Building a portfolio with ETFs

In addition to evaluating the risk profile of clients, suggests Kevin Gopaul, senior vice president and chief investment officer, ETFs, with BMO Asset Management Inc. in Toronto, determine their needs — that is, whether they are seeking income or growth. That decision, he says, would normally depend on your client’s time horizon or his or her position within the retirement cycle.

Typically, a balanced retirement portfolio would have an asset allocation consisting of 40%-70% equity-based ETFs, depending on the investor’s risk profile, and the rest in fixed-income ETFs. Various strategies can be used to achieve this objective, based on the client’s unique investor characteristics.

For instance, at the most basic level, Gopaul suggests using a combination of core ETFs linked to the S&P/TSX composite index for Canadian exposure; to the S&P 500 composite index for U.S. exposure; and to the DEX universe bond index for exposure to a broadly diversified selection of investment-grade Government of Canada, provincial, corporate and municipal bonds. Global equities exposure can be added by investing in an ETF that is linked to the MSCI world index.

For specialty-sector exposure, Gopaul suggests investing in ETFs that focus on sectors such as global infrastructure, which has little correlation to other asset classes; emerging-market bonds, for potentially higher yields; and real estate investment trusts, for capital preservation.

Alternatively, equities exposure can be obtained by investing in “low-volatility” ETFs, Gopaul says. These ETFs are meant to provide protection against wild market swings; they typically invest in a basket of stocks whose level of volatility is lower than that of the broader market. These stocks normally pay a steady dividend and dampen downside risk by providing potentially stable returns. Says Cooke: “Low-volatility ETFs dial up exposure to equities without increasing risk.”

Clients also might add covered-call ETFs to earn income from both the premiums generated from the sale of call options and dividend income from the underlying stocks. Generally, these ETFs decrease the risk of stock ownership.

Barry Gordon, president and CEO of First Asset Capital Corp. in Toronto, recommends constructing the core component of the portfolio using ETFs that have a combination of investment-management styles, such as momentum, which is based on price and earnings momentum; and value,which is achieved by investing in stocks trading below their intrinsic value.

These ETFs perform differently in different market conditions, Gordon says, and could help the portfolio get the best risk-adjusted returns.

According to Gordon, the portfolio does not necessarily have to include, for example, an ETF that tracks the S&P/TSX composite index, which is heavily weighted in resources and financial stocks. He suggests looking for complementary ETFs that do not have a significant overlap of similar stocks, with diversification by sector.

When adding niche sectors, Gordon recommends looking for ETFs that increase risk-adjusted returns: “You can get away with as few as five or six ETFs in a well-diversified portfolio, and add more colour with eight.”

As part of the portfolio’s core component, Mary Anne Wiley, managing director of iShares Canada, a division of BlackRock Asset Management Canada Ltd. in Toronto, suggests investing in ETFs that are capitalization-weighted (for example, the 60 largest stocks in an index), fundamentally weighted (based on factors such as book value, cash flow, revenue, sales or dividends) or value-oriented.

In niche sectors, Wiley says, clients can gain exposure to specific segments of the market and get in and out of these segments in an efficient manner, allowing them to combine actively managed and passively managed core positions with a wide range of niche holdings, such as emerging-market debt.

Wiley notes that the ETF sector is changing to meet client demand by offering packaged ETF products. “Instead of investing in six ETFs in a balanced portfolio,” she says, “clients can buy one packaged solution.”

Adds Cooke: “[These packaged products] have prescribed risk and return characteristics and benefit from professional management.”

Both the core and niche components of a balanced portfolio, Cooke says, are unique to the individual client. The core component typically should include Canadian and global equities and fixed-income securities, including government bonds. Clients can “slice and dice” the bond market, he adds, and mitigate interest-rate risk by investing in, for example, floating-rate or short-duration bonds.   IE