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Investments in ETFs have exploded. According to Morningstar, global ETF assets jumped to more than $3 trillion (USD) in 2017 from $580 billion (USD) a decade earlier.

Initially, ETFs were only used by institutional investors, but when their advantages became apparent, they were rapidly embraced by retail investors as an alternative to mutual funds.

One of these advantages is that ETFs allow investors to get in and out of the market at a far lower cost than mutual funds, explains Manmeet Bhatia, Senior Vice President of Online Brokerage and Digital Wealth at Aviso Wealth, the parent company of Qtrade Investor.

ETFs also cater to a wide range of investment goals. “They provide a quick and cost-effective way to move between investment opportunities for individuals looking to shift portfolio exposure for the short or potentially long term,” explains Bhatia.

Rapidly expanding choices

The ETFs that initially appealed to investors were passive index trackers—broad-based funds that weren’t designed to beat the market, but to align with it and provide investors with all the benefits of investing in the market.

Those large, inexpensive, “plain vanilla” ETFs are still around, passively tracking the ups and downs of the market. But a curious thing happened since those early days: the ETF universe expanded, giving investors many more choices—including actively managed funds.

“There’s a new breed of ETFs that don’t track the broad market directly, but use strategies designed to tweak exposure in such a way that they try to outperform the market,” says Dan Bortolotti, Associate Portfolio Manager at PWL Capital.

The growing range of ETFs also includes specialized niche funds allowing investors to participate in industry trends or gain exposure to particular sectors, geographic regions, market caps, and so on. These provide more options for diversification and for designing an asset allocation to achieve the investor’s goals for growth, income and capital protection.

Of course, compared to passive index-tracking funds, these actively managed specialty funds are more expensive, with some charging fees similar to mutual funds.

Given the changing nature of ETFs, how do you choose the best options? What questions should you ask? And how, exactly, do you decide between two or three ETFs that appear to be exactly the same? To help, we’ve compiled a handy checklist:

  1. Check that the ETF fits
  2. Make sure you’re comfortable
  3. Fill the niche
  4. Check the costs
  5. Examine the construction
  6. Keep an eye on volatility

This checklist will help guide you through the increasingly complex world of ETFs. By doing your due diligence, you can easily construct and rebalance a portfolio that will grow into a sizable nest egg.

#1: Does the ETF fit your investment strategy?

If you want to earn strong returns over a long investment horizon, start with plain vanilla, broad-based, well-diversified ETFs that mimic the market, says Bortolotti. ETFs that cover a broad Canadian or U.S. equity index, like the S&P/TSX Composite or the S&P 500, are great options, as are ETFs that track fixed-income benchmarks, and funds that track international markets. Bortolotti adds there are even ETFs that contain more than one of these indexes within a single product.

“The goal is to build a well-diversified portfolio using a small number of products that offer the broadest diversification at the lowest cost,” adds Alex Bryan, Director of Passive Investments at Morningstar. There may be periods when the market value of the funds falls, says Bryan, just as there can be a correction in the index they follow. But time and again, studies show that investors do well over the long-run when they simply follow the market, compared to trying to beat the market through an actively managed fund or by individual stock selection.

Bhatia suggests a “core and explore” approach, in which investors hold broad-based market ETFs as their core portfolio exposure on a long-term buy-and-hold basis, then tactically use niche ETFs to enhance returns or limit risk. This can be a cost-effective way to create a more active portfolio from investment vehicles that, for the most part, are seen as more passive.

He adds that ETFs can also be used as a risk reduction tool. For example, bear market ETFs invest in short positions and derivatives in order to profit when equities fall in value, and help investors mitigate the impact of market corrections.

#2: What brand are you familiar and comfortable with?

When researching ETFs, you’ll likely find yourself having to choose between two or three that are virtually the same—with nearly identical holdings, weighting and costs. For example, when choosing a broad-market Canadian equity fund, you may come across products from Vanguard, iShares and BMO that are almost interchangeable. “People ask me which one I should choose and I say, half joking, ‘Flip a coin’,” says Bortolotti. “There is no big risk or advantage when selecting one of these broad-based ETF providers over another,” he says.

#3: Are you looking to fill a niche market or find a specific product?

Once you’ve picked your broad-based ETFs as the foundation of your portfolio, it may be time to further diversify. This is the moment when you must decide whether or not you want to augment your asset allocation in order to increase your overall returns.

Niche ETFs should not be a core part of your portfolio, Bortolotti says, but they certainly have a place when you are comfortable with adding a bit more risk in your investing strategy with the hope of greater rewards.

“Just don’t get too cute investing in these areas,” Bortolotti advises, noting that specialized ETFs aren’t necessarily the type of investment that will stay in your portfolio for the long term. For example, there are ETFs that cover the growing cannabis sector, and although they may be fun to own and offer a bit of investing excitement, he says, “I can’t see someone owning these types of ETFs over 10 or 20 years.”

