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ETF

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Looking for a defensive play in your retirement portfolio? Exchange-traded funds, or ETFs for short, are seen by many investors and financial advisers as an effective way to mitigate market volatility.

"ETFs work well because you diversify away your individual company risks," says Tyler Mordy, president and chief investment officer at Forstrong Global Asset Management Inc., in Kelowna, B.C. "You're not just buying a single company, so if something idiosyncratic happens with one particular company then you're not so heavily impacted."

Investors looking to adopt a defensive position should consider ETFs with high liquidity and diversified sector exposure, says Irina Dorogan, a senior research analyst at Cougar Global Investments in Toronto. It's also important to pay attention to metrics such as an ETF's Sharpe ratio, which measures risk-adjusted return.

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"Looking at these measures will help determine how risky an ETF is," says Ms. Dorogan. "And risk is what we define as the probability of losing money."

So what kind of ETF would provide a buffer against market volatility? Graham Westmacott, a Waterloo, Ont.-based portfolio manager at PWL Capital, points to bond ETFs, a basket of investments that track an index of bonds and which, unlike individual bonds, trade on a stock exchange.

Mr. Westmacott highlights three particular bond ETFs: BMO Aggregate Bond Index, iShares Canadian Universe Bond Index, and Vanguard Canadian Aggregate Bond Index.

"All have Canadian investment-grade bonds and all have low MERs," or investing fees, he explains. "For people who don't want or don't feel able to make a bet on interest rates, or don't know which part of the bond market – short term or long term – will do well, buying the whole bond universe is a good way to go forward."

These all-Canadian picks don't come with currency risks, he says, and having investment-grade bonds, which have a low risk of defaulting, means they're likely to be priced fairly even in times of market stress.

Mr. Westmacott notes that like individual bonds, bond ETFs tend to be unappreciated by many investors.

"I think that there's a bias toward thinking of ETFs as equity vehicles, and with today's low yields the first objection is: 'Why should I bother investing in bonds, especially in ETFs? I might as well flip from cash to equities,'" he says.

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While it's generally true that adding bonds to a portfolio won't boost returns, defensive investors will appreciate bonds' ability to dampen portfolio volatility, says Mr. Westmacott. Bonds have a negative correlation with equities during times of turmoil, which was underscored in 2008, when Canadian stocks fell by about 35 per cent while the Canadian bond index rose by 6.4 per cent.

"If investors remind themselves that the purpose of bonds is not to try and boost returns but to have a negatively correlated asset that will dampen some equity volatility, then I think they might look at bond ETFs differently," he says.

Mr. Mordy matches ETFs to various risk concerns. For instance, as a buffer against rising interest rates, he picks Invesco Ltd.'s PowerShares Senior Loan Portfolio, which tracks the S&P/LSTA U.S. Leveraged Loan 100 index. "It's got floating-rate interest exposure, so as rates go up it tends to do better," he says.

Those worried about a shortfall in investment income as a result of low interest rates might want to look at the iShares Emerging Markets Local Currency Bond ETF, Mr. Mordy says, as this fund offers higher income potential, thanks to its exposure to currency-denominated government bonds issued by emerging-market countries such as South Korea, Brazil, Colombia and the Philippines.

These approaches aren't just for the conservative investor, says Mr. Mordy. A solid portfolio is one that's diversified, with a mix of components that move independently of each other, so adding these defensive ETFs could simply provide more balance.

Mr. Mordy says he's not convinced, however, that a defensive posture is the best strategy today.

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"I think the main event right now in the world economy is a shift away from using interest rates to engineer growth, to using government spending to stimulate growth," he says. "We're entering a period where global growth is going to pick up."

Whether the markets stay strong or start to flag, investors need to be able to stay the course, says Mr. Westmacott. The best way to do that is with a portfolio designed to withstand volatility.

"We advise clients that they will do far better by building a portfolio with a mix of bonds and equities that can make bad times tolerable for them," he says. "Those risks will occur, so it's important to be able to cope with them and to be able to harvest long-term returns."

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