Our criteria and the 4 types of ETFs

We previously mentioned the 4 types of ETFs, according to the classification system of the TSX. Which of these types of ETFs meet our criteria?

Before viewing the matter in detail, you should know that there are writers who believe that it is misleading to label as ETF’s funds that do not follow an index tracking approach; see IndexUniverse.com . For our site, the basic investments of the typical self-investor are common shares (i.e. equity) and plain vanilla bonds, and any other investment should be considered in the in the alternative investments category. ETFs other than those that invest in a traditional portfolio of equity or bond securities should be treated as alternative investments. If you agree with this conclusion, consider our criteria for alternative investment (for more, see Alternative Investments- Asset classes and individual investors on our site):

• They are securities which can be traded at a limited cost.
• They represent a category of assets, such as an index fund.
• With respect to products such as hedge funds, metals and commodities, the investor should limit himself to those categories for which he has a personal expertise.
• They add an important and different characteristic to a portfolio.
• The return depends on the performance of a market (rather than on active management for which an individual is not equipped).
• They form part of the broad deep investable market.

The recommendation of our site is not to invest in alternative investments that do not meet these criteria, unless you do so in small quantities, using what we call your pocket money; see the section Pocket Money on our site.

Index tracking approach

This is the classic type of ETF. The typical fund in this category attempts to effectively replicate a global market, or at least a major recognized benchmark. The premier ETF in this category is undoubtedly the Barclay's XIU fund. Why? It aims to replicate the well known S & P / TSX 60 index (the 60 largest companies listed on the TSX), it has a super low MER (0.17%), and it has the highest asset size and trading volume in the category. For bonds the largest ETF in the category is Barclays XBB ($ 1.2 billion in assets and a MER of 0.30%). Another fund with a even lower MER (0.15%) is the Claymore CLF fund that invests in government bonds with a maturity of up to 5 years, but it’s much lower asset size ($174 million) makes us hesitate.

Inverse approach

This type of ETF is designed to take advantage of declining markets. For us it represents a speculative, short term technique. We don’t consider this type of fund to be appropriate for an independent investor who invests for the long term in order to build up a retirement portfolio. If it is considered as an alternative investment, it does not meet our criteria. Leave it for speculators and day-traders

Leveraged approach

These ETFs use a leveraged approach to create a fund based on an underlying index, and then employ leverage strategies in order to enhance the returns of the fund (as measured daily). They often use a variety of derivatives such as futures contracts and index swaps. These funds (as well as inverse approach funds) have been the subject of criticism or warnings from various sources, including from Fair Canada , and IRROC ( which regulates brokers in Canada). In the USA, see the notice by Massachusetts authorities and by FINRA (the association that regulates brokers in the USA).

These funds also have technical defects which makes them often fail to achieve the goals they have set themselves; see MacDonald Canadian business 2009 doc.1384 and Elston et al 2005 doc.1385; ETFDB.com ; MichaelJamesMoney.blogspot.com ; and AccruedInterest .

In summary, for us these are not products for the investor who is buying for the long term; see ETFtrends.com . If it is considered as an alternative investment, it also does not meet our criteria. As a comprehensive article doc.1386 (or direct link here ) analyzing these products in detail by IndexUniverse.com states:

Given all the complexities of geared ETPs, we think they are most appropriate only for speculative investors and short-term traders who truly understand all the moving parts that affect the total return of geared ETPs.

Active management approach

The most recent invention of ETF sponsors is the ETF that takes an active approach to asset management. For us it is the antithesis of an ETF (remember: investors went into ETF’s in the first place to get away from active management). It is likely that these new funds will quickly develop the weaknesses associated with managed actively mutual funds; see actively managed mutual funds on our site. Readers of our site know that we believe that the chances of an independent investor successfully beating the market over the long term (or identifying in advance a manager who will do it for you) are very poor; see Beat the market? on our site.

Conclusion

This article gives you the references needed to find yourself among the ever longer list of ETFs available in Canada (in a future commentary we expect to repeat the exercise for ETFs traded in the USA. Our overall recommendation: limit yourself to ETFs that track a well known major index, and within this category choose ETFs taking into account management fees, fund size and the other criteria we have identified for you.