Risks to consider as ETFS take off

expense ratio for Canadian equity ETFs ranges from 0.07% to 0.25%. This is quite a gap considering research has shown that very few active managers outperform passive strategies.

However, there are some risks the average investor should be aware of before investing in ETFs.

First, we are not a big fan of levered ETFs for a number of reasons. In particular, retail investors at times may lack the expertise in assessing the risks associated with individual products, thereby compounding the volatility.

More importantly, these ETFs (especially levered com- modity ones) can also diverge from their underlying index if held for the longer term, because of something called contango, where forward contracts have to be purchased at higher prices, which then impacts the valuation of the ETF.

Investors may also have a difficult time understanding ETFs that are actively managed, synthetic in nature, use increasingly complex financial instruments, or trade inverse of their underlying index.

For example, there has been tremendous growth in covered-call ETFs, which can be a poor investment in a rapidly rising market such as the one that has transpired in the U.S. over the past few years.

Finally, investors who use a stockbroker as an advisor should check that they are not being double charged — a commission and a trailer — because the broker is purchasing an “advisor class” of ETF.

According to Morningstar, Canada is the only market in the world where financial advisors can collect a trailer fee for selling an ETF. These advisor classes can substantially add to the cost of the ETF, since we’ve seen the trailers be as high as 0.75%.

Institutional investors have clued in to the overall benefits of using ETFs and they now represent 60% of the Canadian ETF market, while gains by the dominating commission-based brokerage industry in Canada have been slower.

As one of those institutional investors, we use a number of ETFs for a portion of our fixedincome exposure, as well as international markets, where it can be quite challenging to outperform by stock selection. In addition, we like that many of the larger ETFs trade in an option market, allowing us to add value and manage risk through various option strategies. Even though the rally in U.S. equity markets has stuttered and further volatility will lead to more pullbacks through summer months, stocks remain a far better bet than bonds south of the border, say analysts.

“While the short-term picture for equities is admittedly cloudy, we remain comfortable with our view that US stocks are in the midst of their next secular bull market,” Brian Belski, chief investment strategist at BMO Capital Markets, said in a note.

“After all, every bull market encounters several periods of market weakness along the way — something that we view as a healthy market characteristic, by the way.”

The S&P 500 has given investors a rough ride since hitting a new closing high of 1669.16 on May 21. The benchmark fell as much as 3.6% to a low of 1608.9 on June 5, but closed Monday at 1641.78, just 1.6% off its peak.

Mr. Belski said the increase in volatility is primarily due to disappointing economic data south of the border, including recent consumption, manufacturing and employment figures.

Periods of decelerating economic data typically coincide with periods of higher market volatility, he said, which usually equates to poor stock market performance.

He believes investors should prepare for more backand-forth action this summer, but continues to recommend adding U.S. stock exposure with a focus on higher-quality names that have improving operating performance, reasonable valuations and strong cash-flow generation.

“Investors will need to remain patient and disciplined with their investment decision-making,” he said.

“However, the recent rise in interest rates has started to open up some eyes and made investors realize their bond holdings are not as bulletproof as previously assumed and that stocks aren’t such a bad long-term investment choice after all.”

Jan Loeys, chief market strategist at JPMorgan Chase & Co., has a slightly different take on the recent pullback, saying it was set off by warnings from U.S. Federal Reserve members that an end to the central bank’s large-scale asset purchases may come sooner than anticipated. But he agrees equities offer investors better opportunities than bonds.

“Market volatility in response to talk of an early end to easy money will not last, even as it may not be completely over, but it gives ideas on where the vulnerability to the real end to easy money lies,” he said in a note to clients.

Mr. Loeys doesn’t expect an end to the easy-money regime until next year, but said the impact, when it happens, will be much bigger than previous exits from ultra-loose monetary policies because this cycle has lasted much longer and was more extreme.

“We have learned from past regime changes that the longer they last, the more the market will have gotten used to them, and could even be said to become leveraged and addicted to the old regime,” he said.

Mr. Loeys recommends investors scale down in the market areas most leveraged to the easy-money regime and load up on those that haven’t fared as well.