Understanding the appeal and the realities of ETFs

If mutual funds were the leading investment craze of the late 20th century, Exchange-Traded Funds (ETFs) are the investment of choice for average investors in the early 21st century.

The appeal of ETFs, driven by surging sales around the world and especially in North America, is easy to understand. They’re particularly popular in Canada, where mutual funds are notorious for being among the highest-priced in the world. Many studies have shown that active security selection rarely makes up for the cost of its own fees; by contrast, low-cost ETFs that track the major stock indexes offer almost all the benefits of equity mutual funds, but with a higher return after fees.

A look at the latest SPIVA (S&P Indices Versus Active) results shows the indexes continue to beat a large number of actively managed funds.

ETFs, like equity mutual funds, provide broadly diversified, easily assembled baskets of stocks focused on an economic sector or world region of your choice.

Add to this tax efficiency (in contrast with actively managed funds, which constantly generate taxable events as stocks are traded), and passively managed ETFs become in theory the perfect buy-and-hold vehicle for investors content to take the dividends and reinvest them in more units.

Indeed, like index mutual funds before them, ETFs make it easy for anyone (especially do-it-yourself investors using discount brokerages) to create simple “set-it-and-forget-it” portfolios – what MoneySense magazine calls the “couch potato portfolio.”

A typical couch potato portfolio might consist of just 4 ETFs: 60% in 3 equity ETFs divided more or less equally among Canada, U.S. and international stocks, and 40% in a fixed-income ETF.

Such a portfolio – low-cost, tax-efficient and highly diversified – would undoubtedly work over time. You’d have exposure to thousands of stocks around the world, as well as bonds (likely Canadian bonds denominated in Canadian dollars). It might not give you much excitement, but who ever said investing should be entertaining? That’s what Vegas and Atlantic City are for. Set up the ETFs to automatically reinvest the dividends in more units, and once a year rebalance: if equities surge, sell off some of the gains so you return to 60% stocks and use the proceeds to buy more of the bond ETF.

That’s what we at MoneySense call “The Perfect Portfolio,” which is also the title of an annual guide we publish, authored by Dan Bortolotti.

So there you have the appeal of ETFs. But what about the realities? Like the mutual fund industry before it, the ETF industry has created new, more dangerous ETFs that slice and dice securities markets to almost a ludicrous extent. The more specialized and narrow the market, the higher the fees; in some cases they approach those of mutual funds. Even more disturbing is that these ETFs expose investors to the dangers of over-concentration in narrow sectors and market timing – and along with that, likely more negative tax events.

Worse, we now see narrowly focused ETFs that are doubly and triply leveraged to narrow sectors like gold or oil, so there’s potential to win big but also to lose. And even more problematic are double- and triple-reverse ETFs that let investors profit when a sector falls in value – which of course means you lose when the sector gains. Such products do have a use in portfolio hedging, but it’s best to consult a qualified financial advisor before buying them.

Generally, if you want a true couch potato approach, stick to broadly diversified ETFs that are low-cost and can be held over the long term. That was the reason we embraced ETFs in the first place: keep it simple and your all-ETF portfolio should retain its appeal; overthink it and you’re inviting trouble.

Jonathan Chevreau is editor of MoneySense magazine and author of Findependence Day (US and Canadian editions), available at www.findependenceday.com.

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2 Responses to Understanding the appeal and the realities of ETFs

  1. One area that seems to weak is the topic of risk management.

    Investments are interesting and everyone likes talking about it, but only 53% of Canadians have there own life insurance policy.

    Brian

  2. TruthTeller TruthTeller says:

    …and add ‘excessive insurance’ to the heap of over priced things that nobody needs. But I’m sure Brian, CFP will be happy to manage all of your risk away for one small fee and one juicy commission.

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