With tax season just around the corner, the time has come to make your Registered Retirement Savings Plan contributions for another year.
Exchange Traded Funds, or ETFs, can be powerful building blocks in constructing a cost-effective, balanced investment portfolio that can help you reach your financial goals.
ETFs are open-ended trust units that are listed on major stock exchanges around the world and they come in many varieties. Some are set up to replicate the returns of stock and bond markets in Canada, the U.S., and internationally. Other ETFs are designed to track the returns in sectors such as technology, real estate, gold, or emerging markets. Every major stock exchange index in Canada and abroad has a corresponding ETF associated with it. According to Barclays Global Investors, $4.2 billion flowed into ETF investments in Canada in 2008. By comparison, sales in the mutual fund industry were flat over the same period.
Below are a few of the advantages and disadvantages of investing in ETFs.
Low management costs: Unlike mutual funds, ETFs have a substantially lower management expense ratio — usually less than 0.5 per cent because they duplicate an index and are not actively managed. By way of contrast, the average equity mutual fund has an MER closer to 2.5 per cent.
Risk reduction through diversification: ETFs that track the return of market indexes hold many different stocks or bonds, so you eliminate company specific risk in your portfolio. I recommend index tracking ETFs; avoid specialty ETFs that focus on a specific industry or use leverage to attempt to enhance returns.
Outperformance of actively managed products: Buying an ETF does not guarantee outperformance of a mutual fund or a similar managed product, but it does put the odds in your favour. The most recent Standard & Poor’s Indices Versus Active Funds Scorecard noted that the vast majority of active money managers do not beat stock market indices. The report stated that Canadian money managers failed to beat the index over 90 per cent of the time in the past five years, and U.S. and international money managers failed to beat their indices 70 per cent of the time in the past five years.
Difficult to dollar cost average: Because ETFs trade like individual stocks it is difficult to contribute to them on a monthly basis. The additional brokerage costs would negate the benefits of investing in ETFs. If you contribute monthly, you may want to accumulate money in a traditional no-load balanced mutual fund, and then purchase your ETFs on an annual basis.
Tracking error: Tracking error occurs when the ETF’s return is different from the underlying assets that it is designed to track. A small tracking error is normal, however some ETF returns differ significantly from the assets they are supposed to track. This is due to a variety of reasons, including poor ETF management. It is important to choose large, well-established ETF providers when investing in ETFs.
Investing in ETFs can be risky and favours patient investors with a long-term investment horizon. As such, it is important to request a prospectus from your financial adviser, which details all fees and charges about the specific ETF and read it carefully before you invest.
In the next article, I will be giving you ideas on how to best use your tax refund.
Alan Acton CFP, CIM, FCSI is a financial adviser in Ottawa and can be reached firstname.lastname@example.org. The opinions expressed are those of Alan Acton and not necessarily those of Raymond James Ltd. Statistics, data, and other information are from sources believed to be reliable, but their accuracy cannot be guaranteed. This document has been prepared to assist individuals with financial concepts and is for informational purposes only. Raymond James is a member of CIPF.