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Choosing ETFs

It's really quite easy to narrow down the list of ETFs

Too much choice can lead to inaction. We’ve probably all experienced it and nowhere is it more evident than in the investing world. There are thousands of mutual funds and exchange-traded funds (ETFs) to choose from as a Canadian investor. It can feel overwhelming and very likely it has resulted in inaction for a lot of people. This is hugely unfortunate because the value of money sitting in cash instead of being invested is dwindled away by inflation.

When I’m faced with a decision, I need a narrow list of options to choose from. Please don’t send me to The Tile Store to pick tiles for the kitchen - I’d much rather be presented with three options that someone else has pre-vetted for me. Otherwise, there’s a big risk I’ll walk out of there having chosen nothing.

Luckily, the options to choose from when it comes to ETFs is very easy to narrow down.

Let’s look at Canadian equity ETFs, funds that invest in Canadian stocks. There are hundreds to choose from. However, most of them can be immediately removed from the pool of options. I’m talking about the sector funds, the style-focussed funds, the market cap-based funds, low volatility funds, and dividend or high yield funds. These are all non-essential ETFs that only serve to muddy the waters of a simple investing strategy.

Way too complicated

One of the most annoying things about the financial industry – from someone who had a long career in the financial industry – is how complicated it has become. Banks and investment companies are always creating new products. Why? To keep their business growing. I’ve got nothing against a business growing, but in this industry, the growth sometimes comes at the expense of its customers. By adding more and more products, regular people get confused and intimidated. It makes them feel like they need a “professional” to explain a product to them or just let the “professional” do all the work for them. It can also prompt them to throw up their hands and go out to mow the lawn instead.

It's so frustrating.

This unstoppable new investment product train started out well: to make stock market investing more accessible to more people, mutual funds were invented. Owning a mutual fund allowed you to get instant diversification with just one investment. It also gave people access to “professional money management” and “investment talent” that previously was only available to the wealthy. This was all good.

Then in 1975 the index fund was invented. This is a mutual fund that is passively-managed, meaning it simply follows a market index. The thinking was that most mutual funds couldn’t perform any better than the overall market, so why were people paying 2% or more in fees?

The offspring of the index fund was the exchange-traded fund, which emerged in the 1990s: an index mutual fund made better. The fees were lower and you could buy and sell them throughout the day, unlike a mutual fund which only trades once a day. The advent of ETFs was another giant leap forward for the average person.

And then it got messy.

ETFs that simply track an index were so boring. More importantly, we didn’t need more than a few of them since they are undifferentiated. Can you see where this is going? The banks and investment companies needed growth. They needed more customers and more money. So they got creative and started offering all kinds of ETFs, including actively-managed ETFs, covered-call ETFs, sector and style ETFs, ETFs that allow you to invest in tiny industries like psychedelics. You name it, someone’s probably offering it.

To demonstrate the point, here are two examples of ETFs that you can simply ignore.

BetaPro S&P/TSX Capped Energy™ -2x Daily Bear ETF (HED): “HED seeks daily investment results, before fees, expenses, distributions, brokerage commissions and other transaction costs, that endeavour to correspond to two times (200%) the inverse (opposite) of the daily performance of the S&P/TSX Capped Energy Index™.”

Complicated? Unnecessary? Hilarious? Yes.

BMO SIA Focussed Canadian Equity Fund ETF: “The ETF provides exposure to Canadian equity securities by actively investing using relative strength. The strategy is unconstrained and provides high conviction by investing in a focused portfolio.”

As a former mutual fund analyst, I understand (basically) what this means. Does the non-ex-mutual fund analyst understand it? Not a chance. Does it do better than the overall Canadian market? In some years it does and in some years it doesn’t. It’s unnecessarily complex.

You only need one kind of Canadian ETF

The point is this: you don’t need all of this complicated messiness. Of the thousands of ETFs available in Canada, you can ignore at least 90% of them (and that might be an understatement). For your Canadian stock exposure, all you need is an ETF that tracks the S&P/TSX Composite Index. How many of those are there? A handful. Are they identical? Nearly. Does it matter which one you choose? No. Whether you choose the iShares, BMO, or Horizons version of the ETF, you’ll do fine.

What about the other popular Canadian option, the high dividend yield ETF? If you’re looking to earn an income stream from your investments, this might make sense for you. But it you’re not, just stick with the one that tracks the S&P/TSX.

Another favourite seems to be the bank ETFs. These are funds that give you exposure to the Canadian banks. The banks have been pretty good long-term investments, but that doesn’t mean you should make a big bet on them. The broad-market ETF has 30% exposure to financials anyway, most of which are banks. You really don’t need more.

As for all the other Canadian equity ETFs, you can look away. You don’t need an Energy ETF, or a mid-cap ETF or a value ETF. When you buy one of these, you’re making a bet that one segment of the market will do better than the rest. As I’ve discussed many times, this is a fruitless endeavor that should not be undertaken by the average do-it-yourself investor.

Despite the huge number of ETFs available, narrowing down the choice is easy. The same applies for a U.S. fund that tracks the S&P 500 and international ETFs. There are really just a few and it’s easy to pick one. Have a look at the MoneySense Best ETF list – you’ll see a small set of “best ETFs” in each asset class. Any of these will do fine. You can also have a look at my list.

Don’t be fooled by the vast array of ETFs available – focus on very a narrow sub-set and get invested. It’s that easy.


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