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Avoid cost and risk with Exchange Traded Funds.

Most investors prefer to avoid cost and risk. Well duh!

Costs reduce returns while cost management can contribute to performance. Risk means short-term volatility (for most investors) while risk management can help to avoid blowups. Avoiding risks can mean smoother, more predictable, performance. It’s easier to sleep at night too.

Investors (and portfolio managers) can address cost and risk issues with Exchange Traded Funds (ETFs).

ETFs are basically low cost index funds – diversified portfolios that mimic an entire market index like Canada’s TSX or the US S&P 500. Because ETFs mirror an index, they contain ALL the securities in the index and therefore are lower-risk than individual stock or bond holdings.

How so?

Securities tend to move in groups. Royal Bank and Bank of Montreal, for example, tend to move together. (At least until recently). If one moved $1, the other moved about $0.90. They are correlated at about 90%. Why, then, assume the risk and cost of selecting one over the other? What if your pick is wrong?

Assume you picked the accident-prone CIBC on August 2nd, 2005. On August 3rd, 2005 CIBC announced a $2.4 billion Enron related write-off. CIBC stock dropped 7.5% that day. The financial ETF, however, dropped only 1%. By August 10th, CIBC had dropped 12.2%. The ETF only dropped 3.2%. Why? Because CIBC is only about 7% of the financial ETF, the impact of this particular CIBC blowup was moderated.

Instead of a pick, if you like (dislike) the banks simply increase (decrease) the exposure not to ‘A’ bank but to ALL banks. The financial ETF is one way to do so.

Other familiar blowup examples might include Loewen Group, Ballard Power, Bombardier and some Income Trusts too. Because ETFs are so diversified, they avoid individual company blowup risk.

ETFs work for bonds too. Once upon a time Laidlaw was a growth story. Laidlaw bond holders then watched their bonds drop from $1000 to $600. A bond ETF too, will moderate the impact of a single bond blowup.

Further, stock and bond picking is expensive – research is not free. ETF costs (as low as 0.09%) are a fraction of traditional mutual fund costs (averaging over 2.50%).

Instant diversification across asset classes, geographies, currencies and sectors while avoiding individual stock and bond risk and cost – Perfect for risk averse investors.

ETFs are, however, just products. Like any product – fund, stock or bond – ETFs must still be managed together in a portfolio context. One can pick top performers but without proper portfolio structure still have brutal portfolio performance. It’s the combination of products in a portfolio that deliver results not individual products. A portfolio strategy and strict selection criteria is still required.

Originally published in the Business Thompson Okanagan news, May 2008.

Doug Cronk CFA is Manager, Investments for a Canadian Pension Fund.

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