How to Build an ETF Portfolio in Canada: One-Fund, Couch Potato and Three-Fund

The first decision comes before the funds: your asset mix, or how much goes to stocks, bonds and cash. The Ontario Securities Commission’s investor site, GetSmarterAboutMoney, says that mix will largely set your portfolio’s risk and expected return. After that, the approaches differ in who keeps the mix on target. One all-in-one ETF holds a stock and bond mix inside a single fund and is rebalanced by its manager. Here, a couch potato or three-fund portfolio means a few index ETFs held at a mix you set and keep on target yourself. This page explains how to make those choices. It has no fund list: the funds are compared on the ETF family pages.

On this page: Asset mix · Risk and time horizon · Approaches · How many ETFs · Rebalancing · Getting started · Which account · DIY or robo

What is an asset mix, and why does it come before choosing ETFs?

GetSmarterAboutMoney names three main asset classes:

• Cash and cash equivalents, like a savings account, a GIC or a money market fund.
• Fixed income, such as bonds and bond funds or ETFs.
• Equities, such as stocks and stock funds or ETFs.

Splitting your money among those classes is called asset allocation. The right split depends on what you’re investing for, how much risk you can live with and how long until you need the money. Because the mix drives most of the risk and expected return, the funds come second: an ETF is a way to fill each part of the mix. Broad stock index ETFs are covered on index ETFs listed in Canada, bond funds on how bond ETFs work, and the cash part on money market ETFs.

How do risk tolerance and time horizon shape the mix?

The OSC’s site splits your risk profile into two parts. Risk capacity is how much financial risk you can handle: whether a loss would hurt your everyday finances. Risk tolerance is how much risk you’re willing to take on. Your earning power from work is part of your capacity, since income from a job can help make up for investment losses. Tolerance is easy to misjudge: the site warns that it can be easy to overestimate it while markets are rising. One question advisors ask is how you’d react if your portfolio dropped by 20%.

Time horizon is how long you expect to hold an investment until you want the money back. GetSmarterAboutMoney sorts horizons into three bands:

• Short: less than five years.
• Medium: five to 10 years.
• Long: more than 10 years.

In general, the longer the horizon, the more risk you can afford. Stocks can be very risky for money you’ll need soon. The site’s own guidance is that you “should reduce your allocation of longer-term, high risk investments” as the horizon shortens. A mix isn’t set once: it changes as your needs and goals change. Rules of thumb that tie the stock share to your age are covered on asset allocation by age, and drawing income from ETFs in retirement on ETFs for retirement income.

One fund, a couch potato portfolio or three funds: what’s the difference?

All three are usually built from index funds, which track a market index instead of trying to beat it. GetSmarterAboutMoney describes a passive approach as one that “aims to match the average market returns, rather than attempting to beat it”. Index funds come as mutual funds or ETFs and tend to cost less than actively managed funds.

The one-fund route. An all-in-one (asset allocation) ETF holds a mix of global stocks and bonds in a single fund, BlackRock says. BlackRock says its funds are rebalanced as needed to keep their target weights, and Vanguard says its mixes are regularly rebalanced back to the target. You choose the level (the stock share) and the fund keeps it. The funds and their levels are compared on all-in-one ETFs, which also explains what an all-in-one ETF is.

The couch potato portfolio. The name comes from US columnist Scott Burns, whose site calls him “the creator of Couch Potato investing”. As this page uses the name, the structure is a few index funds, which tend to cost less than actively managed funds, held at a mix you pick and brought back to it from time to time (see rebalancing).

The three-fund portfolio. This page uses the name for the same structure with three funds, for example one each for Canadian stocks, stocks outside Canada and Canadian bonds .

Here is how the arithmetic of a three-fund mix works.

What a blend of funds costs a year depends on each fund’s MER and its weight; the MER calculator works it out.

How many ETFs do you need, and what is overlap?

Diversification works across asset classes and inside them: GetSmarterAboutMoney says it’s also important to diversify within each class, for example across industries and countries. The site’s example of overlap: if you own one bank’s shares and add another bank’s, your industry diversification hasn’t changed. Funds work the same way. BlackRock’s report on XEQT lists the iShares Core S&P Total U.S. Stock Market Index ETF among its holdings, so a separate US index ETF added beside it raises the US weight more than it spreads risk. Sector funds are covered on sector and thematic ETFs.

How and when do you rebalance?

Over time your mix drifts as some holdings rise or fall more than others. The parts that did well grow into a bigger share, which can raise the portfolio’s risk; rebalancing brings it back in line.

The OSC’s site describes two common ways to rebalance:

• With new money: put new contributions into the part that has fallen below its target.
• By selling: sell some of the part that has grown and move the money to the others. Count the trading fees when you do.

As for how often, the site says that “for many investors, re-balancing once or twice a year should be sufficient”, and that rebalancing too often can add buying and selling costs. In a taxable account, selling units at a profit is a taxable capital gain; selling or switching ETFs covers the tax. An all-in-one ETF and a robo-advisor do the rebalancing for you (approaches, DIY or robo).

How do you get started, and all at once or a bit at a time?

GetSmarterAboutMoney lists building an emergency fund and reducing debt as uses for extra money, and notes that an emergency fund lets you cover a surprise bill without selling investments; investing for beginners covers those first steps. The two self-directed routes on this page differ in who rebalances: one fund whose manager keeps the mix on target, or several funds you rebalance yourself. Small monthly amounts in an all-in-one ETF are covered on that page, and opening an account and placing orders on how to buy an ETF.

Dollar-cost averaging means investing a set amount at regular intervals to spread out your risk, so you aren’t trying to time the market. The OSC’s site notes its downsides too: more transaction costs if you buy often, and missing out if prices rise early. The dollar-cost averaging calculator compares it with investing a lump sum.

Which ETF goes in which account?

Interest, dividends and capital gains earned in a TFSA are generally tax-free, even when you withdraw them. Income earned in an RRSP is usually exempt from tax as long as the funds remain in the plan, and you generally pay tax when you receive payments from it. The rule in full is on how investment income is taxed.

In a taxable account, placement matters because kinds of income are taxed differently: BlackRock notes that interest is typically taxed at your marginal rate, while Canadian dividends may get favourable treatment. Foreign withholding tax works differently: for a Canadian-listed ETF holding US stocks, BlackRock says it applies whether the fund sits in a taxable or a registered account. Asset location covers which fund to hold where, and withholding by route the layers of US tax.

Should you manage it yourself or use a robo-advisor?

Self-directed investing means you put together and run your own portfolio. In Ontario, robo-advisors (online advisers) manage the portfolio for you, usually using model portfolios of ETFs or low-cost mutual funds and rebalancing them from time to time. They start with a questionnaire about you, and their fee is generally a percentage of your portfolio’s value. Robo-advisor vs ETF portfolio compares the two, and robo-advisors in Canada the firms. Index mutual funds are a third route, covered on how to invest in index funds.

Where to go next

• All-in-one ETFs for the one-fund route.
• Canadian-listed ETFs by category and bond ETFs for the funds in a couch potato portfolio.
• The MER calculator for what fees cost over time.
• Asset location for which account holds which fund.
• ETFs for retirement income for drawing on a portfolio.
• Brokers and robo-advisors for where to open the account.