My Pros and Cons List of Exchange Traded Funds (ETFs)

The other day I was asked by a client, “What are the pros and cons of exchange traded funds (ETFs)?” Immediately, I knew that I had to write this article because you might be interested in the answer as well.

First, it’s important to put some context around the question. ETFs are financial products. Meaning they are created by asset managers for use by investors both retail and institutional. Second, not all ETFs are the same, and third, what I think my client really wanted to know was, are ETFs something they should be considering for their investment portfolio?

Let’s dive into the benefits.

1. ETFs are often inexpensive ETFs have made diversified investing a cost effective solution for all investors. They are cost effective because many ETFs simply seek to achieve beta returns (returns that match a given asset class or benchmark), compare this with active funds which seek to achieve alpha returns (returns in excess of a given asset class or benchmark).


2. Tradeable throughout the day ETFs trade just like stocks, meaning that you can trade them throughout the business day (9:30 - 4 pm Monday to Friday). This is a unique characteristic for pooled funds, which typically price and trade once per day. This tradability means that you can gain or shed exposure at a moment’s notice. It’s a great feature that gives you additional financial and portfolio flexibility.


3. Limited turnover (tax efficient) Passive ETFs have limited portfolio turnover (meaning they don’t buy/sell positions that often). This is in stark contrast to a number of actively managed funds that might see portfolio turnover greater than one hundred percent a year (meaning the portfolio manager will trade in and out of securities throughout the year). Portfolio turnover will increase the tax liability for non-registered investors. Any tax liability borne by investors will reduce their overall rate of return.


4. Broad exposure ETFs often provide investors with diversified exposure to a particular asset class, benchmark, or multi-asset portfolio. As you know, diversification is a cornerstone investment principle. Being able to diversify your portfolio, in a cost effective, flexible, and tax efficient way can lead to solid results.

Now the drawbacks:

1. Mostly beta driven Most ETFs are what the industry call beta-driven. This simply means that the portfolio manager is seeking to replicate the results of a particular asset class or benchmark. They aren’t trying to outperform. Whereas, mutual fund managers typically seek to overachieve the benchmark or asset class returns. If these active managers do their jobs well, you could have performance results better than the asset class or benchmark result. You won’t get that outperformance potential with most ETFs.


2. Too much choice There are now 33 ETF providers, and 655 ETFs in the Canadian marketplace, according to the Canadian ETF Association. This amount of choice can lead to confusion, misinformation and a lack of understanding by the end user. I experienced this first hand in 2009 when I was working in Toronto and clients were trading leveraged ETFs. They didn’t understand how the funds worked, and they ended up losing large amounts of money. Too much choice can also lead to indecision, leading you to do nothing which can be counterproductive.

Conclusion

I have to admit that I am a big believer in ETFs. I use them extensively in my business and recommend them often to my clients. However, to answer the original question, what are the pros and cons of ETFs? ETFs are cost effective, flexible, tax efficient financial products, with some negatives. They won’t be right for every investor, but they could be right for you.

If you’d like to explore the topic of ETFs in more detail and determine if they are a sensible addition to your existing investment portfolio email me at kurt.lucier@raymondjames.ca with your questions and I’ll get back to you within two business days.

Sincerely,

Kurt Lucier, CFA

Information in this article is from sources believed to be reliable. However, we cannot represent that it is accurate or complete. It is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell securities. The views are those of the author, Kurt Lucier, and not necessarily those of Raymond James Ltd. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decision. Raymond James Ltd. is a Member Canadian Investor Protection Fund.