Savvy investors love this investment tool

There’s one thing most investors have in common: A hatred for high fees. So it’s no surprise that assets in exchange-traded funds — a low-cost mutual fund alternative — have grown by an astonishing 90 per cent per year over the last decade.

Doug Morrow is just one of many investors who moved his savings from mutual funds to ETFs. The 34-year-old consultant began buying ETFs four years ago, after he left his advisor and opened an online brokerage account.

“I found them to be transparent and cheap,” he says. “It was an easy way for me to manage my portfolio.”

Exchange-traded funds were invented 20 years ago in Canada to enable investors to buy into a fund that follows an index.

Unlike mutual funds, where portfolio managers create a basket of stocks based on research and analysis, an ETF often holds a bit every stock on a particular exchange.

ETF investing is often called passive investing because there’s no manager actively choosing the stocks.

An investor who wants exposure to the Canadian market would buy a fund that follows the S&P/TSX Composite Index. If the index returns 14 per cent, the ETF’s return would be about the same.

Because a portfolio manager isn’t involved, management fees are much less expensive — often between 1 per cent and 2 per cent lower than mutual funds.

It can also be traded like a stock, and, while the point is generally to hold broad-based ETFs inside a long-term portfolio, more sophisticated investors can easily buy and sell these investment vehicles.

The biggest difference between an index fund and an ETF is the frequency with which they are priced and traded. Index funds are mutual funds, and, so are priced once a day after markets close.

ETFs are priced throughout the day, and can be bought or sold whenever the markets are open.

Index mutual funds are priced based on the underlying securities, whereas the price of an ETF depends on supply and demand for the security.

Dan Bortolotti, who runs the ETF-focused blog Canadian Couch Potato, says, generally, actively managed funds have trouble beating the index.

Even if a manager outperforms an index, high MERs eat into returns. His own ETF portfolio has a total MER of 0.29 per cent — about 90 per cent lower than most conventional mutual funds.

The cheap fees mean one thing: More money in an investor’s pocket.

Morrow’s portfolio, which holds seven ETFs and has an MER of 0.36 per cent, returned 9.1 per cent in 2010.

“That’s pretty much what a globally balanced portfolio saw,” he says. “I was very happy with that.”

ETF investing is best suited for advanced, do-it-yourself investors who can stomach volatility, cautions Robert Abboud, an Ottawa-based financial advisor and author of No Regrets: A common Sense Guide to Achieving and Affording Your Life Goals.

“ETFs are for people who can understand how markets work and won’t panic and sell during difficult times,” he says. “An average investor that sees their portfolio drop by 30 per cent will not be able to hold on.”

Bortolotti agrees. Most investors buy and sell ETFs using a discount broker and that can make things complicated for the novice investor.

“This is probably not for the first-time investor who has zero experience,” he says. “You have to have a bit of familiarity with a discount brokerage.”

Once that hurdle is crossed, ETF investing is fairly easy — as long as people stick to the basics.

Bortolotti suggests buying no more than 10 name-brand ETFs.

Because these funds often hold hundreds, if not thousands of stocks, an investor can be well diversified by owning by owning just four.

At the very least, investors will want to own ETFs that track the main Canadian, U.S. and European indexes, as well as a bond ETF, to serve as the fixed-income part of a portfolio.

Investors should watch out for more exotic ETFs. Over the last few years many idiosyncratic funds have been created to attract savvy investors, such as PowerShares Water Resources Portfolio, which focuses on water-related companies.

If an investor is dead set on jumping into a particular sector or country, it may be wise to buy a technology sector ETF, rather than a few tech company stocks.

“If you believe that tech. is the palace to be, you can try and determine which of several tech. stocks to own or you can buy the whole sector,” says Howard Atkinson, president of Horizon Exchange Traded Funds and author of The New Investment Frontier: A Guide to Exchange-Traded Funds for Canadians. “If you get that one tech. stock wrong, you’ll get hurt; if you buy a basket and that one poor performing stock is in there, you can still do well.”

If past growth is any indication, ETFs will continue to do well in 2011. While no investment vehicle is perfect, many people, like Morrow, will likely never buy a mutual fund again.

“There is some criticism out there, but nothing anyone has said has changed my mind,” he says. “For typical retail investor, these really are the preferred investing tool.”