity, T. Rowe Price or Vanguard - which eliminates unnecessary trading entirely, since these funds always own everything.

As Vanguard’s founder Jack Bogle likes to say, “Buy right and sit tight.” To get a result as good as a pension fund would give, you must act as rarely and patiently as the best pension managers do and shun funds that think short term.

The Forester Value fund (FVALX), which invests primarily in large, blue-chip companies, is up 7.4% year-to-date. according to Morningstar. The average U.S. stock mutual fund is down 28.5%.

I spoke with Forester Value manager Tom Forester this morning to find out how’s he been able to avoid the market bloodbath and what he’s doing now.

And guess what? He was buying yesterday while the global markets were in full-blown Armageddon mode.

“I bought a lot yesterday. I’m just about back to being fully invested,” he said. “When you see panic selling, it’s usually a pretty decent time to buy.”

Forester said he had been raising cash throughout August and that he has been using it to take advantage of big market routs in the past few weeks. The fund is still relatively small though, with about $33 million in assets.

“When you have nosedives like this and since our fund is still in positive territory you feel more confident when you’re buying shares,” he said.

What has he been buying? Forester said that he’s finally starting to find some values in financials, which he had largely avoided earlier this year.

“I saw this crisis happening a few years ago and it surprised me that it took so long to find its way into stock prices. So I stayed away from many firms with mortgage exposure,” he said.

But with bank and insurance stocks getting crushed in the past month, Forester said that it’s time to sift through the rubble and find quality companies that should emerge from this crisis as survivors.

As such, Forester said he added to positions yesterday in insurers Allstate (ALL, Fortune 500) and Travelers (TRV, Fortune 500) as well as regional bank US Bancorp (USB, Fortune 500).

Tellingly, Allstate and U.S. Bancorp, which is also a top holding of Warren Buffett’s, both fell less than 1% yesterday despite the market’s carnage. And shares of Travelers actually went up.

He said he’s also considering buying shares of beaten-down investment bank Morgan Stanley (MS, Fortune 500) and insurer Hartford Financial Services (HIG, Fortune 500) - but he’s not ready to invest in them just yet.

Stock and bond markets have not fared well since the passage of the $700 billion bailout plan last week. But Forester is optimistic.

“From the sounds of the bailout, this will take care of a lot of the trouble,” Forester said. “You never know where the bottom is but I do think this bailout helps tremendously.”

Forester concedes that there still are plenty of problems. He said many banks still have troubles, housing prices could fall another 20% and the holiday-shopping season could be a bust as consumers pull back.

But there are ways to stay invested in stocks and make money despite such a gloomy scenario. Many of Forester’s top holdings are so-called consumer-staples firms, food and household products companies that are less likely to suffer big declines in sales and profits in a poor economy.

Two of his largest investments are in H.J. Heinz (HNZ, Fortune 500), whose stock is up 10% year-to-date, and Kraft (KFT, Fortune 500), which is flat this year.

He also said that he bought shares of Wal-Mart (WMT, Fortune 500) and McDonald’s (MCD, Fortune 500) earlier this year because he felt that they could benefit as more cash-strapped consumers look to cut costs.

“If consumers are getting pinched, they’re likely to trade down. Instead of going to Chili’s they may go to McDonald’s and instead of shopping at Nordstrom they may shop at Wal-Mart,” he said.

Those calls have helped his fund’s performance. Shares of McDonald’s are flat this year and Wal-Mart’s stock is up nearly 25%.

But Forester isn’t just playing defense. He said he’s also been taking a look at three hard-hit sectors for bargains: tech, media and healthcare.

Microsoft is a relatively new position in the fund and Forester said it’s now a top-five holding. He likes the fact that Microsoft (MSFT, Fortune 500) has a lot of cash, recently announced a $40 billion stock buyback program, increased its dividend and trades at a reasonable valuation.

“In times like this, Microsoft should be a really steady stock,” he said.

And even though Forester is aware that many experts are sounding the death knell for the traditional media industry, he recently bought a new position in television and radio broadcaster CBS (CBS, Fortune 500).

Forester said he was attracted to the stock’s 8.4% dividend yield, steady cash flow and bargain-basement valuation of just 7 times 2009 earnings estimates.

He added that he thinks sales and earnings for media companies will eventually bounce back along with the broader economy, despite continued competitive threats from the Web.

“Yes, traditional media has been losing share to the Internet. But a lot of media stocks used to sell at huge premiums to the market,” he said. “Now, even though you could say there’s not much growth, so much bad news is priced in that CBS looks like a pretty safe stock.”

In the healthcare area, Forester said he recently bought managed-care firm UnitedHealth (UNH, Fortune 500). That stock has plunged more than 60% this year but Forester bought it when it was trading in the low $20s. He said he’s actually sitting on a small profit - on paper - in the investment so far.

