July, 2009
The Second Opinion: Exchange Traded Funds (ETFs)

Exchange Traded Funds

It has been twenty years since the development of the first ETF in 1989—known then as TIP 35 (Toronto Index Participation Fund). Several years later, in 1993, the first US ETF appeared. Known as `spiders`, these Standard and Poor`s Depository Receipts (SPDR) quickly grew in popularity. It was not long before `cubes` (based on Nasdaq), and `diamonds` (based on the Dow) became popular.

Fast forward nearly two decades and, as of the end of 2007, there are literally hundreds of ETFs listed around the world, with half-a-trillion dollars in US-based ETFs alone. There are ETFs on bonds, commodities, real estate, and yes, even ETFs on ETFs (these are typically sold as `portfolio solutions` and are akin to a fund-of-funds).

It is becoming very apparent to industry-watchers that ETFs are here to stay. For this reason, we dedicate an entire issue of The Second Opinion to the most popular Canadian innovation to rock the investment world: ETFs.

We explore some of the recent developments in the ETF marketplace, and explain why these new ETFs represent a significant shift away from the original ETFs. We also present Warren MacKenzie`s tip, Be Realistic About the Nature of the Market, which explains in plain terms why ETFs are the right fit. We finish by responding to an inaccurate document released by the Canadian arm of a multi-national mutual fund company espousing the benefits of mutual funds over ETFs.

By Carlo Palazzo, CIM

Recent Developments in the Canadian ETF Market

Introduction

Second Opinion Investor Services has always been a proponent of Exchange Traded Funds (ETFs), and on many occasions has touted the benefits of including them in your portfolio or even building an entire portfolio with nothing but ETFs. However, there are recent developments in the ETF market in Canada that can lead to confusion when implementing an ETF strategy.

This article will discuss these recent developments and why they represent a significant shift away from an ETF’s best attributes.

Leveraged ETFs

Leveraged ETFs are now available in Canada. These products are marketed under the promise of double market exposure – meaning that if the markets rise 10% the ETF will rise 20% (this is actually not entirely true, as we will discuss). Some of these leveraged ETFs also offer inverse exposure, meaning if the market depreciates by 10% the ETF will (in theory) appreciate by 20%.

The first problem with these is that they are leveraged and as such entail a high amount of risk. In the disclaimer at the bottom of a web page run by a leveraged ETF provider, they describe leveraged ETFs as being “subject to aggressive investment risk, leverage risk, and price volatility risk”. For most investors – and particularly seniors – an aggressive amount of risk is simply not appropriate.

The second problem is that leveraged ETFs tend to charge high management expense ratios (MERs). They are usually over 1%, compared to only about 0.2% to 0.4% for un-leveraged, broad-based ETFs. However, compared to mutual funds, the leveraged ETFs are still inexpensive.

The final and perhaps largest problem with leveraged ETFs is that they simply do not work the way most investors believe they work. Most investors are under the incorrect belief that if the market appreciates 10% over the course of a year, a leveraged ETF with double index exposure will appreciate 20% over the same period. This is simply incorrect.

Take a look at this quote from the disclaimer at the bottom of the web page of one of these leveraged ETF providers (note that I substituted the company’s name with the word ‘leveraged’):

“Each [leveraged] ETF seeks a return that is either 200% or -200%...of the return of an index, commodity or benchmark (the "target") for a single day. Due to the compounding of daily returns, a [leveraged] ETF’s returns over periods other than one day will likely differ in amount and possibly direction from the performance of the specified underlying index for the same period.”

So the leveraged ETF provider is actually telling investors that their products do not work the way people think they work. They only work for a single day! For periods longer than a single day, the compounding of daily returns distorts the returns so that they are not expected to provide double the return of the index.

In other words, if the market appreciates 10% in a single day, a leveraged ETF with double index exposure will appreciate 20% that day. However, if the market appreciates 10% over the course of an entire year, the leveraged ETF is not expected to return 20%.

Actively-managed ETFs

Actively-managed ETFs, as opposed to ‘standard’ passively-managed ETFs, are now available in Canada.

Active management is when the investor or fund manager attempts to outperform a benchmark or index. Passive management is when the investor or fund manager simply purchases the stocks that make up the index, thus matching the index’s return.

Over the past few years, ETFs have become synonymous with passive management and all of its benefits, including low fees, tax efficiency, and benchmark performance. While most ETFs still fit this description, it no longer applies to all of the ETFs in the Canadian marketplace.

