ETFs in falling markets

There’s one big advantage to investing in exchange-traded funds (ETFs). There
are never any surprises.

All you have to do is read the business section of your newspaper each day.
If the stock markets are down, your equity ETFs will be too. If the bond market
has gone up, your bond ETFs will reflect that.

What this means is that there is nowhere to hide when markets plunge. Active
fund managers can move into defensive stocks and/or build cash reserves. ETFs
don’t have that kind of flexibility. They are a reflection of whatever benchmark
index they have been created to track. Almost three-quarters of the S&P/TSX
Composite is made up of resource and financial stocks so that’s exactly the
mix you get when you buy the iShares CDN Composite Index Fund (TSX: XIC).

Unfortunately, many investors don’t seem to be able to grasp that simple concept.
Part of the problem may be a misconception created by what I consider to be
misleading reports that are regularly produced by Standard & Poor’s. They
consistently show that only a minority of actively-managed mutual funds beat
their benchmark indexes. These reports are important because they are regularly
picked up by the media and the resulting stories convey the impression that
index funds are a better choice. There is absolutely no evidence for that conclusion.
In fact, by definition, index funds underperform their benchmarks 100 per cent
of the time after deducting fees and expenses. If S&P would produce reports
comparing the performance of index funds with actively-managed funds, then we’d
have something useful for comparison purposes.

There are two strategies you can use with ETFs. The first is a long-term buy-and-hold
approach. This is really an invest-it-and-forget-it strategy, sometimes referred
to as a “couch potato portfolio”. If you use it, be prepared to stay
in for the long haul and be sure that you have the intestinal fortitude to ride
out market slumps like the one we have been experiencing.

The second approach is to trade ETFs as if they were stocks, buying and selling
based on your view of where the markets are going. This strategy requires constant
vigilance, a strong sense of market timing, and the willingness to pull the
trigger quickly on trades. It is also more expensive because every trade generates
a brokerage commission. If you go this route, use a discount broker.

Personally, I favour bond ETFs over their equity stablemates. They historically
display much less volatility and they are the least expensive way to buy into
a well-diversified fixed-income portfolio. Here are two bond ETFs I have been
advising readers of my Mutual Funds Update newsletter to buy for some
time. Ask your financial advisor about them.

iShares CDN Bond Index Fund (TSX: XBB). This fund tracks the
performance of the DEX Universe Bond Index, which includes a broad range of
Canadian government and corporate bonds. It gained 7.1 per cent in the year
to Aug. 31, a much better return than you would have received from the average
Canadian fixed income fund over that period. A low-cost bond ETF like this offers
good portfolio diversification and helps to offset any stock market losses you
may experience.

iShares CDN Short Bond Index Fund (TSX: XSB). This is just
about the safest ETF you’ll find and it has been performing very well recently
with a one-year gain of 6.9 per cent. That’s unusually high, however —
the three-year average annual compound rate of return of 3.6 per cent is more
along the lines of what you should expect. This is the fund to choose if you
are an ultra low-risk investor and you want to move some money out of the stock