As with all types of investing, it is wise to read the prospectus and the fund fact sheet for any particular ETF, which are generally available on the ETF providers’ websites and www.SEDAR.com, providing detailed information on the ETF’s investment objective, strategy, risks, costs and historical performance (if any). Investors must then determine whether those objectives are consistent with their goals and whether the risks associated with a particular ETF are within their risk tolerance. It is also wise to seek the advice of an investment professional prior to making investment decisions. Together with your legal, financial and tax advisors, the following are some preliminary questions you may wish to ask when considering ETF investing.
1Do I understand what is under the hood?
Investors should understand what they are getting exposure to through an ETF and how. The level of risk and return of an ETF depends on the type of fund and what it invests in. You should understand the methodology of the underlying index or benchmark the ETF tracks. An index-based ETF may not achieve the same return as the index it tracks because the weightings of investments in the ETF may not be exactly the same as those in the index, and fees and expenses could lower the return. If you are interested in investing in certain sectors or asset classes through ETFs, you should be aware of the market cycles and risk factors related to that area of the market. ETFs will generally mirror the underlying market fluctuations of the investments they hold. Commodity ETFs tend to be higher risk because they are concentrated in one sector and the prices of commodities can vary greatly. Don’t invest in something you do not understand – if you cannot explain the investment succinctly, you may need to reconsider it as a potential investment.
2Do I understand the concept of tracking error?
Tracking error is inherent in all ETFs. It is a measure of how closely the fund tracks the index to which it is benchmarked. Tracking error is the difference between the performance, based on net asset value (NAV), of the fund and the performance of the index to which it is benchmarked. It is the difference between the percentage change in the NAV of the ETF and percentage change in the underlying index. Theoretically, in a perfect ETF, tracking error beyond the management expense ratio (MER) would not exist – fund performance would be identical to index performance. Generally some tracking error exists. You should check whether the ETF you are considering has a significant tracking error or history of significant tracking error and whether this is material. Various factors affect how well an ETF tracks its underlying index. One is the MER – generally, the higher the MER, the more likely a higher tracking error. Large, liquid funds may have tracking errors equal to their MERs. Another source of tracking error is the result of a sampling strategy whereby there is a gap between the composition of the ETF and that of the index. This type of tracking error is common in fixed income ETFs.
3Is the ETF Leveraged?
If so, you should be aware that, while your returns may be magnified when the investment goes up in value, your losses will conversely be magnified when the investment goes down in value, and these losses will be compounded if your holdings are not rebalanced on a daily basis. Leveraged ETFs are highly sensitive to market volatility. As a general rule, if you do not actively manage your portfolio on a daily basis, or if you do not understand the concept of leverage and daily rebalancing, these ETFs are not a good choice for you. Leveraged ETFs are generally not suitable for investors who are looking for investment which they plan to buy and hold for a longer period of time – unless they understand the added risk leverage represents, and accept that their ultimate returns may vary meaningfully from that which the daily leverage level suggests when held over any period exceeding one day.
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