Preserving capital with ETFs

ETFs are popular for many reasons, but a reader wants to know if they make you more vulnerable to market fluctuations? Bruce Sellery weighs in.

4

by Bruce Sellery
September 28th, 2012

Online only.

4

market_graph_322

Question

I would like your opinion on ETF’s. My financial adviser and I have rebalanced my portfolio to give me as much protection as possible from market volatility. Whenever I ask him about getting into ETFs, he dissuades me from doing so, indicating that the lower management fees are offset by the vulnerability to market fluctuations and are not appropriate for the philosophy we have adopted to preserve capital. I realize that if I went into ETFs he would lose considerable trailer fees. Although one cannot ignore the potential conflict of interest, I do not believe that this is the major influence on his advice. I would be very interested in your opinion on ETFs considering that preservation of capital has to be a major objective.

Answer

I’m afraid that your adviser is confusing two different things. Saying that he doesn’t like ETFs because they make you vulnerable to market fluctuations makes no sense. It is akin me saying I don’t like horror movies because I don’t like bubble gum ice cream. Both dislikes are true, but unrelated.

Arguments against ETFs

There are a number of arguments that naysayers make against exchange-traded funds. For example:

  • Actively traded portfolios outperform passive ETFs.
  • Mutual funds with trailer fees ensure that advisers get paid to deliver client services.
  • The underlying structure of an ETF is confusing and feels risky.

One can debate the validity of these arguments and see both sides. But I can’t see how you can argue that ETFs increase vulnerability to market fluctuations and serve as an impediment to your objective of preserving capital.

Strategies to minimize market fluctuations

I don’t know what specific strategy your financial adviser is using to minimize market fluctuations, but I would say he basically has two options: Reduce your exposure to the stock market or hedge against those market fluctuations.

Let’s say he chooses to reduce your exposure to the stock market. He could have you invested mostly in a bond mutual fund with the remainder of your money in a conservative equity fund. This strategy would be just as simple to execute using ETFs. He could invest your retirement money in a bond ETF and put the remainder in an ETF that mirrors the performance of one of the many indices out there—the TSX, the S&P 500, capped financials—whatever.

If, instead, your financial adviser chooses a hedging strategy, he could do that with ETFs as well. It is more complicated, and I would say riskier, but he could buy an ETF that delivers the inverse of the performance on the stock market.

Start with the objective

Your financial adviser has worked with you to identify your investment objective, which is to preserve capital. He then identified a strategy and chosen mutual funds as the product to deliver on that strategy. Mutual funds could be a great choice for you. He might have chosen low fee products that deliver solid performance when compared to the benchmark indices and at the same time provide compensation to him for giving you investment advice. All good.

On the other hand, he could have chosen mutual funds that compensate him but don’t deliver performance to you. At this point, you don’t know which it is, but I think it would be worthwhile to find out. Simply ask him to review your portfolio performance against the relevant benchmark indices over a 5-year time horizon and compare that to a similar weighted basket of ETFs and see what that shows.

You have a history with this financial adviser and you clearly like and respect him, which is important. But I’m my opinion his rationale for not using ETFs is setting off alarm bells that are definitely worth investigating.

It’s like me saying I don’t like horror movies because I don’t like bubble gum ice cream. Both may be true, but one has nothing to do with the other.

ask@moneysense.ca

4 comments on “Preserving capital with ETFs

  1. ETF’s are a great way to build a portfolio and with the diversity in strategies, investors now have the flexibility to invest in products that were once reserved for professionals.

    Great article!

    Reply

  2. The irony of comparing a 5 year history of mutual funds to a 5 year history or similar ETF's is that 5 years ago there were barely a handful of ETF's. The fact of the matter is no one knows how these ETF's will respond in markets such as 2008.

    Reply

    • Hi Steven,

      There are two statements in your note that aren't quite accurate. A handful of ETFs five years ago? Ishares has had a full line of ETFs for years, and Claymore came onto the market in 2006 adding more.

      Regarding how ETFs will respond in markets such as 2008. We know how they responded because they were available then. And then responded as expected: The ones that mirrored the performance of equity markets got hammered, as they should. Then when markets rebounded, the ETFs rebounded.

      Thanks for reading.
      Bruce

      Reply

  3. the horror movie/bubble gum analogy is an irrelevant comment and not connected in any way to the question about ETF's and market vulnerability. Now, if you said you don't like horror movies because they scare you, that's valid and relates to the ETF question. Why? Because by design ETF's seek to replicate an index or portfolio (unless they're inverse or multiplier ETF's), and so, when an index or portfolio falls, so does the ETF (proviso above in brackets); when the index or portfolio rises, so does the ETF. Indeed, ETF's are vulnerable to market volatility, just as any other non-guaranteed investment is. If you subscribe to the premise that passive investing is better than active investing, well then, perhaps ETF's are better. But to say they aren't affected by or protect against market volatility is just plain wrong. In fact, the closer an ETF tracks its proxy index or portfolio, the closer to 1 the beta number will be, and 1 is "just as risky as the index, portfolio, market, etc.".

    Reply

Leave a comment

Your email address will not be published. Required fields are marked *