Hot ETFs

One of the most important things to remember about investing in an equity-based mutual fund or ETF is that the narrower the focus, the greater the risk. The flip side is that focused funds also have higher return potential.

The most conservative equity ETFs are broadly based, designed to emulate the returns of major indexes such as the S&P/TSX Composite and the S&P 500. Among the specialized funds, those that invest in preferred shares, financial institutions, and blue-chip dividend paying stocks tend to be at the lower end of the volatility scale. But that doesn’t mean any of these are risk-free, as the market crash of 2008-09 reminded us.

I believe these lower-risk equity ETFs are the right choice for most people. But some investors seem to want greater short-term growth potential, even if that means taking on a higher degree of risk. Until recently, these folks had to go to the U.S. market to find what they were looking for. But that’s changing quickly.

As interest in more aggressive ETFs grows, companies like BlackRock, Claymore, BetaPro Management, Claymore, and BMO are responding by introducing more exotic funds. Some of these, such as the leveraged offerings from BetaPro, can be very risky and should only be used by knowledgeable investors. Others have very small portfolios and are heavily concentrated in a few companies. The iShares S&P/TSX Capped REIT Index Fund (TSX: XRE) falls into that category. It has only 13 holdings, with almost half the portfolio invested in just three REITs: RioCan, H&R, and CREIT.

But there are an increasing number of focused ETFs that provide investors with an opportunity to invest in a large basket of stocks within a specific sector at a much lower carrying cost than a comparable mutual fund will charge. Some of these have been turning in impressive numbers recently.

Here is a look at one of the current top performers among the specialized ETFs. Remember, there is no guarantee these results will continue into 2011. But if you want to invest a little money in an ETF with above-average return potential, this one may be to your liking.

iShares S&P/TSX Capped Materials Index Fund (TSX: XMA). This has been the top-performing fund in the iShares line-up thus far in 2010 with a year-to-date gain of 32 per cent (to Dec. 22). The fund holds a basket of 61 companies and income trusts involved in gold mining, base metals, fertilizers, forest products, etc. The largest positions are in Barrick Gold (15 per cent of assets), Potash Corp. (12.7 per cent), and Goldcorp (10 per cent).

This ETF has been around since late 2005 so we have a track record of almost five years to help us assess performance. Overall, it has been excellent. The fund has been a first-quartile performer in every year but one (2009) in the Natural Resources Equity category (which includes mutual funds, segregated funds, and ETFs). The four-year average annual compound rate of return of 15.3 per cent (to Nov. 30) is far superior to the category average of 4.2 per cent. However, that’s something of an apples and oranges comparison as most resource funds hold energy stocks, while this ETF does not.

The MER is 0.58 per cent, which is very good value for a fund of this type. I give it my top $$$$ rating, with the caveat that it is only suitable for investors who can handle risk. When markets turn down, this ETF can be highly vulnerable; it lost 43.6 per cent in the 12 months to Oct. 31/08. This fund would be a good choice for an aggressively managed TFSA.

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