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Want a diversified portfolio without exorbitant fees?

One of the best ways to get a well-diversified portfolio is by investing in mutual funds. But the price you pay for active stock-picking is often high, eating into your returns. What's the best way to avoid that, while enjoying the benefits of investing in a wide range of securities?

Try exchange-traded funds, or ETFs. They track all sorts of indexes, sectors and countries, and come with management expense ratios (MERs) that are a fraction of what you'd pay for a mutual fund.

What's the best way to use ETFs in your portfolio? What are the advantages and pitfalls? And how do you find the one that's right for you?

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Ask Gordon Pape, a well-known writer on investing and finance, who joins us for a live online discussion at noon (ET) on Monday. Get a head start by submitting your question here. Your questions and Mr. Pape's answers will appear in the space below.

Mr. Pape is the editor and publisher of four : Mutual Funds Update, a monthly publication on mutual fund investment strategies; the Internet Wealth Builder, a weekly e-mail investment advisory; The Income Investor, a monthly report on income securities; and The Canada Report, a monthly newsletter for U.S. residents who want to invest in Canada. He has also written and co-authored many books, with total sales in Canada and the U.S. exceeding one million copies. His latest book is Tax-Free Savings Accounts: A Guide to TFSAs and How They Can Make You Rich, published by Penguin Canada in January 2009.

Editor's Note : editors will read and allow or reject each question/comment. Comments/questions may be edited for length or clarity. HTML is not allowed. We will not publish questions/comments that include personal attacks on participants in these discussions, that make false or unsubstantiated allegations, that purport to quote people or reports where the purported quote or fact cannot be easily verified, or questions/comments that include vulgar language or libellous statements. Preference will be given to readers who submit questions/comments using their full name and home town, rather than a pseudonym.

Sonali Verma, Globe Investor: Hello, everyone, thanks for joining today's discussion. We've got Gordon Pape standing by for your questions, and there are many, so let's get going.

Brad Brien writes: While I agree that ETF's are a better choice than most mutual funds, does active daily trading of ETF's cause long-term investors too much anxiety ? Price gains and slides to the extreme can cause many less experienced market investors to bail, without giving ETF's true regard .

Gordon Pape: ETFs were never originally intended to be actively traded. They were created as classic buy-and-hold securities which, over time, would provide investors with the long-term gains of whatever underlying index they tracked. Proponents of ETFs maintain they can do this more effectively and with less cost than actively-managed mutual funds.

There are two major problems with this, however. The first is that some investors may lose their commitment to stay the course when markets drop sharply as they did last fall and winter. They bail out, thereby defeating the whole purpose of buy-and-hold ETF investing.

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The second factor is the proliferation of specialized and leveraged ETFs, which must be tracked on a regular basis and traded like stocks. Specialized ETFs include those that focus on specific market sectors, such as energy or healthcare. We have seen how volatile the energy sector can be so obviously if you invest in an oil and gas ETF you'll experience the same effect. The idea is to buy when oil is cheap and take profits as it moves higher.

Leveraged ETFs magnify the movements up or down of an underlying index of commodity. They are really suitable only for experienced day traders. Anyone who buys without understand them will certainly endure the anxiety symptoms you describe.

R. Sulyak writes: Mr Pape, what can you recommend in terms of an ETF portfolio for my 6 and 10 year old children who just each inherited $20K from their grandmother. I have opened an in trust discount brokerage account for each of them. Both children already have RESP accounts close to their maximum so the objective of this inheritance money would be long term aggressive growth. Being a faithful IWB subscriber, your advice is very valued and respected.

Gordon Pape: I understand the desire to maximize growth but I cannot in good conscience recommend an all-equity portfolio at this point in time. Despite the strong market run we have seen, the recession is not over and another correction is possible.

Therefore, my suggestion is to begin with a portfolio that is 40% bonds and 60% equities. As the economy improves, you can increase the equity weighting, but I think it is important to minimize risk at this stage. Here's how such as portfolio might look:

  • 20% XCB
  • 20% XSB
  • 40% XIC
  • 10% XSP
  • 10% XIN

Hope this helps.

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John Francis writes from Tobermory, ON: I just finished Jeff Rubin's book (Your World is about to get a whole lot smaller) and I am convinced that his broad conclusions are correct - specifically that the price of oil will rise considerably over the next several years.

Are there stable, reputable ETFs that track the Canadian oil and gas industry? The international oil and gas industry?

Gordon Pape: My choice among the Canadian ETFs is the iShares CDN Energy Sector Index Fund . As you might expect, it is coming off a bad year but despite that the five-year average annual compound rate of return is 11.7%.

