Today’s volatile equity markets have probably demonstrated to more than a few investors that their portfolios are not as diversified as they would like.

For those among your clients who are feeling a bit whipsawed, exchange-traded funds could be one way to address their asset-mix problems, says Heather Pelant, head of business development of ETFs at Toronto-based Barclays Global Investors Canada Ltd.

“My sense is the strength of the Canadian market, in combination with our own natural home country bias,” says Pelant, “means that most Canadians are likely to have an overweighted portfolio with Canadian equities, underweighted [in] fixed-income and probably underweighted [in] international equities.

“There is risk [for] the client who is overweighted, and ETFs can simply rebalance the portfolio, reducing that risk instantly,” she says.

An ETF is a security that tracks the performance of a market index or a basket of assets. In that sense, it is like an index mutual fund; but unlike a fund, it trades on the stock exchange and is thus priced throughout the trading day. Investors can place stop-loss orders, price-limit orders, sell short, buy on margin, and purchase as few as one share — exactly as for a stock.

In Canada, there are 46 ETFs with assets totalling about $17 billion. The market is dominated by Toronto-based Barclays, which offers 24 iShare-branded ETF products. At one point, Toronto-based TD Asset Management Inc. was also in the ring, but in March 2006 TDAM liquidated its four Canadian equity ETFs.

In the past two years, Claymore Investments Inc. and BetaPro Management Inc. , both based in Toronto, have joined the ETF market by developing unique products.

“Today, there is a far more complete set than even a few years ago, and that enables you to build portions or entire portfolios with ETFs,” says Howard Atkinson, president of BetaPro’s Horizon BetaPro ETFs division. “They are very flexible vehicles that go with other investments very nicely. They are like Lego pieces: you can pretty much build anything you want or just use a few pieces.”

Pelant says that using ETFs to diversify a portfolio internationally, or by combining these passive investments with actively managed ones, are among the strategies advisors can use to help their clients.

“We see advisors adopting these key ETF strategies across their businesses,” she says. “If there are holes in a client’s portfolio, these strategies can help fill them.”

Clients should also know that ETFs can be a tax-efficient way to invest, compared with mutual funds.

“With a more passive portfolio, investors don’t see a lot of turnover in the funds, so there isn’t a lot of stock buying/selling,” says Claymore president Som Sief. “Investors don’t trigger a lot of capital gains in the fund on a regular basis, so ETFs become more tax-efficient.”

Clients pay commissions to buy and sell ETFs, but management expense ratios for most are lower than those of the average mutual fund.

Sief says advisors can help their clients build portfolios that are designed for the long term and save a significant amount at the same time.

“The biggest benefit of all with an ETF is the cost,” says Sief. “That is the bottom line. Canadian investors have woken up to the fact that there are better ways to invest without paying the big fees.”

Clients may have to put up with more conservative return expectations in general in the near future; therefore, the level of fees paid are likely to become more important to them, says Danielle Park, a portfolio manager and president of Barrie, Ont.-based Venable-Park Investment Counsel. In 2003, Park founded her own investment-counselling firm with partner Cory Venable. The pair use ETFs exclusively as their equities tool.

“Historically, if you look at the returns from the great bull market of the ’80s and ’90s, we can see why higher fees were more tolerable,” says Park. “When returns are higher, people are able to pay higher fees and still make decent returns. But, going forward, I think things may be changing. People are likely to need lower fees to make acceptable returns through the next several years.

“I don’t think ETFs will solve all the market risk problems,” she adds, “But I think it’s certainly an excellent tool in the right direction.”

@page_break@If your clients have overloaded their portfolios with Canadian stocks, there are several ways to increase their international exposure by using ETFs, says Pelant.

For instance, Bar-clays offers iShares CDN S&P 500 Index Fund for those who want to start investing assets in the U.S. market or iShares CDN Russell 2000 Index Fund for exposure to U.S. small-cap companies.

“These products are good to use either to complete a portfolio by giving investors broad exposure to the U.S. market or be used alongside mutual funds to get full exposure to the asset class,” says Pelant.

For investors who are looking at international markets, advi-sors may opt to invest in developed markets outside of North America with iShares CDN MSCI EAFE Index Fund.

This ETF replicates the performance of European and Far Eastern markets, hedging the Canadian dollar against 11 currencies.

When it comes to clients with underweighted fixed-income portfolios, advisors can elect to provide broad exposure to the Canadian bond market via iShares CDN Bond Index Fund, says Pelant.

This fund tracks the performance of the Scotia Capital universal bond index, which tracks primarily semi-annual, fixed-rate bonds issued in Canada. The index consists of roughly 70% government bonds and 30% corporate bonds, containing investment-grade fixed-income issues only.

For yield enhancement, advisors could look at iShares CDN Corporate Bond Index Fund.

This fund replicates the performance of the Scotia Capital all-corporate bond index, which tracks primarily semi-annual, fixed-rate corporate bonds issued in Canada.

There are also ETFs designed to help investors profit from bull and bear markets. BetaPro, for example, offers ETFs that provide investors with inverse and magnified exposure to the S&P/TSX 60 index.

“ETFs can now be used to hedge portfolios or as a tool when the market goes down,” says Atkinson. “We have products that give you twice the inverse daily performance of an index, so now you have ETFs for both the bull and the bear markets.”

Since its first set of bull and bear ETFs, BetaPro as been able to add three more pairs focusing on the financial services, energy and gold sectors.

“People can use ETFs entirely in their portfolio or as a component of them, and sectors are just one component that will allow you to make a decision on how to use the ETF,” says Sief. “If someone wants exposure to the financial services market or the energy market, then [ETFs] could be a great product for them.”

Claymore, for its part, has developed four sector ETFs, including Claymore S&P/TSX Global Mining ETF and Claymore Oil Sands Sector ETF. In June, Claymore S&P Global Water ETF was launched to provide investors an opportunity to invest in the water industry.

“It is one of the biggest areas of future growth,” says Sief, “and there is a targeted market for people to put that into their portfolio, just like they would buy [shares in] a
company.” IE