What to know about ETFs before you buy

OTTAWA – With the widespread use of exchange-traded funds, investment experts say you need to understand what you are buying and how an ETF works within your portfolio.

ETFs have grown in popularity with the promise of low-fees compared with mutual funds. But not all ETFs are the same. Even if they are trying to track the same index, they can differ in how they do that.

An ETF can hold the stocks or bonds that make up the index that it is supposed to track, or it can be what is referred to as a synthetic ETF that uses a contract with a counterparty, usually a bank, which promises to pay the return of the index.

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“You just have to be careful with them and use them as a tool, rather than an investment on its own,” says CIBC Wood Gundy portfolio manager Daniel Girard.

“You use them as a piece of a total portfolio and just use them in a way that gives you the best risk-return profile with the lowest cost,” says Girard, who is based in Waterloo, Ont.

Girard says he looks for simplicity, low-cost and ability to trade when it comes to ETFs.

“Sometimes you’ll identify an ETF that looks great for a number of reasons, but it doesn’t trade,” he said.

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You also need to watch for tracking error when the returns of the ETF are different from the index it is supposed to track. The difference can arise because of ETF fees and also because the ETF’s holdings may not exactly match the index.

In recent years, the industry has moved to offer investors more than just a replication of a given index.

Traditional ETFs that track the S&P/TSX composite index, for instance, have a heavy weighting toward three sectors — financials, mining and energy. So an ETF that tracks that index may not provide the diversification that an investor wants.

So-called smart beta, or factor investing, offers a twist on traditional ETFs by weighting sectors differently than the index does.

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BlackRock Canada’s Pat Chiefalo says an investment manager can set different goals — for example, reduced volatility.

“Maybe I want to assemble those stocks in a way to maximize my dividends,” says Chiefalo, head of iShares Product at BlackRock Canada.

Alfred Lee, a portfolio manager with BMO ETFs, says outcomes of smart beta funds can vary because each is constructed differently.

“If you’re looking for low volatility, there’s no rhyme or reason why you need the same sector exposures as the TSX,” he said.