Picking the right ETF may be a question of balance

The other day over dinner a friend issued me a challenge.

“Suppose I gave you a million dollars to invest, but you could only put it in two securities. Not funds, just stocks or bonds,” he said. “Which ones would you choose?”

I didn’t have to think twice before answering.

“None,” I replied. “It’s not an option anyone should consider. That’s not investing, it’s a crap shoot.”

At first, my friend was taken aback by this answer, but after I explained he began to come around.

One of the keys to successful investing is diversification. As I have written here before, no one can predict with certainty what is going to happen in the financial world. Stocks that looked like sure winners one day end up being hammered the next. Look what happened to the big technology companies this week after reports emerged that the U.S. Department of Justice is looking at launching an antitrust investigation into their business practices. Shares of Facebook, Apple, Amazon and Alphabet tumbled. Then there was the $ 18 billion drop in in the value of automotive stocks after Donald Trump unexpectedly threatened to slap new tariffs on Mexico in an effort to stem the tide of illegal immigration.

The message is clear: take nothing for granted.

That’s why I always want to see the maximum possible diversity in a portfolio. That doesn’t stop with a proper allocation of stocks, bonds and cash. It includes geographic, sector and currency diversification as well.

Two securities couldn’t come close to achieving that. It would be putting all the eggs in two baskets and hoping an elephant doesn’t decide to sit on them.

The best way for most people to achieve proper diversification is through the use of balanced funds, which offer a combination of stocks, bonds, and cash. They have been the backbone of the mutual funds industry for many years. As of the end of April, more money was invested in balanced funds (almost $ 800 billion) than in all other segments combined (equity, bonds, specialty and money market). That’s according to figures released by the Investment Funds Institute of Canada (IFIC).

But when you look at the way we invest in exchange traded funds (ETFs) it’s a totally different story. According to IFIC’s numbers, Canadians have invested only $ 3.6 billion in balanced ETFs. That’s about 2 per cent of the total amount invested in the rapidly growing ETF market.

Why the huge discrepancy? Basically, because ETF providers haven’t provided the products. Until very recently, they seemed to take the view that investors weren’t interested in balanced ETFs, despite the obvious huge appetite for them on the mutual fund side.

I suspect the reason for this goes back to the origins of ETFs in the late 20th century. They were originally created as a low-cost option to track the performance of major stock indexes like the Dow, S&P 500 and the TSX Composite. That made the ETFs easy to understand.

Over the years, they have become increasingly complex, tracking more obscure indexes and even introducing active management. But they continued to shy away from balanced portfolios, perhaps because they can be complicated to benchmark.

Now that is changing. Vanguard recently launched a line of four balanced funds. They offer asset allocations ranging from 20 per cent equity/80 per cent fixed income to an 80/20 split the other way. The higher the level of stocks, the greater the risk. They all offer low fees (0.25 per cent management expense ratio or MER), but none have produced impressive results so far. The best has been the Conservative ETF Portfolio (60 per cent bonds, 40 per cent stocks), with a one-year gain of 4.48 per cent.

Vanguard isn’t the only ETF provider to suddenly discover there may be a lot of potential business in balanced funds. In February, BMO announced the launch of three asset allocation funds. The BMO Conservative ETF targets a mix of 60 per cent fixed income, 40 per cent equity. The Balanced ETF aims for 60 per cent equities, 40 per cent fixed income, while the Growth ETF is the more aggressive with 80 per cent in equities and 20 per cent fixed income. All funds have a MER of 0.2 per cent.

Blackrock’s iShares, the largest ETF provider in Canada, has two balanced offerings. The iShares Core Growth ETF Portfolio invests in a mix of eight other iShares funds, with an allocation of roughly 20 per cent fixed income, 80 per cent equities. As of June 4, the year-to-date return on this fund was 9.42 per cent.

The iShares Core Balanced ETF Portfolio is ahead 8.33 per cent this year. It offers a more conservative approach with a portfolio mix of about 60 per cent equities and the rest in fixed income and cash. The MER for both iShares funds is 0.18 per cent.

If you’re interested in an actively managed fund, check out the Horizons Balanced Tri ETF Portfolio, which was launched in August of last year. It invests in a portfolio of other Horizons funds, targeting a mix of 70 per cent equities, 30 per cent fixed income. It’s ahead by 9.41per cent so far in 2019. The MER is 0.16 per cent.

Horizons also offers the less aggressive Conservative Tri ETF Portfolio, which has a 50-50 mix of stocks and bonds. It too has only been around since last August. The year-to-date return is just over 9 per cent. This one has a MER of 0.15 per cent.

As you can see, there are now a lot of balanced ETFs options from which to choose, with the list growing all the time. Most of these funds are very new, so picking potential long-term performance leaders is a guessing game at this stage.

My advice is to decide on the asset mix that you are most comfortable with and go with the provider that offers that option at the lowest cost.

Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.

TORONTO STAR

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