In contrast, mutual funds (except index funds) have become synonymous with active management and all of its detriments, including high fees, high portfolio turnover, and underperformance.

It is important to understand that the reason why ETFs earned a good reputation is they were passively-managed investments and the reason why mutual funds earned a poor reputation is that they are usually actively-managed investments. In other words, the actual legal/regulatory structure of the ETF or mutual fund is not the main cause of their performance – the main cause of their performance is the type of strategy followed. Therefore, if an ETF follows an active strategy it will likely suffer from the same high fees and poor performance that mutual funds currently experience.

Sector ETFs

Sector ETFs have been around for awhile, and are not really “new”. Nevertheless, the number of sector ETFs available is increasing. It is important to be aware of the differences between a sector ETF and a broad-based ETF, and in particular how they should be used in a portfolio.

Sector ETFs are ETFs that invest in only a single sector of the economy. In Canada, they are usually designed around the larger sectors of the economy such as energy and financials. This is one of their main problems; an investor who purchases an index fund – or even most Canadian large cap mutual funds - will already have a sufficient allocation (if not an over-allocation) to these sectors. Owning both the broad-based index and the sector ETF on top can lead to a poorly diversified portfolio.

A second issue with sector ETFs is that they tend to cost significantly more than standard, broad-based ETFs.

Sector ETFs are not necessarily “bad”. They are just not suitable for the core of an investment portfolio. They are more appropriately used for making short term calls in a particular sector. Attempting to build a portfolio with sector ETFs as the core is not advised.

Why are ‘standard’ ETFs better?

After reading the above, one could reasonably ask themselves the question, “if these ETFs are ‘bad’, what makes ‘standard’ or ‘traditional’ ETFs ‘good’”?

Knowing the answer can help investors identify which ETFs they should hold in their portfolio. There are essentially three main features of standard ETFs that make them superior to most (or all) other investment products, and they are:

  • Broad-Based: The ETF should track an index that has a ‘wide’ or ‘broad’ base, meaning that it invests in a fairly large number of stocks across many sectors. For example, an ETF that tracks the TSX Composite Index is broad-based because it tracks the performance of the entire Canadian large-cap equity market, while an ETF that tracks the TSX Financial Index is not broad-based because it tracks the performance of only a single sector. While these sector ETFs can play a role in a portfolio, they certainly should not be used as the core of the portfolio. The big advantage of broad-based ETFs is that they provide extensive diversification in a single, low-fee product.
  • Passively Managed: As described above, passive management attempts to match the benchmark while active management attempts to beat the benchmark. There is no reliable way to beat the benchmark over the long term and on a risk-adjusted basis, however active managers will charge high fees in an attempt to do just that. It is simply better to keep fees low while matching the benchmark. The big advantage of passively-managed ETFs is that they will provide benchmark performance less fees and tracking error. A secondary advantage is that passive management is considered tax efficient because portfolio turnover is lower, allowing capital gains to be deferred for a longer period; whereas with active management portfolio turnover is higher, causing capital gains to be realized and taxed sooner.
  • Low Fee: The amount of fees charged is closely related to whether the funds are being managed actively or passively. Active management usually costs about 10 times what passive management costs (quite literally – passive equity ETFs tend to charge around 0.25% while active equity mutual funds tend to charge around 2.5%). The big advantage to keeping fees low is very simple – the less you pay to your advisor or investment manager, the more you have for yourself!

Conclusion

Second Opinion strongly supports the purchase of broad-based, low-fee, and passively-managed Exchange Traded Funds. However, we caution people to beware that not all ETFs fit this description. Beware of ETFs that charge high fees, are actively managed, include only a single sector, use leverage, and/or provide inverse exposure.

Most importantly, don’t fall for claims by funds or advisors that they can always beat the market, and justify their high fees with these claims. When in doubt, recall the words of legendary investor Warren Buffet:

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

By Carlo Palazzo, CIM

Be realistic about the nature of the market

Why this is important: It is never wise to base your financial future on false hope. Average investors can’t expect to beat the market consistently unless they take on additional risk. And they usually wind up with greater losses than they imagined.

When setting your objectives for investing in the stock market, you have a choice between old school thinking and new school thinking.

The old school way is to try to beat the market. If the stock market goes up by 10%, you expect your portfolio to go up by 12% or more. If the stock market falls in value, you expect your portfolio to fall by a smaller percentage than the market as a whole. If the market drops by 30%, and your portfolio drops by only 25%, you have still beaten the market.

