Don't buy exchange-traded funds blindly

Canadian investors have been steadily accumulating exchange-traded funds (ETFs) in their portfolios, with many viewing them as a one-ticket solution for such things as diversification, liquidity, low fees, flexibility, transparency and tax efficiency.

A research report from National Bank Financial states Canadian ETFs attracted $1.5 billion for June, despite negative returns for both stocks and bonds.

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This puts total Canadian ETF assets just over $59 billion, and a large portion of the June net inflows can be attributed to the iShares S&P/TSX 60 Index (TSX: XIU), which had a whopping $1.1 billion of the flow.

Unfortunately, it appears that investors are not doing their homework; instead buying ETFs blindly, without assessing whether particular products are right for their portfolios. The popularity of XIU is a case in point.

More than 70 per cent of the ETF is comprised of financials, energy and materials. While financials tend to be more stable in nature, the energy and materials sectors are subject to high volatility. In fact, the materials sector is down -33 per cent on the year and is one of the largest contributors to the underperformance of the S&P/TSX this year.

According to RBC Wealth Management analysts, Canadian equity portfolios with TSX Composite-like sector composition face the prospect of sub-par returns in years ahead.

RBC analysts believe the main Canadian equity sectors are set to confront a number of headwinds that are unlikely to abate in the foreseeable future, and that maintaining such a high level of concentration risk is an approach unlikely to be rewarded.

The key reasons are the effect of high household debt levels and inflated real estate markets on the financial industry, and pending issues in the commodities markets.

That's not to say that investors should avoid the Canadian index ETFs.

Rather, they should be more cognizant of the products they are purchasing and realize that more diversification may be warranted.

To diversify Canadian equity portfolios, investors should consider ETFs that provide exposure to other areas of the index; creating a much more balanced approach.

Investors could purchase the First Asset Morningstar Canada Momentum ETF (TSX: WXM) and the First Asset Morningstar Canada Value Index ETF (TSX: FXM).

The former uses price momentum as a core component of its screening process while the latter screens for price-to-earnings ratios, cash flow ratio, price-to-book value and sales, and earnings estimate revisions. A combination of the two has provided a better risk-adjusted return with reduced volatility, and has outperformed the benchmark every year since 2001.

The BMO Low Volatility Canadian Equity ETF (TSX: ZLB) is another interesting product. As the name implies, the ETF has been designed to provide exposure to a low beta weighted portfolio of Canadian stocks. This ETF's sector allocation has a much heavier weighting in the more defensive sectors such as consumer staples and utilities.

Investors without the time or inclination to "do the homework" for proper diversification can opt for a professionally managed ETF portfolio, either through Separately Managed Accounts or with wraps.

In the former, investors have direct ownership of the individual ETFs but institutional-calibre managers handle the investing and ongoing rebalancing.

The latter are similar to mutual fund wraps, except that the underlying investments are generally much more cost effective.

Kim Inglis, CIM, PFP, FCSI, AIFP, is an investment advisor and portfolio manager with Canaccord Genuity Wealth Management, a division of Canaccord Genuity Corp., Member - Canadian Investor Protection Fund.

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