ETFs are cheaper alternative to mutual funds

The spectacle of markets reaching ever higher levels should give you a feeling of queasiness, not giddiness, if you plan to buy stocks in 2006.

After all, if you're a buyer, you want prices to go down, right? U.S. market watcher James Grant, one of America's most elegant chroniclers of investing folly, put it nicely in the most recent issue of Forbes: "When investing this New Year, resolve to underpay."

That brings us to a new set of funds introduced just before Christmas by Barclays Global Investors Canada Ltd.

Barclays, purveyors of the iUnits family of exchange-traded funds, brought out four new ETFs that track some of the hottest investments in Canada in recent years.

Barclays' new offerings trade on the Toronto Stock Exchange and track the performance of Canadian materials stocks (essentially mining, forestry and steel), income trusts, dividend stocks and real-return bonds. Details can be found at www.iunits.com.

In keeping with our New Year's resolution to try to buy low, or at least lower, we're going to exercise caution in buying these funds at current prices. That's because all four indexes tracked by the ETFs have enjoyed strong price appreciation in recent years.

The S&P/TSX Capped Canadian Materials Sector Index has produced a 16.2-per-cent annual compound return over the last three years; the S&P/TSX Capped Canadian Income Trust Index has returned 31.9 per cent in the period; the Dow Jones Select Dividend Index has returned 23 per cent; and the Scotia Capital Real Return Bond Index has returned 15.2 per cent.

Those number suggest richly priced markets, but the creation of the funds is still very good news for investors.

That's because ETFs offer advantages over regular mutual funds that have made them among the most popular investing innovations in the last decade. Globally, there are now more than 400 ETFs covering every conceivable geographical and asset segment. The assets in these funds total more than $400 billion U.S., a ten-fold increase over the last five years.

A big part of their appeal is that ETFs are so much cheaper than the principal alternative: actively managed mutual funds.

An investor who goes by the moniker Bylo Selhi notes that the new ETFs offered by Barclays have management fees that are about one-fifth of what you would pay for an actively managed mutual fund in the same market segments.

That's huge, especially when you consider that most actively managed mutual funds fail to beat their benchmark index in any given year.

Montreal investment counselor Keith Matthews said the new ETFs are a welcome addition to the portfolio-construction tool box.

"You have to decide whether this is the right time to add these asset classes given they've all done extremely well in the last few years," said Matthews, author of Empowered Investor: A Guide to Building Better Portfolios. "But the point is that these new products offer investors alternatives to regular high-expense mutual funds. And that's great."

Among the less well-known asset classes represented in the new ETFs is real-return bonds fund. RRBs are issued by governments and pay a return that is adjusted for inflation, thus protecting the purchasing power of an investor's money.

They've become a popular investments, especially in RRSPs where they are best held for tax reasons.

But the yields on RRBs, not including the inflation portion, have dropped to less than 1.5 per cent from three per cent a couple of years ago. That's led to a debate over whether it's better to purchase short-term bonds in hopes the yield on RRBs will improve with time.

Bylo Selhi, who operates an excellent investing site at www.bylo.org that includes a section on RRBs, finds the yield too low for his taste and he's shying away from buying RRBs.

He readily acknowledges there's no way of knowing if or when yields will become more attractive. The same goes for knowing when prices will come down in income-trust and dividend-stock markets.

That's why patience is so important in the stock market and why it's so hard to keep a resolution to buy low.

dmacdonald@thegazette.canwest.com