Low-cost diversification is the key driver behind the popularity of exchange-traded funds. A portfolio built with just a few funds can offer investors the world, or at least Canada and the United States.
Yet as their popularity has increased, so too has the number of ETFs. In addition to basic index trackers, investors will find sector-specific, factor-based and even actively managed funds.
All this choice can leave investors confused. After all, weren’t ETFs the “easy button” for diversified portfolio building? Or do we now require more nuanced approaches to achieve true diversification?
The answer is anything but clear.
For many, the simple, passive approach is still best. If you can’t beat the market, own it on the cheap, maintains Gordon Ross, portfolio manager with ModernAdvisor.ca in Vancouver. “Nobody can predict what’s going to happen in various markets with any precision,” he says, which makes specialty funds harder to capitalize on.
That’s why, as Mr. Ross notes, legendary stock picker Warren Buffett and the late Jack Bogle, founder of the ETF giant Vanguard Group, have suggested most investors are better off buying an ETF that mirrors the performance of a broad-based index.
Canadian Couch Potato blogger and portfolio manager Dan Bortolotti sits firmly in this camp. He says do-it-yourself (DIY) investors should favour simplicity.
“Now, you might be able to make the argument that there are some asset classes missing … for example, gold, real estate or inflation-protected bonds,” says Mr. Bortolotti, a money manager with PWL Capital Inc. in Toronto. But the benefit of adding more targeted ETFs to a portfolio is uncertain, he contends.
He is not alone. Portfolio manager Robyn Graham with ETF Capital Management in Toronto also suggests most retail investors would do fine owning a few passive, broad-based ETFs. In fact, she says, a single ETF arguably “achieves any objective or mandate a client may be looking for.”
In that regard both iShares and Vanguard have all-in-one ETFs offering global diversification across stocks and bonds but with emphases on growth, conservative investments or balanced allocations.
Whether it’s one fund or a dozen, the strategy boils down to preference. Ms. Graham further adds that only if an investor wants to control asset allocation and risk exposures “is it necessary to use multiple ETFs” to build a portfolio.
Even then, three or four funds would cover all the necessary major asset classes and regional exposures, she says.
The question investors need to ask themselves is: “What are you trying to achieve?” Mr. Ross says. While the question is seemingly straightforward, many investors struggle with the answer, and that answer often changes depending on market conditions and marketing pitches from the industry, he says. Investors might start out with three or four passive ETFs in their portfolio, but they add more over time, and while their portfolio may appear on the surface diversified, the truth states otherwise.
These investors often end up holding the same stocks or bonds in several ETFs, and that is the opposite of diversification.
Others may be attracted to ETFs covering hot sectors such as blockchain (the secure-transaction technology underlying cryptocurrencies), buying these funds with the belief they are getting “safe exposure” to high-risk assets, Mr. Ross says.
“They get sales pitches like ‘here’s an exciting cannabis ETF,' ” he says, and that can distract investors from the whole premise behind their ETF-based strategy, which is low-cost diversification, because these niche funds effectively concentrate capital in a small and highly risky segment of the market.
In simple terms, “more complexity usually just adds more cost and more distractions,” Mr. Bortolotti says. “For DIY investors especially, this increases the likelihood you’ll make mistakes.”
Still, others argue that “simple” worked well over the past decade but it might not work in the future.
“You really have to understand how [a passive strategy] is going to react to what’s coming,” says Keith Dicker, a portfolio manager with IceCap Asset Management Ltd. in Halifax.
Mr. Dicker, who uses ETFs for his clients, points to the risk that rising interest rates pose for the bond allocation of a passive-strategy portfolio. It’s a likely scenario in the coming years, he predicts, and it could result in losses up to 20 per cent for passive fixed-income ETFs. That’s why he argues a different approach is required, such as incorporating U.S. short-term credit market ETFs in a portfolio.
Yet deviating from a simple, passive ETF strategy requires more homework for the DIYer. And that might require seeking professional advice, Ms. Graham says. The breadth of ETFs now available makes it possible “to implement sophisticated investment strategies using ETFs that are beyond the scope of the do-it-yourself investor,” she says.
Also, these complex strategies are generally suited more for the large portfolios of high-net-worth investors. Most DIYers’ portfolios simply are not large enough to justify owning as many as 20 funds, as these strategies would likely involve significant trading costs to build and manage.
That’s why, she adds, these investors are better served keeping it simple with their portfolio. “It just does not make sense to fragment it more.”