Building an ETF Portfolio

Having an investment portfolio that is right for you is crucial in determining whether or not you will reach your long-term financial objectives. However, before you decide what to include in your portfolio, you first need to consider your personal circumstances.

“Are you ready to invest in ETFs?”

What are your specific investment goals and when do you plan to reach them? How much money do you have to invest? What level of returns are you seeking? What level of risk can you handle? Do you have the time and expertise to manage your own portfolio, or will you rely on a financial advisor or a convenient product like an exchange traded fund (ETF)?

Once you answer these important questions, you can decide how to build your portfolio with products that will work together to achieve the overall results you want.

Below are some key principles and strategies to consider when building a portfolio using ETFs.

Asset Allocation

One of the most significant benefits of having an investment portfolio versus a single investment is diversification. When you own just one investment, you are counting on it to provide the returns you need to achieve your financial goals. That’s a big risk to take, but if you spread your assets across several investments, you can reduce your risk while giving yourself the opportunity to generate returns from a number of different sources.

A good way to diversify your portfolio is through an asset allocation strategy that determines in which asset classes you will invest your money. You can start with the major asset classes (i.e., stocks, bonds and cash), and then get more specific by diversifying within these asset classes. For instance, owning stocks from Canada, the U.S., emerging markets and other international markets will give you broader exposure, as will investing in companies from a variety of sectors like financial services, industrials, health care, natural resources, etc. In fixed income, you can buy securities such as government bonds, corporate bonds, high-yield bonds and floating rate loans.

Asset allocation is simplified when investing in ETFs, which provide convenient, targeted access to specific asset classes, regions, sectors and companies. By combining select ETFs into your portfolio, you can achieve the asset allocation you need to enhance returns while potentially reducing your risk.

Core and Satellite Investments

Another important consideration when building your ETF portfolio is how to incorporate core and satellite investments. “Core” investments are made up of the major asset classes such as Canadian equities, U.S. equities and Canadian investment-grade bonds. As the name suggests, these investments are at the core of many Canadians’ portfolios and will form the bulk of an investor’s holdings. “Satellite” investments are made up of asset classes that typically have a lower weighting in an investor’s portfolio, but are nonetheless valuable for diversification and enhancing the risk/return profile of your portfolio. Examples of satellite investments include emerging markets equities and floating rate loans.

ETFs are ideal for executing on your core-satellite investment strategy. ETFs represent a convenient, low-cost way to invest in core asset classes, while also giving you access to targeted and niche markets that might otherwise be difficult or too expensive to access.

Indexed and Active Investing

Passive – also known as index investing, and actively managed investment products each have attributes that can hold a place in an effective, well-diversified portfolio.

Investment returns of a broad-based, market-capitalization weighted ETF will typically be in line with its respective benchmark index, making it a convenient way to capture broad market performance in your portfolio. Active managers, such as many mutual funds have, look to outperform a given market by constructing a portfolio that doesn’t resemble the index in the fund’s category benchmark. You can incorporate both ETFs and mutual funds in your portfolio weighted appropriately according to your investment goals. Sophisticated institutional investors have been following this strategy for years with the objective of generating the best possible risk-adjusted returns for their clients.

Market Capitalization and Equal Weighting Strategies

In a perfectly efficient market, where stock prices are always an accurate measure of a company’s value, market capitalization can be an appropriate way to weight a stock’s allocation in an index portfolio (a stock’s market capitalization is calculated by multiplying its price by the number of outstanding shares). If prices are not a perfect measure of a company’s value, meaning markets are not perfectly efficient, cap-weighted indices will experience a return drag caused by holding too large a weight in overvalued stocks and too little a weight in undervalued stocks.

One of the realities – and potential risks – of indexes based on market-capitalization (“cap”) is that larger-cap securities will naturally have a greater weighting in the portfolio than smaller-cap securities. This type of weighting results in stronger index performance when larger-cap securities are outperforming. Conversely, when larger-cap securities are underperforming, the index will be negatively affected to a greater degree.

A way to avoid such dramatic market-cap-weighted swings in performance is through ETFs that follow an “equal weighting” strategy. If you have an index that is made up of 100 securities, each security would carry a 1% weighting in the portfolio. This protects the index from “concentration risk,” where too few companies (and potentially too few sectors) have disproportionate impact on the portfolio’s performance. The equal weighting strategy will rebalance the portfolio holdings at prescribed intervals to ensure all securities revert to the same weighting.

Fundamental Indexing

Fundamental Indexing, considered to be the next generation of ETF investing, was designed to overcome the limitations associated with capitalization-weighted indices. The methodology for this approach was developed to address the structural return drag created by traditional cap-weighted indexing strategies. These traditional strategies are systematically overweight overpriced securities in the index portfolio and similarly, underweight, underpriced securities. The fundamental indexing methodology uses variables that do not depend on fluctuation of market valuation; rather it selects and weights securities in the portfolio using a combination of four metrics of company size – total sales, book value, cash flow and gross dividends. This method breaks the link between portfolio weight and the price of the stock.

Capturing Upside and Downside of Capture Ratios

Another major factor to consider when building your portfolio is upside and downside capture ratios of an investment fund. The “upside capture” ratio shows you how much of the positive monthly performance of a broad market index has been captured by a particular fund over a given time period. An upside capture ratio above 100 indicates outperformance by the fund during monthly periods of positive returns for the index, while a value below 100 means the index outperformed during those periods.

The “downside capture” ratio is the other side of the coin. A downside capture ratio of less than 100 indicates that a fund has lost less value than the relevant index during monthly periods of negative returns for the index, while a value above 100 means the fund lost more during those periods.

Why are these ratios important? They provide insight into how a fund performs in up and down markets relative to its index.

For instance, the table below shows how the MSCI RW Top 200 Index NR (CAD Hedged), has outperformed its benchmark, the MSCI World Index NR (CAD Hedged) over the past 17 years with less volatility, as measured by standard deviation. While the fund didn’t capture all the gains of the index in strong markets (up capture ratio of 59.99), it added significant value by protecting capital much better than the index in weaker markets (with a down capture ratio of only 29.67).

Time period: 01/01/1999 to 31/01/2016 First date Annual return Standard deviation Up Capture Ratio Down Capture Ratio

MSCI RW Top 200 Index NR






MSCI World Index NR (CAD Hedged)






(source: Morningstar Direct, As at Jan. 31th, 2016)

Other low-risk weighted ETFs share characteristics of outperforming their respective benchmark indexes while being less volatile and capturing far less of the losses relative to the gains. If it’s important to you to have a smoother investment ride through up and down markets, consider adding a low-risk weighted ETF to your portfolio.

Important information about each CI ETF Fund is contained in its respective prospectus. Individuals should seek the advice of professionals, as appropriate, prior to investing. This investment may not be suitable for all investors. Some conditions apply. Copies of the prospectus may be obtained from your investment advisor, First Asset or at Commissions, management fees and expenses all may be associated with mutual fund investments. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

The commentaries presented are prepared as a general source of information. They are not intended to provide specific individual advice including, without limitation, investment, financial, legal, accounting or tax. The opinions contained in this document are solely those of First Asset and are subject to change without notice. First Asset assumes no responsibility for any losses or damages, whether direct or indirect, which arise from the use of this information and expressly disclaims liability for any errors or omissions in this information. First Asset is under no obligation to update the information contained herein.