“I’m trying to find stocks that sell at really good discounts. Some got beat up more than they should have,” he said.

At the end of the day, Forester said he thinks the most important thing for any investor to do is to stay calm and be ready for big market swings in either direction.

That’s served him well. Since the fund’s inception in 1999, it’s had an average annualized return of 5.6%, outperforming the S&P 500 as well as other large value funds.

“There are always going to be big rallies and declines in markets. You have to be prepared for them,” he said.

And the key is to take advantage of situations when people’s fear cause them to do illogical things.

In fact, Forester said that despite all the talk about how this market meltdown will cause investors and companies to never make the same mistakes again, history shows that’s just not true. There eventually will be another bubble.

“People are still people. We’re emotional beings. When you get rid of the emotions we’ll get rid of the mistakes. In other words, we’ll never get rid of them,” he said.

“But that’s what makes my investment strategy possible. I buy things when they are beat up due to emotional extremes. I’m glad we’re human.”

Many mutual fund investors choose funds that have better than average five or ten year performance numbers. This is partly because people believe that a fund which has done well in the past will do well in the future; it is also because mutual fund companies actively promote and market their best performing funds to the public. I have argued that mutual fund performance is no indication of future returns but apparently too few mutual fund investors pay attention.

On the other hand, most mutual fund investors also follow a buy-and-hold strategy: Once they have invested in a fund they will stick with it for awhile no matter what. For one thing, investors have been taught that a buy-and-hold investment strategy is an effective strategy. Also, there are often financial penalties for withdrawing money from a fund within the first several years–many funds have deferred sales charges and other loads that penalize investors for early withdrawl. Finally, as Lynch and Musto point out, when a fund performs poorly fund managers generally announce a change of strategy, and this announcement mitigates investor’s desire to withdraw funds.

As a result, a mutual fund that outperforms the market will see funds flood in as investors choose it over other mutual funds. Absolutely huge quantities of money flood into the top performing mutual funds. On the other hand, underperforming funds will see money flow out of the fund at a much slower rate. Overall, the rate of inflow to a successful fund is much higher than the outflow from an unsuccessful one.

Mutual fund managers are paid a percentage of assets under management, so their primary incentive is to attract as much money into the fund as possible. On the surface this seems to align their interests with mutual fund investors–the fund manager will be rewarded if the fund does well. However, that looks at only one side of the equation–the flip side is that fund managers should also be punished if the fund underperforms, and while they are, they are not punished nearly so much for failure as they are rewarded for success.

This puts the mutual fund manager into a conflict of interest with mutual fund investors. It is in the investor’s best interest to make sound, sensible investments that have a good probability of paying off, with only a small chance that the investor will suffer a large loss. On the other hand, it is in the fund manager’s best interest to make highly risky investments that create the potential for large inflows of money.

What kind of risky strategy might an active manager follow? Over-concentrating the funds holdings on a few securities in the hopes that one will payoff big would be one strategy. Investing a disproportionate amount of money in highly risky small-caps, foreign securities, or various options and derivatives would be another. None of these investment choices are inherently bad–but if the goal is to increase the risk so as to increase the chances of a high return, then this is probably contrary to the interests of the fund’s investors.

This performance flow effect has been studied extensively in the academic literature. Ippolito (1992), Brown, Harlow, and Starks (1996), Gruber (1996), Chevalier and Ellison (1997), Goetzmann and Peles (1997), Sirri and Tufano (1998), and Del Guercio and Tkac (2002) have all looked into it. The effect is persistent and pervasive: Investors reward success much more strongly than they punish failure.

The implication is that mutual fund investors should be wary of selecting funds based on their past performance, and on the lookout for active managers who seek to increase their own net worth by making unacceptable gambles with fund investor’s money. One way to avoid this is to invest only in indexed mutual funds where fund managers do not make active decisions.

It’s worth pointing out that many fund managers overcome this conflict of interest and attempt to trade in the best interests of their unit holders. The existence of a conflict of interest does not mean that fund managers will expropriate investor’s money–it’s just a big caveat emptor: Let the mutual fund buyer beware.

Canadian mutual funds are in general a lot more expensive than American funds, and there aren’t a lot of different asset classes to choose from.

Fortunately there are two points of light: First, American Exchange Traded Funds (ETFs) can be purchased by Canadian investors as foreign content; second, we have a few ETFs of our own here in Canada. Given the absence of good conventional funds in Canada, I highly recommend that you build your portfolio primarily from these ETFs. But beware of trading fees! In this article I will review what an ETF is, take a close look at the fees, compare ETFs and conventional funds, suggest some strategies, and provide you with a list of ETFs you should consider so as to construct an efficient portfolio.

