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Some advisors use exchange-traded funds to dip into a sector slowly before picking individual stocks for client portfolios

ETF sales are set to outpace traditional mutual funds for the first time in Canada, driven by lower fees and a growing number of choices on the market.tap10

More investors and their advisors are turning to exchange-traded funds as a way to hedge volatile markets or play a specific sector.

The latest research shows ETF sales are set to outpace traditional mutual funds for the first time in Canada, driven by lower fees and a growing number of choices on the market. For advisors, in particular, the growth in ETFs also makes it easier to diversify clients' portfolios and to meet their asset allocation needs.

“Having ETFs in a portfolio makes a lot of sense,” says Martin Pelletier, portfolio manager at Calgary-based TriVest Wealth Counsel Ltd., where ETFs make up about 25 to 30 per cent of client portfolios and are used strategically as part of a broader mandate mix.

For instance, Mr. Pelletier uses ETFs to gain exposure to large, efficient markets, such as the S&P 500, an American stock market index, where it can be more challenging for investors to outperform the market. That’s unlike in Canada, for example, where he believes there are more opportunities to find good actively managed funds (non-ETFs) because the market is smaller, less liquid and more selective.

Mr. Pelletier recommends owning more ETFs earlier in the cycle after a correction, versus later in the cycle when markets top out.

"The reason being that, after a market correction, you don’t know which segment of the market is going to come back first, so it’s better to own the entire market,” he says. “Compare this to the later stage of a bull market, where there’s better value in having more of an active component in order to protect some of the downside in the event of a correction.”

In today’s environment, with markets selling off, Mr. Pelletier believes it’s worth shifting toward passive ETFs, “as long as one believes in the fundamentals such as corporate earnings growth remaining robust.”

For instance, his firm is using ETFs today to buy exposure to sectors such as financial services, utilities and telecoms, which are paying relatively strong dividends despite the large selloff in their share prices.

Robert Sneddon, president and chief portfolio manager at CastleMoore Inc., uses ETFs in his client portfolios as a way to reduce risk, especially in a down market, and as a strategy to enter a sector slowly before potentially picking up individual stocks.

“There’s more risk in individual security selection,” Mr. Sneddon says. “ETFs give you better coverage for downside risk."

He uses the example of the Big Six banks, some of which saw a larger drop than their peers in the recent market downturn. An ETF with all of the bank stocks included would likely have sheltered investors from some of the steeper losses, depending on the investment period.

“There’s safety in numbers,” Mr. Sneddon says.

Another benefit of ETFs is that they allow investors to dip their toes into a sector slowly for the first time, or after a market correction. He cites the example of investors looking to get back into the energy sector, which has been beaten down. By investing in an energy ETF instead of an individual stock, for example, “you get to see if the move has legs,” he says. “ETFs give you a way to start an allocation to an area with more safety, until you get confirmation it’s working.”

Mr. Sneddon also sees a number of buying opportunities in the most recent downturn. “It’s a good time from a risk-reward perspective,” he says.

ETFs are key to providing asset allocation and global diversification in portfolios, says Rodrigo Gordillo, co-founder and portfolio manager of Toronto-based ReSolve Asset Management, which works with advisors and institutional investors and has its own funds, including the ReSolve Adaptive Asset Allocation Fund and Horizons Global Risk Parity ETF (HRA), both of which invest in ETFs within the funds to get exposure to global asset classes.

“We're finally getting to a point where investors and advisors are understanding that the asset allocation decision is the most important part of the equation,” he says.

"In the past, if you wanted to diversify globally and in alternative asset classes like real estate, gold and commodities or even U.S. treasuries you had two choices: expensive mutual funds with liquidity constraints, or futures contracts. Today investors have access to nearly costless ETFs that rival the benefits of futures and can now impact their portfolio returns more meaningfully through asset allocation decisions.”

Still, given the sheer number of ETFs on the market today, Mr. Pelletier of TriVest says choosing the right one can be complicated for the average investor. He says advisors can help investors to choose the best products for their portfolio.

ETFs can also be a good tool for active portfolio managers who are looking at helping investors determine an allocation between active and passive, and what segment of the market they want to be in, Mr. Pelletier says.

And while advisors are moving to passive investments to save clients on fees, Mr. Pelletier doesn’t believe active management should be ignored.

“There are areas of the market where active management is important and worth paying for,” he says, while noting that active management fees are falling quickly to better compete with ETFs.