If you are into the old school mode of thinking, you will have some level of satisfaction as long as you do, in fact, beat the market.

New school thinking, however, recognizes that most investors can’t beat the market. All investors together make up the market. If everyone could beat the market, it would be like everyone in a high school math class performing above the class average.

There will be some investors who outperform the average in any given year, but they are likely to be found in the ranks of financial institutions, and the trading departments of banks and brokerage firms. These institutions, which trade for their own accounts, have the resources, infrastructure, experience, information, and ability to trade in all markets around the world on a 24-hour basis. These are the institutions that the average investor is trading against. For every buyer or seller or who makes a bad choice, there is always another buyer or seller on the other side of the trade who, with better information, was able to make a better choice.

Fortunately, in the long run, you don’t have to beat the market to benefit from stock market growth, you only have to do as well as the stock market average. And, for most investors, having a portion of their investment portfolio “in the market” during the past century has proved to be a wise investment, even when they only did as well as the market average.

While it is almost impossible to outperform the market consistently unless you are willing to take on higher risk, it is very easy to consistently perform as well as the market. The easy way to ensure that you do as well as the market is to purchase index funds or the index itself through exchange traded funds (ETFs). These are investments that have low fees and generally have the same return as the stock market as a whole.

When you invest in individual stocks or equity mutual funds, you are, in effect, trying to beat the market. There is no other practical financial reason to own individual stocks, as opposed to an index fund or ETF, other than the hope that you can outperform the market as a whole.

There is another reason, however, to own individual stocks. Just as some individuals enjoy winning at the racetrack or winning at the blackjack table, some investors enjoy the thrill of opening the newspaper to see how their stocks are doing. It is perfectly sensible to invest in individual stocks if you are doing so for the fun of it, as long as you don’t also think you’re going to beat the market in the process.

Trading in individual stocks or regular mutual funds incurs trading costs and income tax costs. These two additional costs add to the difficulty of beating the market. A smarter approach, used by pension and endowment funds, is to invest a significant portion of the portfolio in exchange traded funds or index mutual funds, thereby benefitting from lower fees and increased income tax efficiency.

Mutual funds are not the answer to consistently beating the market without taking additional risk. Mutual funds can be ranked by their quartile performance. The understandable objective of every mutual fund manager is to be above average – to rank in the first or second quartile in terms of performance. But, according to our law of averages, only half will be above average while the other half will be below average, ranking in the third and fourth quartile. Management fees are an additional cost that makes it difficult for mutual funds to beat the market. You may want to rethink your strategy, therefore, if you own equity mutual funds that have high management fees.

Without question, some mutual fund managers do outperform the market. In trying to find these superior managers, the average investor faces two problems. The first is to determine if the recent performance was due to skill or luck. The second is to know how much additional risk was taken to get this result. And don’t forget that last year’s top-quartile manager is rarely still in the top quartile by the time two or three years have passed.

Compromise is often the best approach. One route to follow is the “core and explore” approach. In this strategy, ETFs or index funds are used for the core of the equity investments. The core investment portion is supplemented by using active managers (those who try to beat the market) to explore opportunities for enhanced returns in market areas where their specialized knowledge may give them a shot at earning an incremental return.

The number of investors using ETFs is growing every year. However, this form of investment is not popular and is rarely recommended by brokerage firms or individual financial advisors. One reason that ETFs are not popular is that these investments do not pay trailer fees to advisors. Another reason is that most financial advisors sincerely believe that they will be able to beat the market consistently.

Bottom line: Don’t waste your time trying to pick stocks or mutual funds that are going to beat the market. Use a low-cost index fund or an exchange traded fund for the bulk of your equity exposure.

What you can do now: Make sure that your financial plan is based on realistic assumptions regarding the rate of return you expect. Don’t expect that your mutual funds are going to produce a higher return than the market itself unless higher risk is taken.

Warren MacKenzie, CA, CFP, CIMA

 

Rebuttal: ETFs vs. mutual funds

Introduction

Recently a co-worker emailed me an article by the Canadian arm of a large multi-national mutual fund company titled “ETFs vs. mutual funds”. My expectation on reading the article was it was going to be a logical and dispassionate discussion on the merits of mutual funds versus ETFs. Instead, I was disappointed to find that it contained inaccurate and misleading promotional material.

I now present my rebuttal to that document. Note that I follow their format by responding to the same five questions they pose.

