How to navigate the ETF landscape

November 14, 2012 | Last updated on November 14, 2012
5 min read

Finding the right ETFs for your clients is becoming increasingly challenging.

In the last three years, the number of funds has quadrupled from 60 to more than 250, leaving many lost in a maze of new, specialized products with varying structures and fee models. Planners can go from recommending a traditional, passive fund for one client, to suggesting an ETF investing solely in gold or technology to another.

But should you be researching every product that comes to market? Both advisors and providers say no; and the science backs them up.

Don’t overwhelm clients

Over the last few years, neurofinance has taught us that people can only handle a limited number of choices at any one time.

At this year’s ETF Forum in Toronto, behavioural finance professor Dr. Lisa Kramer said, “It’s only worth choosing the handful you think your clients could benefit from.” If you present eight or more all at once, she says you’ll confuse them.

So, find out which types of funds are most appropriate, based on their time horizons and risk tolerances.

If they’ve asked for ETFs, ask their views on why the product will improve their portfolios. Then, suggest three-to-five funds based on those preferences and needs.

Greg Stevenson, wealth advisor at Richardson GMP in Calgary, uses Standard and Poor’s quarterly SPIVA report to discuss the recent performances of managers and indices. He explains tracking error and ETFs’ fee structure, and outlines the indexing structure used by each fund his clients choose.

As Howard Atkinson, CEO of Horizons ETFs, says, “Clients should understand the basic principles of index investing: first, funds should represent their targeted universes as closely as possible. Second, they should be highly investable, with tight spreads and liquidity.”

Using these criteria, you can help investors cut out poor choices from the outset.

It’s only worth choosing the handful of ETFs you think your clients could benefit from.

How to choose funds

High-quality ETFs stick close to their mandates, neither outperforming nor underperforming underlying indices.

They should also provide value and stability over the long term, says Justin Bender, associate portfolio manager at PWL in Toronto.

He sticks to broadly diversified, tax-efficient funds that follow major indices and, rather than focusing on its independent performance data, and considers how each will act within a client’s portfolio.

Cutting-edge funds offering double volatility and leverage may seem exciting, for instance, but aren’t designed for the majority of investors.

“Adopting a one-size-fits-all approach is dangerous,” says Mary Anne Wiley, managing director and head of iShares, BlackRock Canada. She says an increasing number of products are being released to meet demands in niche categories, such as strategy-based funds that identify promising stocks in given indices rather than merely tracking them.

Stevenson notes he primarily uses such funds to fill gaps in client portfolios and provide inexpensive access to foreign content. “The majority of clients shouldn’t be holding too narrow of a segment,” he says. “They should simply hold the market, rather than try and guess where the next trend will be.”

So if a client comes in excited about a risky or narrowly segmented fund that’s likely too complex or unsuitable, steer him away.

Atkinson says advisors should only stay up-to-date on funds that are relevant to their clients. To better serve them, prepare lists of high-quality, suitable options for every risk profile.

You should also suggest ETFs that have better performance history and higher return potential. Some advisors first choose a good provider and then look for funds; others start by choosing a suitable sector and then scan every provider’s offerings.

Sample ETF portfolio

Brand-new ETFs

Some of the new indices are so niche that no basis exists for performance comparison. As a result, no one can predict how these funds will perform in the long term. So, caution is merited. Atul Tiwari, managing director of Vanguard Canada, says it’s crucial for investors to understand the index being tracked and the methodology behind each product before taking the plunge.

“If you’re truly looking for indexing and market beta, you should purchase an ETF that follows traditional methodology,” he says. “There’s certainly room for other indexing methods, but you need to understand what screens they are using.

“Back-testing may make them look good; however, if it is not straight beta, the product could outperform or underperform in different market cycles.”

Atkinson suggests that because many new ETFs don’t have multi-year track records, it’s harder for clients to know if the fund will perform as expected.

“Typically, an actively managed mandate needs a three-year track record before it’s evaluated by third-party analysts like Morningstar. But the vast majority use well-established portfolio management teams and, in most cases, the strategy the portfolio manager is using has been employed in a mutual fund or hedge fund elsewhere. Advisors can look at the manager’s past performance in these other mandates to get a sense of the historical performance of the team.”

He adds, “With passively managed index funds, on the other hand, most of the indices used do have multi-year track records [available for analysis]. After a year, an investor can look at the performance of the ETF versus the index to get a sense of how well it replicates its targeted index.

“When money is actually allocated to these funds, it changes their performance histories and back tests,” he adds. “You can only suggest how it should do based on past data, and the valuations will change when it [starts trading actively].”

For these reasons, Bender and Stevenson take conservative approaches when choosing ETFs. Stevenson says specialized ETFs are hard to sell and incorporate. In his view, they’re only suitable for experienced investors who are aware of their risks and complexities. He’d prefer to see an increased offering of traditional funds, which would boost market competition and potentially drive down prices.

Bender’s portfolios use only four funds, along with four backup ETFs in case tax-loss selling opportunities occur (see “Sample ETF portfolio,” this page). He also uses low-cost mutual funds to provide fixed-income and global real-estate access.

But despite their cautious approach, both agree incorporating ETFs doesn’t have to be complicated.

“[ETFs] are without doubt essential. You get diversification and can spend less time managing portfolios, which leaves time for better planning and more client interaction,” says Stevenson.