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exchange-traded funds

The stock market has been giving investors a rough ride recently. Is it better to strap in, hold on and ride, or should you diversify now?

For Canadian investors who are into exchange-traded funds, the question now is what to do about the bumpy ride in U.S. markets.

Is it better to strap in, hold on and ride, or should you diversify now?

On one hand, the pullback in the U.S. market could present buying opportunities. At the same time, for a year or so, many have been expecting a U.S. market correction.

Yet in the face of these predictions, despite a few pullbacks here and there, U.S. markets continue to show strength.

It's not clear how close we may be to the end, says Sean Cleary, finance professor at the Smith School of Business at Queen's University in Kingston. "There are lots of positives in the U.S. economy. The question is whether these positives have already been factored into the markets."

Diversification is the way to protect the gains you've made," says Neville Joanes, chief investment officer of WealthBar, a Vancouver-based robo-advisor that offers ETFs. Lots of investors are cautious and may be spooked by this month's correction. That doesn't necessarily mean it's time to run away from the United States, though, he says.

"ETF investors will still want exposure to the U.S. and its growth potential when making an equity investment. Over half of global equities are based there. However, investors will want to reduce the tracking of the cap-weighted index to lower volatility," he explains.

"To start with, investors might look at a fund like the Vanguard Total Stock Market ETF (VTI), which invests in a broad range of U.S. equities, not just the S&P 500. That's still all-in on equities, though, so a market correction would potentially hit them quite hard," Mr. Joanes says.

"For an even higher level of protection, look to broader asset diversification beyond what the retail investor would typically buy into. That might include real estate, high-yield bonds, mortgages, REITs, preferred shares and other investment strategies."

Yves Rebetez, managing director and editor of ETF Insight, says that even if U.S. markets remain robust and show little sign of quitting, investors should always prepare prudently for a 5- to 10-per-cent correction that could occur at any time.

One strategy is to look beyond the United States, he says. "Investors are and have been looking at pivoting more of their exposure to international and emerging markets, where valuations are less demanding," Mr. Rebetez says.

"This can set a more reasonable bar for performance. Emerging markets already had a banner year in 2017, yet there's still room on the upside for valuations."

Darren Coleman, senior vice-president and portfolio manager at Coleman Wealth, Raymond James Ltd. in Toronto, suggests that investors look at ETFs that pay dividends. "We're big fans of dividend investing. We're most interested in ETFs that pursue a dividend-growth strategy, as we can hold that through market cycles most effectively," he says.

Mr. Coleman's colleague, analytics specialist Spencer Barnes, suggests looking at dividend-focused ETFs such as those in the WisdomTree Dividend Growth group.

"In the U.S., the ETF would be WisdomTree's U.S. Quality Dividend Growth Fund [DGRW] or their variably hedged version, DQD [U.S. Quality Dividend Growth Variably Hedged Index ETF]," he says.

"Important for us, particularly in challenging markets, is WisdomTree's quality screen. Their process begins by looking at return on investment, which is a good measure of dividend strength, and return on assets, which helps to eliminate highly leveraged companies that may be unable to sustain their dividend in the future," Mr. Barnes says. "These metrics should also help companies do better than their peers during down markets."

Navigating a down market can be easy if you're patient, Mr. Coleman adds. "In my view, the portfolio shouldn't materially change unless the plan changes. If we've built a properly diversified investment portfolio that is designed to hit our longer-term investment targets, then part of that construction process would have factored in historical levels of volatility," he explains.

"We would never counsel someone to actively time markets. Having said that, if you see $10 on the ground, you should pick it up. Take advantage when great companies go on sale – as they often do in regular market corrections."

For investors looking for large-cap U.S. equity exposure, it's tough to beat the low costs of the Vanguard S&P 500 ETF (VOO) or the iShares Core S&P 500 ETF (IVV). Both have expenses of 0.04 per cent per year, and capture about 80 per cent of the available U.S. stock market, says Justin Bender, portfolio manager at PWL Capital Inc. in Toronto.

"If you don't want to miss out on the remaining U.S. stock market returns, consider investing about 80 per cent of your cash in either of these S&P 500 ETFs and the other 20 per cent in the Vanguard Extended Market ETF (VXF), which costs about 0.08 per cent per year," he says.

"VXF invests in over 3,000 smaller companies that are not included in the S&P 500 Index, giving you the complete package." This ETF tracks the appropriately named S&P Completion Index.

Mr. Bender adds that in the current market, "for a smoother ride, most investors will want to shift their portfolio away from just U.S. stocks into a more globally diversified asset mix.

"Vanguard has recently released three new asset allocation ETFs which provide investors with instant diversification for an overall cost of about 0.25 per cent per year. The new ETFs invest in a mix of Canadian, U.S., developed [outside North America] and emerging markets stocks, as well as Canadian and global bonds," which are hedged back to the Canadian dollar, he says. The new ETFs are: the Vanguard Conservative ETF Portfolio (VCNS); the Vanguard Balanced ETF Portfolio (VBAL); the Vanguard Growth ETF Portfolio (VGRO).

"Vanguard periodically rebalances the funds back to their original asset mix, so investors will no longer have to worry about the individual moving parts within their portfolio."

Should you use ETFs at all to go into U.S. markets, even if they bounce back?

"If you have more than $10,000 to invest, ETFs today are easily the best way to invest. That's true whether you're looking at the stock market or the bond market, Canadian, U.S., or abroad," says Ambrus Kecskés, associate finance professor at York University's Schulich School of Business in Toronto.

Dr. Cleary of Queen's agrees: "You can pretty much tailor your portfolio using ETFs if you have decent knowledge or a good advisor."

"But it's important to lay down a hard-and-fast rule," Dr. Kecskés says. The way you invest makes a difference, not just what you invest in.

"For just about every individual investor and even for many professional investors, the only ETFs [or mutual funds] they should be buying are the classic flagship index ETFs [or funds]," he says.

"Anything else, and you're actively trading securities yourself, and we have decades of research showing that people invariably lose money doing that rather than buying and holding the market index."

Mr. Coleman agrees: "The best advice I can give in a market correction is: Don't just do something, stand there."

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