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ETFs' Risks & Opportunities: What You Need to Know

08 May 2012 by National Bank

Cheaper, more flexible, more transparent… Exchange traded funds (ETFs) seem to have indisputable advantages. But beware: these financial products also carry risks. Here is a quick glimpse at the funds that are taking Canadians by storm.

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Exchange traded funds are a popular choice for investors (small and large) in Canada and across the globe for many reasons. They are similar to mutual funds, but trade like stocks.

When you hear the expression “buy the index”, it refers to buying an ETF, which acts like the index it follows.

ETFs can be a great way to access passively managed exposure to a particular index, but some can do more harm than good. As an investor, you will want to mitigate the various ETF risks by educating yourself and consulting a trusted advisor to come up with the best strategy for your lifestyle.

Tap into the risks and opportunities by keeping the following ETF tips and information in mind.

The Low Fee Advantage

Like mutual funds, ETFs allow you to build and diversify your investment portfolio. One of the many reasons that they are an excellent option for investors is because they have lower costs compared to those associated with mutual funds.

ETFs do not have any opening or closing costs and their management costs are minimal. Annually, they are usually less than 1%. Mutual fund management fees are around 2.5% by comparison. In this period of weak growth, this makes a significant difference.

Mutual funds are managed by a team of analysts whose purpose is to maximize returns. ETFs reduce costs because they simply reproduce their targets, requiring fewer experts and fewer resources…

The Advantage of Flexibility

Buying an ETF has other benefits: you can sell it at anytime if the market is open without any penalties. This makes ETFs a more flexible investment choice, in contrast to mutual funds.

It is very common for mutual funds to charge a redemption fee. When selling their shares, investors must pay a percentage of the amount invested, or the market value share when they decide to sell - a percentage that decreases with time in many cases.

ETFs are also traded at market value all the time, while the value of mutual funds is updated on a daily basis. With ETFs, investors can therefore take advantage of momentary increases or decreases in prices for a transaction that works in their favour.

The Transparency Factor

 

When you purchase an ETF, you know exactly what you’re investing in. Most ETF compositions are published daily. This means you know the investments that make up the ETF and the weight carried by each fund. This transparency means a lower risk for the ETF and a chance to better evaluate their day-to-day performance.

Mutual funds also publish their composition but the information is updated less often (usually every trimester). It is therefore a challenge to monitor their daily progress.

What Makes ETFs Risky?

Just as is the case with any investment strategy, there are certain risks involved with ETFs. That’s why it’s important to first consult with a trusted advisor prior to committing to any strategy.

In Canada, for example, if you wanted to hold an asset which acted like the country’s 60 largest companies in terms of market capitalization you would have to buy the iShares S&P TSX 60 Index ETF (ticker: XIU).

This fund acts similarly to the index it follows, and has very low costs. It also pays out dividends as if you were to hold those 60 stocks.

The XIU is a relatively safe product which can be a great way to gain access to 60 of Canada’s largest publicly traded companies without having to rebalance or to buy 60 different stocks with 60 different trade commissions.

Know the Risks, Tap into Possibilities

The important thing is to be aware of what you are buying when it comes to ETFs, since they move along with their underlying index. Depending on what comes up during an ETF risk analysis, you may end up seeing great success if you divide your portfolio by industry sector, for example. Or, you may choose to divide into domestic and foreign categories.

Speak to a National Bank investment advisor to receive all the latest tips and insights to better tap into the risks and advantages.

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