1. Do ETFs perform as well or better than mutual funds?

Their first point is that “the ETF usually does not pay advisor compensation” while the mutual fund does. This is actually quite true. However, there are ETFs that do pay advisor compensation (Claymore Class ‘A’ Shares), and they neglect to compare their mutual fund`s performance against them. Rather, they compare their F Class mutual funds (which do not pay a trailer fee) to ETFs.

Unfortunately, their comparison is flawed. The F Class mutual funds they display in the article have not all outperformed ETFs as they claim. For example, the fund company’s assertion that their International Disciplined Equity Fund “outperformed” the iShares CDN MSCI EAFE ETF is false.

Recall from last month that Warren MacKenzie’s ‘Words of Wisdom’ was “from a financial advisor’s point of view, the oldest trick in the book is to make a client feel good by comparing performance with the wrong benchmark.”

Alas, we have found an example of a fund company that used this same trick. A quick look at their website and we find that the fund’s benchmark is not EAFE – rather, it is the riskier MSCI World ex US Index. And yes, according to their website, the fund has underperformed its benchmark in all periods displayed (except the one-month return).

In short, the benchmark they are using is inappropriate and was not specified in advance (it is always easier to outperform an index when you select which index you are outperforming after the fact). Comparing the fund to the appropriate benchmark that was stated in advance and lo! – the fund underperformed!

In the accompanying table the mutual fund company shows a list of their funds that beat iShares ETFs as “proof’ that mutual funds perform better than ETFs. That is the equivalent of picking the winning horse in the Kentucky Derby one day after the horse race and claiming that you are a superior handicapper.

The document also has a chart displaying what percentage of ETFs outperformed mutual funds. They point out that “in some periods, the ETF considerably underperformed, beating only 15% of F-series Canadian equity funds”. However, they neglect to point out that, according to the very same chart, at one point mutual funds outperformed only about 5% of ETFs while ETFs outperformed 95% of mutual funds. Furthermore, ETFs have outperformed more frequently than mutual funds.

In other words, ETFs have outperformed in more periods than they underperformed – meaning mutual funds underperform in more periods than they outperform. And secondly, the ETFs out-performance was at a greater magnitude than their underperformance. This chart, analyzed correctly, actually supports ETFs and not mutual funds.

A final note is that, often times, an argument made in support of mutual funds is that when markets are declining an active manager can hold cash as well as lower risk investments while a passive manager must hold onto falling stocks. The implication is thus that mutual funds do better than ETFs in bear markets.

However, the chart displayed does not support that argument. In March 2009, after the worse bear market since the Great Depression, ETFs still managed to outperform over 50% of mutual funds.

2. Are ETFs cheaper?

Diversification and Rebalancing

ETFs are cheaper than mutual funds, even if “investors wish or need to trade” and do not “resolve to trade as little as possible”. In fact, ETFs are cheaper than mutual funds for both investing and trading. They are cheaper for long term investing because their MERs are lower and they are cheaper for short term trading because the brokerage commissions on ETFs are much lower than the front-end or back-end loads charged on nearly all mutual funds.

For instance, they say that “each ETF purchase will require the payment of a trading fee, typically between $10 and $30.” While this is very true, it is also very true that each purchase of a mutual fund will likely cost even more. That is because many mutual funds charge a “front-end load”, which is a fee charged when you first purchase the fund and is usually about 5% of your investment. So, if you are investing, say, $1,000 in a mutual fund, the fee to make that purchase could be $50 as opposed to $10 for putting the money in an ETF.

Not all mutual funds charge front-end loads. Some charge back-end loads (known as Deferred Sales Charges or DSCs), which are similar to front-end loads except the fee is paid when you sell your funds rather than when you buy it. The amount of the DSC is based on a sliding scale and will eventually (usually after about 7 years) be reduced to zero. The major problem with DSC funds is that investors often feel trapped inside the fund, unwilling to sell it until they can do so without facing a penalty. Often, their lost investment income is even more costly than the DSC fee. Few mutual funds offer a “no-load” option.

It is true that some F Class mutual funds may be ‘no load’ funds, however ETFs can also be held in a fee-based account and there will be no cost of trading them either.

Systematic Investing

The example used in the article is misleading because it overstates the fee. In the example, the fee (i.e. the brokerage commissions incurred for purchasing the ETFs) works out to 2.5% - but that’s a one-time percentage of the contribution, and it is being compared to MERs which firstly, are not one-time costs, and secondly, MERs are applied to the entire market value of the investment while brokerage commissions are only applied to the contribution.

