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Reducing portfolio risk with ETFs

With increasingly innovative ETFs on the market, risk management has never been easier.

 

Date: February 13, 2018

With a stock market as hot as this one, it’s easy to forget that when it comes to investing, what goes up must come down. At some point, this eight-year bull run will reverse, and many investors could be in for a rude awakening.

Even though markets are reaching record highs – the Dow Jones Industrial Average hit 26,000 for the first time in mid-January – investors can’t forget about risk management, one of the most important, but often neglected, aspects to investing.

“Different factors can increase portfolio risk, such as economic, political and geopolitical issues, weather and high valuations,” says Michael Cooke, Senior Vice-President and Head of Exchange Traded Funds for Mackenzie Investments. “The prudent approach is to diversify a portfolio across the different risk factors. You can then mitigate downside risk and keep more of your capital working for you over the long term.”

Fortunately, protecting a portfolio has never been easier. Over the last few years, numerous exchange-traded funds (ETFs) have come to market that enable investors and their advisors to create diversified, risk-mitigating baskets of securities for a low cost.

Know your tolerance

Every investor approaches risk differently, says Cooke. Some people are fine with putting their money in the riskiest of assets and can tolerate a big loss. Others can’t handle more than a minimal decline. Most are somewhere in between, but it’s up to the individual to decide where they fall on the risk spectrum.

“Investment risk is a personal thing,” says Cooke. “It’s a function of age, time horizon, investment objectives and other factors. But it’s also about becoming comfortable, and mindful, of your level of risk tolerance.”

Determining your risk profile can be challenging – you may not know how much you’re prepared to lose until the market falls – but talking to an advisor can help.

Once you’re comfortable with your risk profile, you’ll have to build a portfolio that suits your tolerance level. This is the most important part of the investment process, as studies have found that more than 90 percent of a portfolio’s volatility and risk is related to its asset mix, says Cooke. If the asset mix is off, then losses could be greater than what you had anticipated.

Lower your risk profile with ETFs

ETFs are an ideal risk-management tool for several reasons. First, they’re instantly diversified, so you don’t have to worry about one stock sinking your portfolio. They can also be bought and sold at any point during the trading day, just like stocks, which adds additional flexibility to a portfolio, says Cooke. Most are also highly liquid, transparent and low-cost.

“They’re a very efficient asset-allocation tool,” he says. “You can have complete discretion when buying or selling them, and you can see what they hold. They can be effective for diversification.”

You’ll likely want to start building your portfolio with more traditional index-tracking ETFs, such as a fund that follows the S&P 500 or S&P/TSX Composite Index.

But while owning a Canadian, U.S. and international fund will give you a diversified portfolio, holding only traditional ETFs carries some risk.

For instance, a basic Canadian ETF will be heavily weighted to energy and financials.

“Investing in the stock market broadly creates certain non-diversifiable risks,” says Cooke. “So, there is some inherent risk in stock market investing. What you can do, though, is increase diversification in the portfolio, but doing it so it’s still in line with your own preferred asset mix.”

Add smart beta

One way to increase diversification is to incorporate smart beta ETFs into your asset mix. These funds combine active investing strategies, such as value, dividend and momentum, with a passive fund structure.

You’ll still get the same benefits as you do with traditional ETFs – intraday trading, low fees and liquidity – but you can now take advantage of a more specific strategy. For instance, if you prefer value companies, you can purchase a smart beta product that only holds value stocks. If you want to add dividends to your portfolio, you can buy an income-oriented fund.

If you’re worried about being overly exposed to two Canadian sectors, then something like Mackenzie’s Maximum Diversification Canada Index ETF, which has a higher weighting to consumer discretionary and staples stocks than its passive peers, could help reduce concentration risk, too, says Cooke.

Incorporate active ETFs

Those who want to mitigate risk further may want to consider adding active ETFs to their portfolio. Like mutual funds, these securities hold stocks chosen by managers, but they trade in the same way as an ETF.

Mackenzie recently launched four active ETFs, including one based on its Mackenzie Ivy Team, which is known for running high-conviction portfolios of 20 to 25 stocks, and one fixed-income ETF, with bonds chosen by managers.

“By being actively managed, a portfolio would include uncorrelated assets,” says Cooke. “Managers can find picks that can beat the market or implement risk-mitigating strategies.”

Clearly, there are many ways to create a portfolio and take on as much or as little risk as you want. When it comes to risk management, especially in today’s market, having flexibility is key.

“The best practice for investors is to use all these kinds of ETFs,” says Cooke. “You can build better outcomes by using the tools we have at our disposal.”

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