What Is an Exchange Traded Mutual Fund

The basic idea of any mutual fund is to pool money from a large number of investors so that a large number of securities can be purchased efficiently. Each investor therefore gains the advantage of being well diversified, without the time and expense of having to purchase the individual securities. Exchange traded mutual funds are just another variation on this theme–except that they trade on a stock market like an ordinary stock.

There are a few key differences between an ETF and a traditional “open-ended” mutual fund that you would buy directly from a fund vendor:

• You will need a “self-directed” trading account with a discount stock broker
• You have to pay trading fees and spreads to buy an ETF, just like you do when you buy a regular stock, but you won’t pay any other “loads”.
• Whereas investors can redeem units of a traditional mutual fund an ETF generally does not permit redemptions. Instead you sell your units on the market like you would sell any other stock.

I will cover each of these issues in turn, then take a look at the ETFs available to Canadian RRSP investors.

Choose a Discount Broker

Acquiring the appropriate trading account is a small administrative matter, and I recommend you set about doing that anyway, even if you decide not to invest in ETFs. A brokerage account will also enable you to buy mutual funds, and to manage your fund holdings online through a website, generally at lower cost than doing the same by telephone. You lose nothing by setting one of these up, so do it.

As at December 2004 I will even go so far as to recommend a few discount brokerages. Your choice is essentially between TD-Waterhouse, which offers more services through its discount brokerage at not unreasonable prices, or between Credential Direct (associated with Credit Unions) which has slightly cheaper fees but lacks many of the services provided by TD-Waterhouse. In particular, TD-Waterhouse charges a higher brokerage fee ($29) for trading stocks, and a lower fee for trading traditional mutual funds (if you trade TD’s, which are OK). Credential Direct, on the other hand, charges only $25 to trade stocks, but always charges a fee if you trade traditional mutual funds, and their web interface is not as nice. There are also some other services offered by TD that are not available through Credential, but if you just want to invest in ETFs these may not matter to you.

Yes, compared to the United States where you can trade stocks for less than $10 these fees are obscene. Write your Member of Parliament and complain: we are being ripped off.

How Do Mutual Fund Companies Get Paid?

Whenever you interact with the financial service industry you pay an array of upfront fees and an array of hidden fees. Their goal is to maximize the fees you pay. Your goal, obviously, is to minimize fees.

With a traditional mutual fund there are four kinds of fees that you pay:

1. The person who sold you the fund may charge you some service charge.
2. The fund itself may charge you a “load”, either when you buy into the fund (”front-end”) or when you sell your units (”back-end”).
3. The fund will charge every unit holder a “management expense ratio”, which the fund manager will deduct from the fund annually. This expense ratio is widely reported in the fund’s prospectus and in newspapers as the “MER” .
4. The fund will incur trading costs and other expenses in the course of its operation–such as brokerage fees–which are not considered to be part of the MER. It is generally nearly impossible to get a clear accounting of these trading fees, something that should worry you if the fund is paying these fees to a related organization, such as the brokerage arm of the same banking group that runs the fund.

In many cases the person who sold you the fund receives an ongoing kickback from one or more of these fees. Sometimes they are paid once (from the load), and sometimes they are paid on an ongoing, annual basis. This generally means that you and the financial services industry have different interests, as they earn their fees no matter whether you make money or not.

With an exchange traded fund you do still pay the expense ratio and the hidden trading costs, but you do not pay any sort of “load” charge, nor do you pay a sales fee. Instead you pay a commission to your broker every time an order is executed–typically $25 to $29 a trade, plus some cents per share for large orders. You will pay that fee once when you buy, and you will pay it again when you sell. Finally, you pay an implicit “spread” when you buy and sell an ETF: The price at which you can buy is slightly higher than the price at which you can sell, and the people who execute the trades for you in the stock market pocket the difference. It’s real money, even though you may not notice it at first.

Given this fee structure here’s some advice:

• Prefer “indexed” funds, as the MER fees are much lower.
• Prefer “market cap weighted” index funds: These funds do not have to trade when companies move up and down in the index, so they should have lower hidden trading costs.
• Adopt a buy-and-hold approach to avoid incurring the trading fees
• Minimize your buying: place a few big orders rather than many smaller ones.
• Always find out how the people you are dealing with get paid.

Now let’s look at the advantages and disadvantages of ETFs versus open-ended funds.

