Building A Globally Efficient Equity Portfolio with Exchange Traded Funds
EfficientMarket.ca

Presumably this serves as a good guide for an investor: If you want to allocate your investments globally in the most efficient way, you ought to follow the global allocation of capital to equity markets. We do know what the overall allocation of capital looks like. According to The Economist (2006, world in figures), it looks something like this:

Country	Capitalization	Percentage	Market
United States	14266266	46.14%	USA
Japan	3040665	9.83%	FOREIGN
United Kingdom	2412434	7.80%	FOREIGN
France	1355643	4.38%	FOREIGN
Germany	1079026	3.49%	FOREIGN
Canada	893950	2.89%	CANADA
Spain	726243	2.35%	FOREIGN
Switzerland	725659	2.35%	FOREIGN
Hong Kong	714597	2.31%	FOREIGN
China	681204	2.20%	EMERG
Italy	614842	1.99%	FOREIGN
Australia	585475	1.89%	FOREIGN
Netherlands	488647	1.58%	FOREIGN
Taiwan	379023	1.23%	EMERG
South Korea	267745	0.87%	EMERG
Brazil	234560	0.76%	EMERG
Russia	230786	0.75%	EMERG
Belgium	173612	0.56%	FOREIGN
Finland	170283	0.55%	FOREIGN
Malaysia	168376	0.54%	EMERG
Saudi Arabia	157302	0.51%	*EMERG
Singapore	145117	0.47%	FOREIGN
Denmark	127997	0.41%	FOREIGN
Mexico	122532	0.40%	EMERG
Thailand	118705	0.38%	EMERG
Greece	105845	0.34%	FOREIGN
Norway	94679	0.31%	FOREIGN
Chile	86291	0.28%	EMERG
Ireland	85070	0.28%	FOREIGN
Israel	75719	0.24%	EMERG
Turkey	68379	0.22%	EMERG
Portugal	58285	0.19%	FOREIGN
Indonesia	54659	0.18%	EMERG
Austria	54528	0.18%	FOREIGN
Argentina	38927	0.13%	EMERG
Luxembourg	37333	0.12%	*FOREIGN
Poland	37165	0.12%	EMERG
Iran	34444	0.11%	*EMERG
New Zealand	33052	0.11%	FOREIGN
Egypt	27073	0.09%	EMERG
Philippines	23565	0.08%	EMERG
Kuwait	20772	0.07%	*EMERG
Czech Republic	17663	0.06%	EMERG
Hungary	16729	0.05%	EMERG
Pakistan	16579	0.05%	EMERG
Peru	16055	0.05%	EMERG
Columbia	14258	0.05%	EMERG
Morocco	13152	0.04%	EMERG
Jordan	10963	0.04%	EMERG

If we summarize that by market index we come up with roughly this global equity allocation:

Market	Equity Index	Percentage
USA	US Total Mkt.	46%
Foreign developed	MSCI EAFE	41.5%
Foreign emerging	MSCI Emerg. Mkt.	9.5%
Canada	TSX Total Mkt.	3%

Now, if you simply want to follow the global equity allocation you could invest your money along those lines and get the overall optimal result. However, that might not be your personal optimal result. Your situation differs somewhat from the hypothetical "average global investor", and as a result, your portfolio should differ in some ways too. This is just a good starting point. In particular, here are some of the likely differences between you and the average global investor:

• You are a Canadian
• You may have specific current spending needs
• You are an individual with retirement/savings objectives
• You have your own particular tolerance for risk

Your specific income and savings needs may cause you to do a variety of interesting things. You might want to put some money into REIT's, or into other income generating trusts. You might want to put an extra two or three percent into gold or oil stocks as a hedge against high energy prices or a recession (though, if you over-invest in the Canadian market, you have implicitly done both of those already). Nevertheless, the majority of your equity portfolio, its backbone, should be globally diversified.

There is one constraint, however, that does impact your global equity choices: You are a Canadian. This has two interesting effects. First, you experience Canadian economy risk: If the Canadian economy suffers, your home declines in value and your employment opportunities are limited. On the other hand, it is much cheaper for you to invest in Canadian equities than in foreign equities--you do not have to pay exchange rate fees to convert your money (including dividends!) and you probably pay a slightly lower commission to buy and sell Canadian equities than foreign ones.

We can estimate these costs: You will lose about 2% overall to exchange rates when you receive a US dividend in a typical Canadian discount brokerage account and use that money to purchase a US security. You will also pay about 15% more to purchase a US security than you will pay to purchase a Canadian security. Over a 25 year period, then, a Canadian investment will return about 20% more than an equivalent US investment, due to exchange rates. That extra 20% is a powerful argument for investing heavily in Canada; on the other hand, your exposure to Canadian economic risk is a powerful argument against doing so.

My feeling, considering all of this, is that you ought to hold perhaps three to five times as many Canadian equities as the global allocation would suggest--bumping your Canadian equities to perhaps 10% or 15% of your total portfolio, up from the global average of 3%. Remember that you also likely hold a significant number of bonds in Canadian dollars, so your net total Canadian position across all of your investments will be quite a bit more than the 10-15% of your equities.

Factoring in all of that, we come up with this suggestion for a typical Canadian investor's diversified equity portfolio:

Market	Percentage	Low-cost ETF available
USA	43%	US:VTI - Vanguard Total Market Index
EAFE	38%	US:EFA - iShares MSCI EAFE
Canada	10%	TSX:XIC - iUnits capped TSX index
Emerging	9%	US:EEM - iShares Emerging Markets Index

Note that this represents just a portion of your total portfolio. You would separately determine the proportion of bonds that you would hold in your portfolio, and the proportion of "hedge" and "income" investments that you require (presumably REIT's, trusts, gold, and so forth). The above is simply intended to provide you with a guide in determining how to allocate equities in a globally diversified way that is consistent with investment theory, and your own personal situation within the global economy.