The prospect of a trade war has rattled global financial markets, including the shares of Canada's many export-driven companies such as those in the auto-parts, railroad and resource industries.

Canada's benchmark share index <.GSPTSE> has dropped 4 percent this year, compared with a 0.5 percent gain for the MSCI World Index <.WORLD>.

"Whatever we own we try to make sure that they won't be too disrupted by trade," said Steve Belisle, senior portfolio manager at Manulife Asset Management. "In some cases because they have (production) capacity in the U.S."

Belisle name-checked transit bus and motor coach company New Flyer Industries Inc , which manufactures in the United States.

Rather than plunge into defensive sectors such as utilities and telecom, investors are sticking with companies that will benefit from global economic strength and looking for ETF-related arbitrage opportunities. They are weeding out stocks that could be hurt most if the outlook for free trade does worsen.

"We have been holding slightly elevated levels of cash, and have been deploying selectively on big down days in the past month," said Mike Archibald, associate portfolio manager at AGF Investments, adding that Canadian autos continue to represent a risky part of the market.

Stocks that Archibald has bought include mattress retailer Sleep Country Canada Holdings Inc, which targets the domestic market. Its shares jumped after reporting strong fourth-quarter results last week.

A number of countries, including Canada, have threatened to retaliate against planned U.S. import tariffs on steel and aluminum. Canada, the largest supplier of both metals to the United States, is also contending with the potential collapse of the North American Free Trade agreement.

At AIP Asset Management Inc, portfolio manager Jay Bala looks to take advantage of the potential different pricing of the same securities as investors rush to exit exchange traded funds, such as the iShares S&P/TSX 60 Index ETF, which hold some stocks that could be affected by tariffs.

"More aggressive investors could short the ETF and buy the stocks or sectors which have not been impacted," Bala said.

Investors are also assessing the potential for tariffs to boost inflation and push bond yields higher even if economic growth slows.

"You have to be careful where you want to hide because you don't want to be hiding in areas that are going to be hurt due to the higher rates," said Greg Taylor, portfolio manager at Redwood Asset Management.

He favors banks, such as Toronto-Dominion Bank and Royal Bank of Canada, that could benefit from a steeper yield curve and have U.S. operations.

"They are going to be more immunized from a trade war if they are already doing a lot of U.S. business directly with Americans," Taylor said.

(Reporting by Fergal Smith; Editing by Denny Thomas and David Gregorio)

By Fergal Smith