Exchange Traded Funds (ETFs) can provide a way to enhance the performance of a portfolio but the recent proliferation in the number, complexity and variations of the financial instrument may require investors to seek out the guidance of a professional adviser.
In the almost 30 years they’ve been around, ETFs have grown from a relative small and simple financial product into a trillion-dollar global business.
An ETF usually consists of a portfolio of stocks or bonds that track a specific market index, sector or commodity. They were first introduced in the early 1990s in form of index participation shares in the United States tracking the S&P 500 and the TSE 35 here in Canada.
ETFs are becoming increasingly popular because, like mutual funds, they offer a convenient, one-investment solution for investors looking for diversification. One ETF can offer investors exposure to hundreds of underlying stocks.
There are literally hundreds of ETFs listed on Canadian markets today with more than $100 billion in assets under management, tracking everything from broad stock market indices to specific sectors such as technology or health care and asset classes such as commodities, currency, bonds and dividends.
“It’s true that ETFs are growing but they still are a relatively small part of the number of overall financial instruments that are available,” says Sam Febbraro, Executive Vice President of adviser services with Investment Planning Counsel and President and CEO of Counsel Portfolio Services Inc. “There is a real proliferation in the number and variety of ETFs on the market which can cause some confusion for investors.”
ETFs are a way investors can effectively manage their portfolios, get the benefits of tax efficiency and generally pay lower management expense ratios (MERs) than mutual funds.
Most ETFs are structured as passive investments. That is, they typically have little turnover to balance the underlying index or make changes in the securities that make up that index.
Actively-managed ETFs will have a manager or team that can make decisions on and changes to the underlying portfolio allocation to meet the fund’s objectives.
Unlike mutual funds, ETFs can be traded during the day, like stocks, which can lead to “trade costs.” These are the costs of making a transaction such as brokers’ commissions and spreads – the differences between the price the dealer paid for a security and the price the buyer pays— which often are overlooked by investors.
“The total costs of ETFs often are misunderstood,” says Febbraro. “The price of the fund is only one factor. There are many other variables such as volatility, trade costs, and managing fees, which can vary significantly.”
Risk associated with ETFs has risen recently with the launch of leveraged and inverse ETFs.
Leveraged ETFs offer two or three times’ daily exposure to the underlying index. This can work in both directions: if one day the index returns one per cent, the fund will return two or three per cent. However, if the index drops one per cent, your loss would be two or three per cent.
Inverse, or short, ETFs are designed to profit from a decline in the value of the underlying benchmark including broad market indexes and specific sectors. Most investors purchase inverse ETFs to hedge their portfolios against falling prices.
Even though they are easy to trade, ETFs generally are part of a long-term, buy-and-hold investment strategy.
“Most investors want protection,” Febbraro says “ETFs with both active and passive strategies can help the average retail investor achieve diversification. A financial adviser can help them focus on their timeline, risk tolerance and strategy all within the context of their overall financial goals.”
When used properly, ETFs can help investors can gain fast, cost-effective and tax-efficient access to innovative investment and hedging strategies.
Talbot Boggs is a Toronto-based business communications professional who has worked with national news organizations, magazines and corporations in the finance, retail, manufacturing and other industrial sectors.