Chris Kuflik - ScotiaMcLeod Montreal

With the arrival of 2011, many have made, and hopefully not broken their New Year's resolutions. In recent conversations with clients, some have made the decision to improve their knowledge and use of Exchange Traded Funds (ETF’s) for the foreign content portion of their portfolios. This resolution will help them improve their returns and diversify risk. With almost 1,000 different ETF’s available on North American exchanges, which is five times more than were available to investors in 2005, keeping this resolution could be a daunting task without help. 

The exponential growth of the ETF industry has been due in large part to their use by pension funds and other institutional investors. The ETF industry in North America has grown to over one trillion dollars in assets. The transparency of ETFs and high average daily trading volumes, over 1.4 billion shares, have also contributed to the widespread acceptance of these investment products.

Much of the popular press regarding equity ETF’s has focused on the cost and diversification advantages of these investment products. Investors need to be aware of the different construction of each equity ETF prior to investing. Those that are cap-weighted, meaning that the weighting of each security is based upon the value of the component’s equity value (the number of shares outstanding multiplied by its price), can lead to an investor owning a large percentage of their funds in one stock. Probably the best example of this occurred in the Nortel heyday at the turn of the century where Nortel’s value represented over 35% of the value of the TSE 300. So much for diversification! These market cap weighted indices also have a tendency of overweighting overvalued stocks and underweighting undervalued stocks. Other ETF’s are constructed using various other weighting methodologies, such as dividend weighted or equal-weighted funds, where each equity in the index has the same amount of money allocated to it.  The returns due to the different weighting methodologies can be quite substantial.

While many of the western economies are experiencing slow growth, other economies continue to grow at substantial rates. These high growth emerging economies, which have both favourable demographics and an emerging middle class, can be accessed with ease, lower costs and less risk than individual equities through ETF’s. The greatest problem facing most investors is which ETF to use for their exposure to achieve the maximum return. There has been a great deal of press regarding the BRIC (Brazil, Russia, India and China) countries. This press suggests that these countries will outperform in the coming years.  Yet an investment in either one of the largest and most popular ETFs for Brazil (EWZ) and China (FXI) at the beginning of 2010 and held for the year failed to produce positive returns for the investor. It should be noted that both these ETFs invest in large capitalization companies in those countries and are cap-weighted.  Had the investor instead purchased small cap ETFs for these countries, (BRF) for Brazil and (HAO) for China, he/she would have realized positive returns.

The question remains, how can we identify which ETF should be used at a given point in time? The answer lies in both relative strength calculations and technical analysis. Relative strength measures the price performance of one investment versus another. It allows us to determine which ETF should rise more in an up market and decline less in a down market. In addition, it allows us to evaluate which countries, asset classes (large, mid or small capitalization), and investment styles, (growth or value) should be used for maximum risk-adjusted returns. Relative strength helps us to identify trends in the market which can last for weeks to years.

Technical analysis, the second part of this simplified example for identifying those ETFs to consider for investment, helps answer the question of the timing of the purchase and more importantly, the sale of the investment. We use point and figure technical analysis, which unlike many other forms of technical analysis, provides its user with clear buy and sell signals. Point and figure charting was originally conceived by Charles Dow, (yes the Dow Jones Industrial Average takes its name from him). Dow used this form of technical analysis to identify whether a stock should be purchased or sold. We use a US-based subscription database which provides us with the ability to sort through the mountains of data for most assets globally. This company has provided this information to institutions for over three decades. There are very few Canadian wealth advisors who use this time tested superior performing analysis in their practices.

Please feel free to share this article with someone that you feel would benefit from its contents.

Chris Kuflik

Associate Director, Wealth Management

Wealth Advisor

514-287-2931

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Visit our website at www.chriskwealth.com

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