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Happy 20th Birthday ETF

I n March exchange traded funds had their 20th birthday, and it was a Canadian innovation. The world's first ETF was based on 35 companies traded on the Toronto Stock Exchange. It was the start of something big.

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n March exchange traded funds had their 20th birthday, and it was a Canadian innovation. The world's first ETF was based on 35 companies traded on the Toronto Stock Exchange.

It was the start of something big. Nowadays there are 4,133 ETF listings from 123 product providers on 42 stock exchanges around the world, with a total market capitalization of $1.1 trillion.

Exchange traded funds look like mutual funds, but trade like stocks. The main idea of an exchange traded fund is that, like a mutual fund, with a single purchase you can buy an easily identifiable bundle of investments. For example, you could buy an ETF that mimics the Standard & Poors 500 index. In other words, you can have a diversified collection of eggs in your basket with simplicity and cost-effectiveness.

Unlike mutual funds, though, usually there is zero oversight with ETFs. If it's in the index then you own it, like it or not. The principal attraction of the core ETF concept is cheaper management fees relative to most mutual funds since, after all, typically there is almost no management involved with ETFs.

Potentially cheaper fees are good, but the way you hear some pundits describe ETFs you'd think that they were talking about the invention of penicillin. I wouldn't go that far, but as a fully licensed securities broker we do find them useful to have in the toolkit.

With the proliferation of ETFs - there are 145 ETFs in Canada, which is a little silly given the relatively small size of the Canadian market - there has been some mutation from the core concept of an exchange traded fund, which is simply diversification at a low cost.

The sales side of the industry has been quick to seize upon anything that there might be a market for, and now we have ETFs that employ leverage to try to juice their returns, ETFs that are run on the basis that the target investment will actually go down in value, ETFs that will rotate from sector to sector based on the outlook for the economy, hybrid ETFs that can incorporate multiple features, and, paradoxically, even ETFs that are actively managed.

Given all that, the simplicity, transparency and cost-effectiveness, while still present in products that remain true to the original core ETF concept, is becoming blurred in the financial engineering of some of the more exotic offerings. With all these new-fangled variations some of these products are hard to still recognize as an exchange traded fund.

Now that ETFs are becoming more complicated and more opaque, there are some questions that you will want answered if you considering an ETF investment. What stock market index or commodity is the ETF attempting to track? Will you own securities or derivatives? Is leverage employed? How liquid is the ETF? What are the total costs of owning the product?

One of the casualties of the increasingly sophisticated world of ETFs is the reduction in predictability. With the incorporation of either leverage or currency hedging or both into exchange traded funds, certain ETFs will drift from the underlying index that they are based on in as little time as one day.

That's right. In as little as 24 hours you could see something as goofy as the index moving in one direction and the ETF that is supposed to track the index going the opposite way.

Further, the attractive low-fee aspect of ETFs has started to erode. Fees have steadily crept up since the introduction of ETFs, particularly with the exotic ones. Depending on things like how much trading you do, you can easily see the all-in costs of an ETF portfolio exceed other investment options.

Another thing to watch out for is liquidity. Larger products that track mainstream indices are generally pretty safe, but some of the more unusual products can trade at a meaningful discrepancy from net asset value per share.

This isn't to say that ETFs don't have a role to play in an investment portfolio. In my practice we will use ETFs to get a low cost, diversified position in an area where the active management of investments has limited upside. An example is for fixed income investments.

However, there are some ETFs that I would rather just avoid. Primary among these are the ones that are trying to use leverage to juice their returns. While I am not categorically against the use of prudent leverage, bear in mind that the reckless use of leverage was the main contributing factor to the economic nightmare that came to a head in 2008.

The other thing to watch out for is the tendency to use long-term investments for short-term needs. Good ETFs might be cheap, but that doesn't necessarily make them appropriate if you need your money back right away.

Now that the marketing of ETFs has morphed from an inexpensive method of broad-based diversification to include specialized, leveraged, actively traded strategies it has been suggested that 90 per cent of new offerings are suitable for only 10 per cent of investors.

ETFs are very much in vogue right now. If they fit your objectives, then certainly they can be considered as a valid option. After all, low cost, diversified portfolios have some intuitive appeal. But at the end of the day you probably needn't feel that the bus is leaving without you if you are working towards your financial goals with other products.

Still, ETFs are one of the reasons that I went out and got my securities license after several years of working with only mutual funds. I wanted to be able to have full access to all products - stocks, bonds, mutual funds, flow through limited partnerships, and ETFs. I think it's important to be able to draw from multiple sources in order to create customized solutions for a client's unique needs, and ETFs can have a role in doing that.

The opinions expressed are those of Brad Brain, CFP, R.F.P. CLU, CH.F.C., FCSI. Brad Brain is a Certified Financial Planner with Manulife Securities Incorporated, Member CIPF and with Manulife Securities Insurance Agency in Fort St John, BC. Brad Brain can be reached at brad.brain@manulifesecurities.ca or www.bradbrainfinancial.com.