Eric Balchanus, ETF analyst at Bloomberg Intelligence, says the explosion of ETFs certainly offers investors more options and more market exposure. For instance, there is now an ETF that tracks dry bulk freight futures. “Who knew these things even existed?” he says. “Anything and everything that has ever been dreamed up on Wall Street is either reflected in an ETF, or will be.”

Finally, when picking specific products, make sure the niche ETF doesn’t overlap or duplicate what’s already in your broad-based core holdings.

#4: What will it cost you?

The general rule of thumb is to opt for the lowest cost when it comes to selecting between similar ETFs for your portfolio. This applies to the selection of well-diversified, broad-based ETFs that are part of your core portfolio as well as to the specialized ETFs that add exposure to specific niches.

For example, Bortolotti suggests that the broad-based ETFs that make up the bulk of your portfolio ought to charge fees between 5 and 20 basis points. He adds that more exotic and specialized ETFs that track niche areas and are actively managed will come with higher fees. It’s not uncommon to see management fees in the 50 to 70 basis point range. Remember, Bortolotti says, that these actively managed ETFs are still cheaper than actively managed mutual funds.

#5: How is the ETF constructed?

Two different ETFs may have virtually the same holdings, but there could be big differences in how these ETFs are weighted, points out Balchanus.

For example, an ETF that holds 10 stocks may distribute those holdings based on each firm’s market value, which is measured using a company’s market cap. The market cap is calculated by multiplying the price of a stock by its total number of outstanding shares. For example, a company with 20 million shares selling at $50 a share would have a market cap of $1 billion. So, an ETF that distributes its holdings based on market cap would have different percentage weightings of each stock in that fund. Another ETF, with the same 10 stocks, may opt for an equally weighted distribution, meaning an equal exposure to each stock within the fund.

Depending on the strategy used, there could be more volatility, says Balchanus. For instance, an ETF that has equal portions of all the equities will experience more ups and downs than an ETF weighted by market cap. That’s because equal weighting could give smaller stocks, which are typically more volatile, more impact on the ETF returns, for better or worse.

The number of equities within an ETF portfolio can also make a difference. An ETF with 15 stocks may be more volatile than one with 30 stocks, even if both are specializing in the same sector. That’s because, in the more concentrated portfolio, the performance of one stock can make a bigger difference.

These differences are part of an ETF’s weighting strategy, explains Balchanus. “The point is to ask which weighting strategy is being used and what are the pluses and minuses of each weighting strategy,” he says.

Bhatia notes that “smart beta” ETFs, which are constructed with strategies other than the more typical method of using market cap, should be another consideration for investors. This type of ETF can use cash flow, dividends and volatility as factors in constructing a portfolio. These ETFs also offer investors the ability to gain exposure to markets where individual security selection may be difficult, he says. For example, it can be difficult to invest in many Chinese companies whose shares are not traded on North American exchanges. Accessing that market via an ETF might be a better way to go.

Another example of the benefit of going the fundamental smart beta route is mitigating risk from some sectors while gaining exposure to others. A Canadian ETF based on market cap might give more weight to energy, financial and materials sectors, but a fundamental smart beta ETF based on, say, cash flows could reduce those sectors and give more exposure to areas such as industrials and consumer staples.

#6: Pay attention to volatility and liquidity

Another way to choose between two ETFs is to compare their volatility. One way to gauge volatility is to check the standard deviation, where a higher value means more volatility. For example, an ETF with a standard deviation of 20 over a given time frame is likely to exhibit a greater range of price fluctuations than an ETF with a standard deviation of 10, explains Balchanus. ETFs holding blue-chip stocks generally have a low standard deviation, while GICs (an investment product that doesn’t trade) have a standard deviation of zero.

Another measure, when it comes to assessing investment products, is to examine the fund’s liquidity. Thankfully, this is not usually an issue for ETFs, explain Balchanus and Bortolotti, especially with long-standing funds from big names like Vanguard and iShares. In fact, ETFs are often used by traders specifically because they are more liquid.

In general, bigger is better. Newer ETFs with only several million in assets might be less liquid than larger, well-established funds with billions in assets, Bortolotti says. Balchanus adds that the top 15 most-traded ETFs account for half of all ETF volume, while the top 150 account for 90 per cent. “New issuers can sometimes have a real problem getting a new product established,” he says. “You can’t manufacture liquidity—it has to grow organically, and that can take several years.” That means investors who are keen on newer ETFs need to consider their investing timeline and whether or not they are taking on the higher risk of less liquidity.

Bhatia says investors might also want to consider looking at bid-ask spreads of ETFs, especially when they are being purchased with the intention of holding on a short-term basis. “Tight spreads can be an indication of strong liquidity and can reduce the cost impact of a buy-and-sell taking place over a short period of time,” he explains. For ETFs being held for the long-term, bid-ask spreads will have less of an impact.”

This six-step checklist is a great first step for both experienced and new investors when it comes to evaluating and selecting ETFs.

Qtrade Investor is a division of Qtrade Securities Inc., Member of the Canadian Investor Protection Fund.

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