One of the best ways to create a diversified investment portfolio is to make use of index ETFs. You enjoy relatively low costs, and you follow specific indexes. This can help you build wealth long-term providing you with a portfolio with staying power. You don't have to worry about what a fund manager is doing, nor do you have to be concerned about high costs eating into your real returns over time.

You can even use Canadian ETFs, and hold them in a registered account, allowing you to enjoy the resulting tax benefits. An ETF can be a good part of your investment plan.

When looking for an Exchange Traded Fund (ETF) that indexes Canadian equities, the two most suitable choices are from iShares:

  1. The iShares CDN LargeCap 60 Index Fund (XIU) tracks the S&P/TSX 60 Index. This index is composed of S&P’s selection of 60 of the largest, most liquid stocks on the TSX. The Management Expense Ratio (MER) on this ETF is a very low 0.18%.
  2. The iShares CDN Composite Index Fund (XIC) tracks the S&P/TSX Capped Composite Index. This index includes over 200 companies listed on the TSX. It’s MER is 0.27%.

Before you make your decision based entirely on MER, it's important to take a closer look at each of these ETFs. Below are some of my thoughts on the XIU vs XIC issue.

XIU or XIC?

First of all, it's important to note that the top 10 holdings for XIU and XIC are identical. So you are getting the same 10 companies at the top of the list. Additionally, the weights in both of these ETFs are based on market capitalization. But there are some fairly important differences involved as well.

First of all, XIC currently holds 234 companies. Canadian Index ETFs - XIU vs XICCompare that to the 60 held by XIU. With XIC, you are going to see more diversity because you have access to more companies with XIC. Secondly, XIC limits the the weighting in its ETF to 10% of the total holdings. This means that, the top 10 holdings in XIC account for only 33% of the total portfolio, while in XIU, the top 10 holdings make up 46% of the portfolio.

This matters because things can get ugly if one company is too influential, due to market capitalization. A good example of this can be seen with Nortel back in 2000. At one point Nortel's market cap was large enough that it, on its own, made up 34.2% of the TSE 300 Index. That's huge. And when things went south, it was devastating. XIC limits some of the potential for becoming overweighted in one stock with its caps. However, it's important to realize that, at the same time, XIC is a little more expensive, and it's a little less liquid.

Even with the lower liquidity and I higher costs, I think that XIC is a good choice. I believe XIC is worth the extra 0.08% MER as is provides much more diversification, including some exposure to small cap stocks. Ultimately, though, either of these ETFs will provide a better return than the majority of actively managed funds, which are dragged down by higher MERs.

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