The MER is 0.55%. The main weakness is the heavy concentration in three stocks: EnCana, Canadian Natural Resources, and Suncor account for almost 43% of the total assets.

For an international energy ETF, check out the iShares S&P Global Energy Sector Index Fund which trades in New York as IXC. It invests in a large basket of 82 companies from around the world (including some from Canada).

Its largest single component is ExxonMobil with 16.52% of assets. The five-year average annual compound rate of return is 9.6%.

TT writes: How do you justfy ETF with people with smaller money? For example, $10,000 with monthly contribution of $100 will cost tons of money with commission. It doesn't make sense for dollar-cost-averaging. I think there is a place for non-ETF especially for those lower networth or dollar-cost-averating, which ETF can never serve as efficient vehicle.

Gordon Pape: I have never suggested that ETFs are the ideal investment vehicle or that they are suitable for everyone. In the situation you describe, you would probably be better off investing in a low-cost mutual fund with an automatic contribution plan.

Brad Bender writes: Mr. Pape, what is your opinion on ETF portfolio's? These products are quite new, but buying an indexed portfolio with ultra-low management fees is quite attractive.

Gordon Pape: More investors are doing exactly what you suggest - putting their money into a carefully-selected portfolio of ETFs and then sitting back and letting it ride. The "couch potato" approach, if you like. There is nothing wrong with the idea providing you have the patience and the courage to stay with your portfolio through good times a bad. Think of it as a sort of financial marriage.

Just make sure the portfolio is suited to your investment profile and goals. For example, someone approaching retirement would be ill-advised to hold 80% of his/her assets in equity-based ETFs.

Christopher M writes: Hello, Mr. Pape. I am starting to invest in ETF's outside Canada and currently use Vanguard. Given the rise in the CDN dollar would I be better advised to use Barclays ishares that are hedged in CDN dollars?

Gordon Pape: Currency bets are always difficult. There's an that discusses the incredible volatility we have seen in the loonie and that is likely to continue for the foreseeable future.

The effect of this on U.S.-based ETFs is that when the loonie rises, any market profits are eroded by currency losses. When it declines, we see the opposite effect. So you have two choices. You can ignore the currency factor and simply choose the ETFs that you feel offer the most profit potential. This will open up many more possibilities since the U.S. market is much larger than ours.

Or you can hedge your bets back into the Canadian dollar by using such Canadian iShares offerings as and . Just remember that not all Canadian ETFs are hedged.

As for my longer-term currency prediction, I think the trend of the loonie will be modestly higher, with pull-backs along the way. I see it at around US95c at some point in the next 12 months.

Michel LeSann writes: Mr. Pape, I've seen a few specialized ETFs that simply invest in another company's basic ETF, and then add on holdings.  Given the slew of S&P TSX 60 or bond ETFs out there that invest in the exact same thing, wouldn't it make sense for most companies to invest in the same basic ETF that meets their criteria, and then hold additional holdings to customize their offering? Wouldn't that reduce MERs even further?

Gordon Pape: Adding selected holdings to an underlying core index only makes sense if they result in higher returns. So you are betting that a degree of active management will improve results. Perhaps it will, but we will only see evidence of that over time. In the meantime, we are moving away from the core premise of ETFs which is to track an underlying index in a cost-effective way.

It's unlikely that active management will reduce ETF costs - quite the opposite, because now you have to pay a team to research and select stocks to add to the core holdings.

Mark Schlechta writes: The media always highlights the benefit of cost and larger trading volume of ETFs.  Should this outweigh the asset allocation decision or underlying strategy of choosing an ETF?  For example, XIU has a MER of 0.17% and follows the more popular TSX 60 index.  Claymore's CRQ tracks Canada with their Fundamental Index weighting.  It has a MER of 0.65%.  Even though it has a higher cost and less daily volume, CRQ has returned 26.5% vs XIU's 17.3% so far this year.  CRQ has higher allocation to financials too which makes more sense for my total portfolio - wouldn't this be a better option despite the slight cost disadvantage?

Gordon Pape: Cost should never be the sole factor in deciding which security to choose. The most important consideration is what works best for your needs.

Then look for the least expensive way to achieve that.

In making comparisons between different products, be sure you are looking at apples and apples. For example, XIU tracks the performance of the 60 largest companies in the S&P/TSX Composite. CRQ holds 66 stocks, which are selected based on such factors as dividends, free cash flow, total sales, and book equity value. So while many companies appear in both ETFs, they are not identical, as the one-year results show.

