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A good place to start

Paul Carrick

A strong, sustained recovery in the stock market will certainly happen, but you have to be ready for it to get the best bang for your buck.

How do you get started? By dumping any mutual funds that have let you down and replacing them with exchange-traded funds, or ETFs. If you're doing some spring cleaning in your portfolio, that's as good a place to start as any.

A mutual fund can be considered to have underperformed if its results consistently lag the appropriate benchmark, say the S&P/TSX composite index for Canadian equity funds or the S&P 500 for U.S. equity funds mainly holding big blue chips. A fund is fine to hang onto if it lagged the index for a year or two, but matches up well over the long term. But a regular pattern of underperformance is a sell signal if ever there was one.

Sad to say, billions of dollars are invested in mutual funds that lag index returns, which are what pretty much what you get when you buy ETFs, which are index funds that trade like a stock. There are 55 Canadian equity funds with a 10-year track record and just about half of them did worse than you would have theoretically been able to make with an ETF that tracks the S&P/TSX composite index, the iShares CDN Composite Index Fund (XIC-TSX). This ETF hasn't actually been around for 10 years, but you can get an idea of what it would have made over that period by taking the index return and subtracting the fees you have to pay to own it.

The iShares composite index fund has a management expense ratio of just 0.25 per cent, which compares to roughly 2 per cent for the most popular Canadian equity funds and an average of 2.43 per cent for the broad category. Mutual fund and ETF companies take their fees off the top of their gross returns (returns reported to investors are always net of fees), which means low costs are a huge advantage.

The promise of mutual funds is that their smart and savvy managers can choose stocks and bonds that beat the indexes. But often, it doesn't work out for investors. Fees weigh on the results that managers are able to achieve, and then there's the issue of bad decision making. Just as some funds were too heavily loaded with Nortel Networks at the beginning of this decade, so were funds too immersed in financial, oil, metal and fertilizer stocks when the market crashed late last summer.

Some in the investing world love nothing more than to argue the superiority of index investing through ETFs over regular mutual funds, or vice versa. But the fact is, you can own both. Just be sure that your ETFs track sensible, important indexes, and that you don't own any mutual funds that are chronic underperformers. If you do, it's time to do an ETF substitution. Here are some suggestions on how to go about it:

You own a disappointing --- Potential ETF replacement

One major advantage mutual funds have is that they're widely available, whereas ETFs must be purchased through a broker (discount or full service). You'll have to pay commissions of at least $5 to $29 to buy ETFs, but those costs should be more than offset by the low cost of owning them. And then there's the predictability of ETFs. Whenever the stock markets take off again, so will your ETFs. Your mutual funds? Tough to say.

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