In the current environment, some investors may be reluctant to invest significant amounts in the market. However, investing only a limited amount can make it difficult to achieve the diversification necessary to lower the level of risk on your portfolio.

Exchange Traded Funds (ETFs) are a good solution to this problem because they can allow you to diversify your portfolio with relatively small investment amounts. The range of ETFs available includes almost every asset class (ex: stocks, bonds, currencies, commodities, real estate) and sector. A single ETF can provide exposure to market segments, track a specific group of stocks or attempt to imitate the returns of a country.

ETFs are investment funds that replicate the behavior of an underlying index using a variety of replication methods:

Physical replication: Over 90% of the securities that make up the index are held, taking into consideration their weighting in the index. Returns will therefore be very close to those reported by the index (less management fees).

Optimized replication, using sampling: less than 90% of the stocks that make up the underlying index will be held. However, the ETF must replicate the features of the index and attempt to generate an identical return.

Synthetic replication: derivatives (swaps or futures) are used with the aim of reproducing the returns of the underlying.

ETFs also differ in their dividend policies. Some ETFs pay out the dividends or coupons generated by their underlings, while others automatically reinvest them into the ETF, in which case you receive the return on your investment as a capital gain when you sell your shares.

So ETFs can provide investors with a vast array of choice and are especially useful for diversifying a portfolio, but what other advantages do they offer?

• Most ETFs can be traded throughout the day (much like stocks) and are therefore very liquid (in contrast to mutual funds, which are valued at the end of the day based on Net Asset Value);
• ETFs generally have lower expense ratios than mutual funds;
• Investors with little experience can easily find ETFs that track the broader market.

However, while the specific ETF feature of passively replicating changes in an index leads to a lower expense ratio, it also means that, unlike actively managed funds, there is no manager to carefully shield investments in case of a sudden downturn. Investors considering ETFs need to be aware of the specific risks associated with this type of investment:  

Market risk: ETFs are exposed to the market risks of the financial instruments they contain.

Counterparty risk: Synthetic replication strategies, which use derivatives, bear a risk of default on the part of the counterparty (i.e. the issuer of the performance swap). In addition, some physical replication ETFs use securities lending to reduce running costs, which results in counterparty risk because the borrower may become insolvent and may not be able to return the securities.

Liquidity risk: While ETFs are traded on the stock exchange and can be traded throughout the day, the quantities available for purchase or sale may prevent your transactions from being executed at the desired price.

Management risk: The risk of a discrepancy between the performance of the replicated index and the ETF. This risk is greater with synthetic replication than with physical replication.

Currency risk: If an ETF is linked to a foreign stock market index or a commodity traded in a currency other than your reference currency, your gains may be affected by exchange rate fluctuations. Some investors may want to consider ETFs that offer hedging against currency risk (referred to as “currency-hedged ETFs”).