ETFs: Their pros and cons

Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846


Though many investors believe that equities will, over time, outperform fixed-income investments, they still fear the stock market. They worry that they, or their mutual fund, will pick the wrong stocks. Exchange-traded funds, or ETFs, can help you overcome this fear, and let you build a conservative investment portfolio.

ETF pros

ETFs have several advantages over managed mutual funds. Here are some of them:

They have a cost advantage. The mechanical and computerized nature of ETF portfolios gives them a significant advantage over fully-managed funds and even over index mutual funds. The latter must, for example, deal constantly with relatively small amounts of money. What’s more, ETFs have little customer service requirements, and tracking the issue and redemption of units is a minor task, occurring as it does in creation and redemption units only.

The result is low management expense ratios, or MERs. In the case of a broadly-based market index like the S&P/TSX Composite Index, for instance, the MER for the iShares units that track this index is just 0.27 per cent. That compares to an MER of 0.89 per cent for TD Canadian Index, a mutual fund that tracks the same index. What’s more, the average MER for managed Canadian equity funds is 2.35 per cent.

ETFs generally have greater tax efficiency than managed funds. That’s partly because their creation and redemption structure eliminates the effect of unitholder trading on capital gains distributions. But as well, ETFs only buy and sell when stocks are added to or removed from the index. Managed funds, by contrast, tend to buy and sell more — some of the them, a lot more. The low turnover of ETFs, then, not only keeps expenses down. It can reduce the capital gains distributions you periodically receive.

ETFs provide greater transparency than managed funds. That’s because they disclose their exact holdings on a daily basis, while managed funds do so less frequently.

ETF cons

Here are two ETF drawbacks:

Slightly below-market returns. The performance of ETFs will generally lag that of their underlying index by about the same percentage of assets they devote to management fees. In general, then, only a managed equity fund can give you significantly above-market returns.

Problems with balance. Since ETFs are passive investments, their portfolios can become heavily tilted to certain industry sectors. Actively managed funds, however, have the flexibility to create more balanced portfolios.

How to pair ETFs with managed funds

Even if you prefer exchange-traded funds, or ETFs, over managed funds, we recommend you include some managed offerings in your portfolio as well. Below, we explain why you should do so and how to go about including both types of funds in your portfolio.

An equity portfolio entirely comprised of exchange-traded funds leaves you at the mercy of stock markets. That’s good, of course, when markets soar, but bad when they fall.

With equity index ETFs, you have little ability to take defensive actions with your portfolio when markets fall. You can choose to sell them, of course, but unless you’re a skilled market-timer, such efforts are bound to backfire.

When you include some low-volatility managed equity funds alongside your ETFs, however, you benefit — in theory at least — from a professional’s ability to insulate a portfolio against a market downturn. A manager of a mutual equity fund can take actions, such as raise cash, to reduce the impact of a market setback on your equity portfolio.

To put it another way, by including certain managed funds alongside your ETFs, you can reduce the overall volatility of your equity portfolio. You may not participate fully in rallies when stock-market indices outperform managed funds, but you’ll suffer less when markets turn down.

The goal of blending managed funds with ETFs, then, is to benefit from the potential of stock markets to soar every now and then, while securing some downside protection from market setbacks that inevitably occur from time to time.

Below is a list of those of our Top-40 managed funds that we think go well with specific ETFs. By pairing one or more of them with an ETF that operates in their investment category, we believe you’ll obtain an attractive blend of active (managed) and passive (ETF) funds.

Top-40 funds that go well with our Best ETFs

Rather than fill your equity portfolio entirely with exchange-traded funds, we suggest you pair your ETFs with managed funds that offset the volatility of your ETFs. In the table below is a list of managed funds from our monthly Mutual Fund Planning Guide that we think make good complements to a corresponding index ETF from our Best ETF list (on pages 176 and 177). We’ve divided the table into different stock categories. In each category, we list one or more index ETFs (in italics), followed by the managed funds from our Top-40 that we believe complement those ETFs. We also include a volatility rating for each ETF and managed fund.

Fund Name Volatility
 
Canadian Stock
iShares S&P/TSX 60 6
Vanguard FTSE Canada Index 6
Mac Ivy Canadian 3
Mawer Canadian Equity 5
NEI Northwest Cdn. Equity 5
 
Canadian Small-Caps
iShares S&P/TSX SmallCap 10
Fr. Bissett Cdn. High Dividend 6
GBC Canadian Growth 8
IA Clarington Cdn. Sm. Cap 5
Manulife Gr. Opportunities 9
Trimark Cdn. Small Comp. 8
 
U.S. Stock Funds
iShares S&P 500 C$ Hedged 7
Dynamic American Value 5
Sun Life MFS McLean U.S. 5
 
Aggressive U.S. Stock Funds
iShares Russell 2000 C$ Hedged 10
TD U.S. Mid-Cap Growth 6
 
Multi Country Int’l. Stock
iShares MSCI World 5
Mac Ivy Foreign Equity 3
Vang. Developed Ex NA C$ 7
Mawer International Equity 6

 

 

Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846