ETFs: A how-to for investors

Sales of exchange traded funds (ETFs) have exploded in Canada in the past two years. According to a report by Morningstar, sales grew by $4.5 billion in the first quarter of 2012, reaching a cumulative value of $49.1 billion by March 31.
By comparison, according to data from the National Exchange Traded Funds Association, assets in the U.S. have reached $1.2 trillion. Total sales are driven by the marketing efforts of leading ETF suppliers as they try to increase market share.
To my knowledge, North American ETF providers have increased from three in 1999 to more than a dozen in 2012, and the number of ETFs trading in the marketplace has increased from two in 1993 to some 1,400 today. But the most common comment I receive is, “Steve, I keep hearing about ETFs. What are they, and do I need to own some?”
ETFs are pre-structured investment portfolios designed to mimic the performance of a specific index, commodity, or bond portfolio. Think of them as a mutual fund with static holdings, extremely low fees, and excellent liquidity. They cover virtually all of the asset classes, including non-traditional investments as well as leveraged and covered call equity strategies.
ETFs make it easy to diversify investment portfolios. Need exposure to U.S. investments that track the performance of the Dow Jones Industrial Average 30-stock index? Easy, the symbol is DIA. It trades on the U.S. stock exchanges and can be purchased at an online brokerage account or through an investment adviser. Need a fund hedged to the Canadian dollar? No problem, the symbol is ZDJ and it trades on the Toronto Stock Exchange with an expense ratio of 0.23 per cent.
ETFs can simplify or complicate portfolio management. They provide diversification, cost savings, and risk modification when compared to traditional mutual funds or a personally managed investment portfolio.
ETFs can be used for long-term investment purposes or short-term speculative investment strategies. However, caution must be taken with certain ETFs that use leverage to double or triple exposure to specific asset classes.
In addition, there are actively managed and non-standard ETFs that are not suitable for all investors. Investors need to understand both the return characteristics and risk parameters of ETFs or consult an adviser who does.
HISTORY
ETFs were created in the 1990s; the first two (TIPS and SPYDERS) were designed to mimic the performance of the Toronto Stock Exchange Top 100 and the S&P 500 in the U.S. They caught on quickly because ETFs allowed investors to buy or sell two broad-market indices each trading day. From there, ETF providers expanded their coverage to track other indices like MSCI World Index Fund and the Spyder Gold Bullion Trust.
Once the formula for creating ETFs proved financially viable, sub-sector ETFs were created for most of the major stock indices. This was followed by ETFs for commodity, real estate, and fixed-income indices. Today, virtually all of the major indices, foreign and domestic, are represented with an ETF.
Unfortunately, ETF providers continue to invent new ETFs. While there may be nothing inherently wrong with these new indices, they don’t have a long-term track record and their inclusion can skew the risk profile to an unknown level.
WHY SHOULD I OWN ETFs?
First, using ETFs diversifies risk and increases potential returns. They should be used by investors who prefer a disciplined investment strategy. By using an asset allocation model, they can efficiently allocate investment dollars to all asset classes. This will mathematically reduce the risk and increase the expected return of the portfolio.
Second, investors need to understand that returns for each ETF will track the performance of its underlying index. Performance for any given year is unknown, but long-term rates of return and volatility have high degrees of predictability.
Third, most ETFs provide investors with complete transparency. The 30 stocks held within the Dow Diamond ETF generally do not change. Performance is therefore driven by the dollars invested in each ETF asset.
WHAT ARE THE RISKS?
Not all ETFs are created equally, and investors are blanketed with advertisements extolling the virtues of new and old ETFs — but rarely do ads highlight the imbedded risks. Investors need to know what they are buying.
Some ETFs expose investors to higher levels of risk due to leverage and increased volatility. Others contain sophisticated hedging strategies or the use of derivative instruments to approximate the performance of an underlying index.
WHERE CAN I GET INFORMATION?
Try to be as fully informed as possible when making new investment decisions. Check out the individual ETF provider’s website to get all the pertinent information on ETF investments prior to making a decision.
It’s also wise to seek information from unbiased views — the three best sources for Canadian ETFs are Morningstar Canada (Morningstar.ca), The Globe and Mail (theglobeandmail.com), and TMX Money (tmxmoney.com). For U.S. ETFs, follow the newly created National Exchange Traded Funds Association (nationaletf.org) and ETF Database (eftdb.com).
SUMMARY
ETFs are quickly becoming the preferred method for managing investment portfolios. Their low cost, transparency, reliable returns, and liquidity have added to their acceptance by the investment community.
ETFs now allow investors to access all five asset classes with ease and efficiency. They can expand the universe of asset categories with a reliable level of risk and capture excess returns not available under current investment strategies. However, an issuing frenzy similar to the mutual fund craze of the 1980s and ’90s could lead novice investors into costly mistakes. In an effort to increase assets under administration and market share, ETF providers are moving into actively managed products that might not meet the needs of investors or the objectives of the fund.
Ensure you fully understand ETFs or work with an adviser who can help you.
Steve Bokor, CFA, is a licensed portfolio manager with PI Financial Corp Inc., a member of CIPF.