As an example, let’s say an investor has a $100,000 portfolio and makes $9,600 of contributions as described in the article. Using reasonable assumptions we believe a fair comparison follows:

Item ETF Mutual Fund
Current Value $100,000 $100,000
MER 0.25% 2.50%
Front-end load 0.00% 5.00%
Brokerage commission $10 $0
 
Total Contributions Throughout Year $9,600 $9,600
Total Brokerage Commissions $240 $0
Total Front-End Loads $0 $480
Management Fee $262 $2,620
 
Total Cost Of Owning Fund ($) $502 $3,100
Total Cost Of Owning Fund (%) 0.46% 2.83%

However, we would agree that systematic investing, whether withdrawing funds or making contributions, is accomplished more easily with mutual funds as compared to most ETFs.

Bid-ask Spreads

Their argument here suffers from at least two problems. Firstly, the bid-ask spread on high-volume ETFs is very small. Secondly, while ETFs are priced throughout the day and can be bought and sold throughout the day, a mutual fund cannot; orders are not filled until the end of the day, when markets are closed. Therefore, an investor who places a purchase order for a mutual fund with a NAV of $10 may end up paying $10.50 for that fund when the order is filled at the end of the day.

3. Are ETFs tax-efficient?

The assertion that mutual funds are tax-efficient is misleading at best. The fact of the matter is that many mutual fund holders in the last year suffered large (“paper”) losses in the mutual fund and at the same time were paying taxes on capital gains distributions – talk about tax inefficient.

The reason ETFs are tax-efficient is because of their low portfolio turnover. By not trading stocks they allow capital gains to accumulate unrealized. Meanwhile, many mutual funds have a high portfolio turnover. They routinely realize these gains, causing a taxable event for the fund holder – even if the fund holder lost money overall!

4. Do ETFs provide automatic diversification?

They make a point that indexes can become poorly diversified due to a single company dominating the index. However, the index providers have figured this one out.

Take as an example, the iShares CDN Composite ETF that the article describes as being “the only ETF in that category [Canadian large cap] that can be appropriately compared to traditional mutual funds.”

A quick look at the iShares website and we find that the ETF is based on the S&P/TSX Capped Composite Index. The word “capped” is the key word here. It means that the maximum weighting of any particular stock in the index is capped at a certain level so that no single stock will dominate the index.

So, the claim that Canadian large-cap ETFs suffer from an over concentration in a single company is false as the ETF which is “by far is the largest and broadest Canadian equity ETF” in fact has a cap that prevents them from ever being over concentrated in a single company.

5. Are ETFs an easy way to invest?

The entire premise of this section is that ETFs are more complex than mutual funds because ETFs “push all of the money management responsibility back onto the advisor”, including creating appropriate portfolios “from scratch”.

Actually, creating “appropriate portfolios” is always the advisor’s responsibility. Since the mutual fund manager does not know the client, the mutual fund manager does not know if a portfolio is appropriate for that client. For this reason the regulations are clear – advisors, not mutual fund managers, are responsible for the suitability of an investment portfolio. The fact that the portfolio is created with ETFs or mutual funds is irrelevant.

Furthermore, with mutual funds you are paying a trailer fee to the advisor to, in-part, handle money management tasks such as setting an appropriate asset allocation. Since mutual fund clients are paying for these services, one would hope that the advisor is providing them. In the case of F Class Funds, the advisor would not collect a trailer fee but rather would charge an additional fee on top of the already high MER.

Interestingly, the fund company claims that if advisors have to spend time on managing clients money – as they are paid to do – this will take them away from “the time advisors have to work directly with clients and potential clients, a key factor in the most successful and profitable practices.” Their footnote goes further by saying “being client focused, rather than investment focused, can increase advisor profitability”.

All investors must ask themselves this question – “is the purpose of my investments to make my advisor rich?” If the answer is ‘no’ (which it is!), than why would an investor care about what is most profitable for their advisor?

Conclusion

The fund company’s article contains serious inaccuracies. Sadly, they are apparently not the only fund company to release such misleading material. Back in July 2008, I pointed subscribers to an OSC Investor Alert, found here. In it, the OSC warns investors about the difference between independent research and paid promotion. While the article “ETFs vs. mutual funds” appears to be independent research, it is clearly promotional material. Investors beware.

You should also re-visit a second OSC Investor Alert I pointed out to subscribers in February 2008, found here. This OSC Investor Alert provides a truly unbiased run down of mutual fund fees.

By Ken Hawkins and Carlo Palazzo, CIM