Invest in ETFs carefully

The continued popularity of exchange-traded funds (ETFs) has made finding the right funds more difficult.

In the last three years, the number of funds has quadrupled from 60 to more than 250, leaving many lost in a maze of new, specialized products with varying structures and fee models.

Don’t get overwhelmed

You should expect your advisor to narrow down your options for you based on things like your time horizon, how much risk you’re comfortable with, and how you see ETFs improving your portfolio.

As Howard Atkinson, CEO of Horizons ETFs, says, “[You] should understand the basic principles of index investing: first, funds should represent their targeted universes as closely as possible. Second, they should be highly investable, with tight spreads and liquidity.”

Using this approach can help cut out poor choices from the outset.

How to choose funds

High-quality ETFs stick close to their mandates, neither outperforming nor underperforming underlying indices.

They should also provide value and stability over the long term, says Justin Bender, associate portfolio manager at PWL in Toronto.

He sticks to broadly diversified, tax-efficient funds that follow major indices and, rather than focusing on its independent performance data, considers how each will act within a portfolio.

“Adopting a one-size-fits-all approach is dangerous,” says Mary Anne Wiley, managing director and head of iShares, BlackRock Canada. She adds an increasing number of products are being released to meet demands in niche categories, such as strategy-based funds that identify promising stocks in given indices rather than merely tracking them.

Brand-new ETFs

Some of the new indices are so niche that no basis exists for performance comparison. As a result, no one can predict how these funds will perform in the long term. Atul Tiwari, managing director of Vanguard Canada, says it’s crucial for investors to understand the index being tracked and the methodology behind each product before taking the plunge.

“If you’re truly looking for indexing and market beta, you should purchase an ETF that follows traditional methodology,” he says. “There’s certainly room for other indexing methods, but you need to understand what screens they are using.

Atkinson suggests that because many new ETFs don’t have multi-year track records, it’s harder to know if the fund will perform as expected.

“Typically, an actively managed mandate needs a three-year track record before it’s evaluated by third-party analysts like Morningstar. But the vast majority use well-established portfolio management teams and, in most cases, the strategy the portfolio manager is using has been employed in a mutual fund or hedge fund elsewhere.”

He adds, “With passively managed index funds, on the other hand, most of the indices used do have multi-year track records. After a year, an investor can look at the performance of the ETF versus the index to get a sense of how well it replicates its target.

For these reasons, Bender and Stevenson take conservative approaches when choosing ETFs. Stevenson says specialized ETFs are hard to sell and incorporate. In his view, they’re only suitable for experienced investors who are aware of their risks and complexities.

But despite their cautious approach, both agree incorporating ETFs doesn’t have to be complicated.

“[ETFs] are without a doubt essential,” says Stevenson.