These ETFs will wrap up your investments

ROB CARRICK
November 29, 2008 at 12:17 AM EST

Two of the biggest investing questions as we head into year's end: When will the stock markets start to recover, and how will the financial industry get people to invest in the meantime?

The first question can't reliably be answered. As for the second one, the country's biggest player in exchange-traded funds is going with wrap products.

The iShares family of ETFs from Barclays Global Investors was expanded earlier this month to include a series of four funds called Portfolio Builders. Two of the new funds offer a balanced portfolio in a single product, while the others are designed to cover off significant portions of a diversified portfolio. Each is built using iShares ETFs listed in Canada and the United States (global ETFs may be added later).

There's lots to criticize about wrap products, which are about wrapping up all or much of your investment needs in a single fund that is built of other funds. Wraps tend to be pricier than selecting individual funds, and they box you into giving a single company all your business when this may not be earned. And yet, the bear market is making a case for wraps.

The main argument in favour of wraps is that they provide full or partial portfolio diversification. The weak spot in the portfolio of too many individual investors, and this includes both do-it-yourselfers and people using advisers, is excessive exposure to the stock markets.

This has become painfully apparent in the market plunge of 2008. Even balanced portfolios have been whacked, but those with most of their assets in stocks or equity funds have taken staggering losses. Investors may have thought they understood the downside risks of a stock-heavy approach, but the events of the past several months have been far worse than almost anyone imagined.

Building a diversified portfolio – stocks, bonds and cash in proportions linked to your age, goals, risk tolerance – is not complex. But wraps make it easier.

The iShares Conservative Core Portfolio Builder Fund offers a way to quickly and easily buy a portfolio that is almost two-thirds weighted to bonds with the rest mainly in stocks. The growth version in the Portfolio Builder series offers a rough 60-40 breakdown between stocks for the most part and bonds.

These two funds are designed to account for all or most of a small-size account, while the other two Portfolio Builder funds are more complementary. The iShares Global Completion Portfolio Builder Fund is meant for investors who own primarily Canadian bonds and stocks. Presto, instant global diversification. The iShares Alternatives Completion Portfolio Builder Fund is for people with conventionally diversified portfolios who want exposure to “alternative” assets such as commodities, gold, infrastructure and real estate.

You can find comparable wraps from most any big mutual fund family, from the online bank ING Direct and from a competitor to Barclays in the ETF sector, Claymore Investments. Two key considerations in choosing between them are price and methodology.

Fees for the Portfolio Builder funds contain some padding beyond the underlying ETFs, but they still beat the competition. The management expense ratio for the conservative and growth portfolios is 0.6 per cent, which compares with 0.68 per cent for a competing income-oriented ETF wrap from Claymore and 0.84 for Claymore's growth ETF. ING Direct's StreetWise funds have an MER of 1 per cent, while mutual fund wraps can run anywhere from 2 to 2.5 per cent. Of course, fund wraps have built-in fees that flow to the investment advisers who sell them, whereas ETFs do not (except for a special series of Claymore ETFs).

In terms of building its wrap ETFs, Barclays says it uses blueprints created by in-house experts who manage investments for institutional investors such as pension funds. What you get with these four funds is a mix of iShares ETFs that trade on Canadian and U.S. exchanges. And what a mix it is. The conservative fund has 16 underlying ETFs, and the growth fund has 21.

Yes, there is such a thing as overdiversification, where overall returns are watered down by spreading assets in a wide but thin manner. But Barclays says there's a benefit to each holding in terms of balancing risk and return.

“This is a very sophisticated, institutional allocation,” said Heather Pelant, head of iShares for Barclays Canada. “It's designed to maximize return for a given level of risk.”

Competing wraps typically have fewer moving parts. Claymore's income wrap has nine component ETFs, while the growth version has 10. The StreetWise wrap product from ING Direct is based on just four underlying index mutual funds.

Both the Barclays and Claymore products strive for a more sophisticated, active approach than StreetWise's approach of using just Canadian bonds and stocks plus U.S. and global stocks. The iShares conservative and growth portfolios both include ETFs with exposure to commodities, emerging markets, real estate investment trusts, inflation-protected bonds (also known as real-return bonds) and infrastructure stocks. The Claymore Balanced Growth Core Portfolio includes exposure to water, gold, natural gas and BRIC (that's Brazil, Russia, India and China) ETFs in the Claymore family.

Wraps should reduce the risk of being caught in big market declines through their diversification. But in providing this diversification, the iShares portfolio builder ETFs expose you to varying amounts of currency risk. This is the danger of having a rising Canadian dollar erode returns (or worsen losses) from investments in other currencies.

You get both hedged and unhedged exposure to the U.S. and international markets in the conservative and growth ETFs, which seems a reasonable approach. But many of the ETFs these funds use to provide enhanced levels of diversification are listed on U.S. exchanges and thus unhedged. They could be a drag on the overall portfolio if the Canadian dollar were to rebound from its recent decline against the U.S. dollar.

Trading volumes for the two Claymore wrap ETFs are very low, which tells us that investors have not embraced these products. That's no surprise because do-it-yourself investors are independent minded, and wraps are about letting the experts take over for you.

Should you consider giving way to the experts? Your returns in the current bear market will help answer this question.