European markets offer strong consumer and industrial exposure, and the United States offers investment opportunities in health care, technology and industrials over and above what is available in Canada, says Stephane Rochon, managing director and head of private client strategy with BMO Nesbitt Burns in Toronto. Thus ETFs are a good way to get greater diversification in those sectors.Artur Marciniec/Getty Images
As real estate pros plug "location, location, location," investment experts stress the need for "diversification, diversification, diversification."
A widely diversified portfolio provides well-documented protection as markets go through the inevitable ups and down of economic life cycles.
Canadians know only too well how the high-flying energy sector, with the price of oil leading the way at more than $100 a barrel, came crashing down in 2014 and still hasn't recovered.
"The most efficient way to gain that exposure internationally is through a pooled vehicle such as exchange-traded funds or mutual funds," says Alice Fang, vice-president of investment solutions at Scotia Wealth Management in Toronto.
Canadians are familiar with mutual funds, often favouring them as investments in their registered retirement savings plans (RRSPs). But the lesser known exchange-traded funds (ETFs), whose shares can be traded just like stocks, have been steadily gaining favour with investment pros. ETFs track market indices such as the Toronto Stock Exchange (TSX), New York Stock Exchange (NYSE), Standard & Poors 500 (S&P), or others around the world.
"We always tell people 'don't buy an ETF blindly that would have a lot of commodity exposure, because if you're trying to diversify away from Canada, for example, which is very commodity centric, you don't want to go out and buy a Brazilian oil company or a Russian mine. We have plenty of those here,'" says Stephane Rochon, the managing director and head of private client strategy with BMO Nesbitt Burns in Toronto.
Mr. Rochon notes how, for example, the European markets offer strong consumer and industrial exposure, and the United States offers investment opportunities in health care, technology and industrials over and above what is available in Canada. Thus ETFs are a good way to get greater diversification in those sectors.
Tim Morton, a senior vice-president and portfolio manager with TD Wealth Management in Toronto, illustrates how the purchase of international ETFs can tamp down the risk of being too heavily exposed to a single domestic market.
"If you use the TSX capped composite index as your domestic benchmark, it's 12 per cent in basic materials. There's a lot of volatility there," he says.
So his team examined what would happen if investors complemented their TSX composite exposure by purchasing three additional ETFs giving exposure to the S&P 500, NASDAQ 100 and the Russell 2000 (equally weighted across the four ETFs with 25 per cent in each).
They discovered that the 12-per-cent weight in basic materials on the TSX alone would decline to 4.3 per cent. They also looked at what would happen with two other major components of the TSX – finance and energy weightings.
"Finance on the TSX is 32 per cent. With our broadly based North American portfolio, you'd be down to about 14½ per cent. And then if you look at energy, another very volatile component, the TSX is at 21 per cent. Complementing the portfolio with these three additional ETFs put together will bring you down to 6 per cent," he says.
ETFs offer other features as well.
"The advantage of an ETF is that it trades throughout the day, and so if you want to make a transaction during the day, you can do that, rather than waiting till the end as you would have to if it was a mutual fund based on that same index – say, the S&P 500 as an example. If something happened during the day that made you want to either buy or sell, you could activate that decision very, very quickly with an ETF," says Mr. Morton.
Another fairly new feature of ETFs is that they can be currency-hedged or currency-exposed, meaning investors can pick up the exposure they want globally without necessarily having to take a currency risk if they don't wish to.
For example, "if you bought the S&P through ETFs and you took the currency risk, and the currency risk worked against you by 5 per cent – for example if the Canadian dollar, which is currently trading around 75 cents U.S., gained another 5 per cent – there goes 5 per cent of your U.S. dollar exposed return, which might be a significant portion. So ETFs are a great way for an advisor or the end investor to be able to hedge out currency," Mr. Morton elaborates.
But there are also potential drawbacks with the ETF, which doesn't feature a portfolio manager to make discretionary calls to increase or reduce exposure to certain sectors or countries based on what they are personally observing.
"The real problem here is that it can fully expose investors to the weight in the index for a particular industry. So let's say an investor has energy, which is a great example right now because the oil price keeps coming down. In broad market ETFs you're fully exposed to the index weight of that energy sector," says Mr. Rochon.
"Also, because so much money is flowing into ETFs, it can exacerbate market moves. If everybody starts to sell in a panic, for example, money flows out of these funds and indiscriminately, stocks start falling. So it exposes clients to massive liquidity outflows," he adds.
Therefore, note experts, the popular mutual fund product, which involves a pool of funds consisting of stocks, bonds and other instruments that many individual investors participate in, also has a role to play in a well-diversified portfolio.
In fact, there are times when having actively managed mutual funds can be more beneficial than ETFs, says Mr. Rochon. "We've done some studies on this when it comes to global equities at large, but especially with emerging markets, active managers can reduce downside risk. That's where active managers can actually add more value," he explains.
"ETFs are a good idea, and should be a core component of any portfolio. [But] I would say the answer is not to go 100 per cent in ETFs, nor is it to go 100 per cent with managed traditional mutual funds. I think there is a just middle in there," Mr. Rochon adds.
"As ETFs have become more prolific and their assets have grown, ETF costs have come down significantly, so it is also a cost effective way to gain exposure to the global markets," Ms. Fang says.
However, in the international markets, active management through mutual funds may offer investors a stronger investment experience for a small incremental cost, she adds.
"With distinct geographies, demographics, economies and currencies, international markets can be complex, so active managers can often add value selecting and trading securities in these markets. This can mean protecting capital during market declines and taking advantage of specific opportunities at the right time.
Not all ETFs are priced the same and not all actively managed mutual funds are equally well managed, so seeking advice from investment professionals or doing research can be informative," elaborates Ms. Fang.