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Rob Carrick

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The ABCs of ETFs

Rob Carrick

TORONTO (GlobeinvestorGOLD)—In an investing world so complex that nobody seems to know which end is up, mutual funds stand out as a beacon of blessed simplicity. It's a sham, though. Funds may look simple, but there are intricacies involved.

Mutual funds can be a great investment for the masses, but they're far from transparent. Now, exchange-traded funds, they're transparent.

If you own equity funds, ask yourself this: do your mutual funds hold large-capitalization stocks mainly, or a mix of large- and smaller-caps? Do they hold a lot of cash or are they fully invested? Are securities in the fund traded often, thereby building up commission fees that can reduce returns, or is a buy-and-hold approach used? All of these questions can have a bearing on your returns, and not knowing the answers can leave you blind-sided by a fund that does the unexpected.

On the other hand, owning an ETF is like investing in a tiny, proportional fraction of all the stocks in any one of dozens of Canadian, U.S. and global stock indexes, including the S&P/TSX composite and S&PTSX 60 indexes, the S&P 500, the Nasdaq 100 or the Dow Jones industrial average.

If you buy a large-cap index like the S&P 500, then you own large-cap stocks and nothing else. As for cash, there's none. ETFs are fully invested in their respective indexes. Active trading? Forget about it. ETFs only make changes when their underlying indexes make changes, which is seldom.

Let's say you've taken the time to get to know your equity mutual funds and you understand the approach taken by their respective managers. Unfortunately, managers change. Even when managers stay, they sometimes change their strategies. Suddenly, a quiet little equity fund is making bets on gold or telecommunications or small caps. This approach can yield excellent results at times, and produce disasters at others. Thing is, you don't necessarily know what's coming.

You don't exactly know with ETFs, either, but there's one thing you can be sure of: If the stock index your ETF tracks is on a tear, so is your ETF. You get more or less the same return, minus a management fee that is a small fraction of what a comparable mutual fund would charge. This also works in reverse, which explains why ETFs have trailed actively managed equity funds over the past year in virtually all major equity categories. Long term, however, the major indexes have met or surpassed the average equity fund in their categories.

The transparency of ETFs makes them a precision tool for taking an asset allocation model and translating it into an actual investment portfolio. To start, let's say you want to put 30 per cent of your portfolio in bonds. There is a pair of Canadian bond ETFs, one of which strives to produce the yield of the Government of Canada five-year bond, the other a comparable 10-year bond. Next, you could put 30 per cent of your portfolio in Canadian equities. There are several Canadian market ETFs, some tracking the broad market and some focusing on blue chips.

Now, what about your international exposure? There's a Canadian ETF that gives you exposure to the S&P 500 while remaining fully eligible for registered retirement plans, and another similar ETF that tracks the MSCI Europe Australasia Far East Index. If you wanted to use a finer point with your portfolio building, there are ETFs sold in Canada that track indexes focusing on information technology, financials and real estate investment trusts, among other sectors (many more ETFs are listed on the American Stock Exchange).

The process of buying ETFs is somewhat more transparent than mutual funds as well. ETFs trade like a stock, which means you can buy them through any broker—discount or full service—any time during the trading day. As with any stock, you can buy ETFs at the market price, or set a limit on what you'll pay. With mutual funds, you get the end-of-day unit price if your order is submitted by mid-afternoon. If not, you get the following day's closing price.

The experience of the bear market has shown that ETFs are best used in combination with individually selected stocks or traditional mutual funds that hold up when the broad indexes are falling. That way, you end up with a portfolio tuned for both performance and a measure of clarity that funds alone may not deliver.

Rob Carrick has been writing about personal finance, business and economics for more than 12 years.

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