CRQ has only been around for slightly more than two years so it does not have a long history. Therefore, no one can say with certainty whether it will outperform XIU over time. I like the technique Claymore uses to select the stocks but that higher MER means it will have to consistently outperform to beat XIU.

Matt S. writes: For bond ETFs - iShares offer indexes with more diversification but they have a higher duration. Claymore's bond ETFs have lower duration, slightly lower cost and roll maturing bonds to capture the higher yields. If interest rates are going up, would I be better to go with Claymore Bond Ladder ETFs?

Gordon Pape: If rates are expected to rise, the safest course is to choose a short-term bond ETF such as XSP. That minimizes the rate risk factor. You can move into longer-term bond ETFs when rates are higher.

Claymore offers two laddered bond ETFs, if that's what you prefer. One invests in corporate bonds (CLO), the other in government bonds (CLF). CLF is safer from a credit perspective but I think CLO offers greater profit potential right now.

Robert Findlay writes from Toronto: In my search, admittedly not exhaustive, for ETF model portfolios I've noticed a number of things that have raised more questions than answers. I guess my main questions are: Should an investor tweak a model portfolio to better fit his or her needs and if so, how, and how much - additional/different ETFs, different allocations?

Gordon Pape: Of course, you should adjust any model portfolio to meet your specific needs. There is no such thing as one-size-fits-all when it comes to investing. Model portfolios are just that: models. They are designed to give you a starting point. From there you should make appropriate adjustments based on age, risk tolerance, investment goals, etc. How much should you tweak? Let's put it this way: if you feel you need to make a lot of changes you should look for another model that comes closer to your base requirement.

Bing Han writes from Ottawa: For the average investor with not much time to do his/her own research, to invest via ETFs is definitely a good idea. This is a wise advise, and one is not affected very much by the ups and downs of individual companies, and hence you can sleep better.

However, I have not yet read about the securities guarantee behind the ETFs or the regulations on the assets of the issuing ETF companies, such as Barclays, Claymore, Vanguard Group, etc ? What happens if e.g. Barclays or Claymore went bust? What protects the small investor? The small investor does not have the share certificates supporting the ETF. All the small investor has is trust in the issuing company.

However, in these uncertain days of large companies going bust (Bernard Madoff, Lehman Brothers, Oversea Chinese Fund Ltd, etc.) an article about the regulations protecting the small investor would be very timely and very much appreciated.

Gordon Pape:To begin with ETFs (like mutual funds) are normally held in the form of trusts. This means they do not form part of the underlying assets of a company and are not exposed to creditors if the sponsors go belly-up.

Of course, this does not protect investors against criminal fraud, which was what happened with Bernie Madoff. But that is unlikely to occur in the case of publicly-traded funds backed by reputable companies.

You might also be interested in checking out the details of the which provides insurance coverage in the event of the insolvency of a dealer-member. For more information about individual funds, review the prospectus.

Sonali Verma, Globe Investor: This is totally off-topic, but since we have the time -- we also have a couple of questions about reverse mortgages.

Gordon Pape: Reverse mortgages have been very popular in the U.S. for many years and, in fact, have been financed by government money. I have always said they are suitable in certain conditions but you need to know exactly how they work. There is a lot of useful information on the if you want to learn more.

Ron Kokotailo writes from Calgary: As an income-seeking investor I read your recent positive recommendation on the Claymore Canadian Dividend & Income Achiever ETF, now the Claymore S&P/TSX Canadian Dividend ETF . Subsequent to your recommendation the underlying index was changed from Mergent's Canadian Dividend & Income Achievers Index to the S&P/TSX Canadian Dividend Aristocrats Index. I am wondering, with this change to the index, if you still feel this ETF is a buy? Thank you for your time.

Gordon Pape: Actually, I like the new criteria for security selection even better. This ETF now invests only in stocks or income trusts that have raised their dividends/distributions for at least five years in a row and have a market cap of no less than $300 million. No stock can comprise more than 8% of the portfolio and the ceiling on an individual income trust is 5%, with a 30% maximum for the sector. Theoretically, this should improve cash flow while reducing risk. However, the proof of the pudding and all that. I continue to recommend this ETF but I'll be keeping a close watch on it.

Sonali Verma, Globe Investor: Gordon, thank you so much for taking our readers' questions and sharing your expertise with us. We really appreciate it.

Gordon Pape: Thanks, Sonali and thank you to everyone who participated. I enjoyed it and I hope my comments were helpful. By the way, we cover ETFs in my if anyone is interested.

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