Although the underlying principles for using exchange-traded funds to build a balanced RRSP portfolio for your clients are no different than if you were using mutual funds to achieve the same objective, the increasingly popular ETFs provide added choice and fewer costs.

Much as with mutual funds, you still have to take your client’s investment objectives, risk appetite and time horizon into consideration when determining the most appropriate mix of ETFs, advises Vikash Jain, vice president, portfolio management, with archerETF Portfolio Management, a division of Oakville, Ont.-based Bellwether Investment Management Inc.

The main difference between the two product categories, says Lou D’Aversa, senior financial consultant with Ottawa-based MD Management Ltd. in Toronto, is that “ETFs provide a more efficient, largely passive solution for portfolio construction.”

Essentially, an ETF consists of a diversified basket of securities, just like a mutual fund. But unlike mutual funds, ETFs are listed and traded on stock exchanges, providing intraday liquidity at current market prices. ETFs also have significantly lower fees than mutual funds and are more transparent because their holdings are disclosed daily.

There are more than 200 ETFs listed on the Toronto Stock Exchange and almost 3,000 listed globally. An ETF may track a broad underlying index or benchmark, such as the S&P/TSX 60 index, the S&P 500 composite index, the MSCI world index or the DEX universal bond index. In addition, an ETF also can mirror the performance of specific market sectors, such as energy or financials, or be linked to currencies or commodities, such as oil and gold.

Although most ETFs use a passive investment strategy by tracking the performance of a benchmark, more actively managed ETFs that seek to outperform the relevant benchmark are a relatively new development. These ETFs may use derivatives-based strategies to achieve their objectives.

Basically, says Tyler Mordy, director of research with Hahn Investment Stewards & Co. Inc. in Toronto, ETFs provide “structured eclecticism” or diversity with “rigorous risk parameters” and “open up different asset classes that were traditionally out of reach of average investors.”

Put simply, says D’Aversa, “They make available just about every geographical region, industry sector and specialty categories to investors.”

This means your clients have a wider range of options for building balanced portfolios. More important, says Mordy, clients receive diversified exposure to all of the securities comprising the specific index that the ETF is tracking in a single transaction.

However, D’Aversa warns that as simple as building a balanced, ETF-based RRSP portfolio may appear, the depth and breadth of ETF options “can make the selection process complex.”

And although Jain suggests you need only about five or six ETFs in such a portfolio, he cautions that some ETFs — those using futures contracts, leverage and inverse leverage — are designed for short-term trading and are not necessarily suitable for longer-term RRSP portfolios. In addition, he says, “The average investor really does not understand how they are constructed.”

For example, Jain cautions that clients may assume that investing in a crude oil-based ETF, which uses futures contracts as its underlying investment, will provide the same return as that of the commodity. But, as a result of the pricing differential between the future contracts and the spot price of oil, the return on the ETF will not reflect the current price of oil. Jain points to iPath GS Crude Oil ETF, which trades on the New York Stock Exchange: the price of crude oil is currently more than 50% higher than it was five years ago, but the ETF is down by almost 40% over the same period.  IE