Q&A: Investing in ETFs

Question: I have a question regarding index investing and buying ETFs. While the stock markets (or broad-based ETFs) have gone up and down throughout the years, what are the chances of an index that never fully recovers? The best example is the Japanese Nikkei Index which crashed in the 1990s and never fully recovered. It’s been something like 20 years and the index is still the same. What are the chances of this happening to the TSX, S&P, etc.? Having said that, wouldn’t buying an index ETF be a bad investment choice? – Chris C.

Gordon Pape answers: Yes, that sort of thing can certainly happen. And the Nikkei is not the only example. The S&P 500 has been in a prolonged slump as well. In fact, the iShares S&P 500 Index Fund (CAD-Hedged) that I have recommended for the new TFSA portfolio showed an average annual loss of 0.54 per cent over the 10 years to the end of February.

Based on recent history, you would not want to invest in this or any other non-Canadian ETF except for those tracking emerging markets. However, the past doesn’t tell us about the future. U.S. stocks outperformed Canadian issues in 2011 and are continuing to do so thus far in 2012. So some diversification out of Canada should be an important part of your investment strategy at this time.

Whether this is done through ETFs, mutual funds, or individual stocks is a matter of personal preference. An increasing number of investors are dumping mutual funds in favour of ETFs because of their lower carrying costs. ETFs also make it easier to obtain broad portfolio diversification, which is especially important where the amount of investable capital is relatively small.

ETFs are not perfect, however. Because they are index-based, their returns will mirror what the benchmark is doing. If it crashes, so will the ETF — the manager does not have the option of retreating to cash or more defensive stocks. As a result, an ETF will tend to be more volatile than a conservatively managed mutual fund that benchmarks the same index.

That does not make ETFs a bad investment choice but you must keep a close eye on these securities and be prepared to exit quickly if markets begin to head south.

Photo ©iStockphoto.com/ Simon Smith

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