Advantages and Disadvantages of Exchange Traded Funds

Exchange traded funds have several key advantages over traditional open-ended mutual funds:

• ETFs tend to have lower MER fees. This is the main reason why we’re talking about them. In the United States this isn’t true–they have open-ended funds with even lower fees–and hopefully, eventually, that will happen here in Canada too. 
• The ETF doesn’t have to execute redemptions (with a conventional fund you can call your broker and exchange your units for money, this is called a redemption). To turn your ETFs into cash you sell them on the stock market, not back to the fund. This saves the fund money because it has much less work to do, and it’s vitally important during a market downturn when many investors rush to sell their units. With traditional funds this incurs high costs as the fund has to come up with the money by selling a large number of stocks while the market is falling. That activity hurts those who stayed in the traditional fund, not just those who panic and sell. 
• You don’t have to worry about being a victim of the “market timing” tricks that have been in the news recently, where sophisticated investors flip in and out of a fund extracting a profit at the expense of long-term fund investors. The fund trades on a market, so this attack on the fund simply isn’t possible. (This scam depends on being able to place orders to buy and sell the fund with information that came out after the fund’s daily price came out. An ETF doesn’t have a “daily price” that is set by anyone, it trades on a stock market instead.) 
• You can buy US ETFs on the market like any other US stock, whereas US mutual funds are simply not available to you in an RRSP. 

The main advantage, though, is price. That’s mitigated somewhat by the main disadvantage:

• You have to pay $25 to $29 to your broker every time you buy or sell, plus
• You implicitly pay the difference between the bid and ask spread

Note that your broker only gets paid when you trade. Most brokerages will offer you newsletters, analyst reports, and services that are designed to get you to trade more. Don’t.

The way to cope with these trading fees on ETFs is to adopt a buy-and-hold approach. You should do that anyway–it’s the only sound way to invest. You should also attempt to minimize the number of transactions, say by purchasing the ETF just once a year, rather than buying in a little every month. This is bad: It is much better to do “dollar cost averaging”, where you buy your investments a little at a time and get a fairer, average price.

There is a way out of this trap: A good technique here is to save up money in a no-load/no-fee open-ended mutual fund, such as a money market, or equivalent stock-market index. Once a year transfer all your money from this open-ended fund to your ETFs. You will pay a higher MER on that open-ended fund, but you will have a relatively small amount of money there–the money you’ve built up over years of investing will be in an ETF, and just the money you’ve added this year will be in the open-ended fund with the higher MER.

Be careful with this strategy: Check with your broker and find out how long you have to leave your money in the open-ended fund to avoid sales charges. Pick a fund that will allow you to transfer your money to the ETF once a year.

What ETFs Should You Buy

In this section I will draw your attention to the key ETFs that you should be interested in, and what they are. Deciding what proportion of your portfolio should be in each is a subject for a future article, but in general it is much better to split your money between a variety of different kinds of stocks than to put all your eggs in one basket. You’d like some US large stocks, some US small, some overseas, some Canadian, and perhaps some emerging markets or REITs. Don’t just buy the TSX-60 and the S&P-500, that’s not diverse enough.

You should also know that you can hold just 30% of your RRSP in foreign securities. Fortunately there are two solutions: First, if you hold bonds in your RRSP then simply hold Canadian bonds. Unlike stocks, there is not as much advantage in diversifying bonds internationally, and this will use up a lot of the Canadian content portion of your RRSP.

Second, there are special Canadian ETFs that give you exposure to foreign assets without actually being foreign assets (by way of a complicated scheme involving futures contracts).These have slightly higher fees than holding the foreign assets directly, but they do enable you to use “Canadian content” in your RRSP to gain exposure to foreign equity. For example, instead of using the US ETF “VTI” you can use the domestic Canadian ETF “XSP” (with a slightly higher MER). See below.

The most interesting ETFs for Canadian investors are (as at December 2004):

There are of course many others, but these are a few that I think are key. Using these you ought to be able to build a fairly diversified portfolio containing exposure to a variety of asset classes: bonds, US large caps, foreign equities, US small caps, US values and Canadian equities. I have also included a few non-traditional classes such as REITs and precious metals. How much of your portfolio should be in REITs is not well understood–perhaps a lot is ok, perhaps not. Precious metals should play only a small role in your portfolio.

Beware of overlap. In many cases these funds hold the same assets. For example, if you buy VTI as well as XSP you have essentially bought the S&P 500 index twice, as the S&P500 dominates the US total market.

Conclusions

Use Exchange Traded Funds (ETFs) instead of mutual funds. Buy once a year, investing your money in a broad array of ETFs representing diverse asset classes. Do not trade often. Save your money during the year in a no-load/no-fee open-ended fund of some sort, even if it has an unfortuante MER.

Whenever you invest in TD Mutual Funds, you’ll find the advice and guidance you need to help you reach your investment goals. Investing your money with TD Mutual Funds can help move you closer to funding the dreams in your life.
Source: www.tdcanadatrust.com