FORUM MAGAZINE
INVESTING
The ETF Explosion
Exchange-traded funds (ETFs) have had a major surge in popularity over the last year as investors search for alternative ways to grow their portfolios. With the Canadian market capitalization at almost $40 billion, Michael Callahan looks at what makes ETFs so attractive, the various types of ETFs available today, and how to determine if they are right for your clients
Currently representing around $1.7 trillion in assets, the global ETF market is massive. Here in Canada, the growing popularity of ETFs is no exception. Since 1990, when ETFs were first introduced in Canada, the ETF market has grown by leaps and bounds. In fact, as of September 2011, Canada’s 213 ETFs held a whopping $39 billion in assets under management — an increase of almost $5 billion since the beginning of the year.
The ABCs of ETFs
An ETF, or exchange-traded fund, is an investment vehicle that has properties of both a mutual fund and a stock. Like a mutual fund, an ETF is a portfolio of underlying securities, such as stocks, bonds, commodities, derivatives, real estate income trusts, or currencies. However, unlike mutual funds, ETFs trade like stocks on an exchange, and are not sold or redeemed at net asset value (NAV). Rather, ETFs are bought and sold by investors throughout the trading day, thereby allowing their prices to fluctuate above, below or at par with their NAVs.
Market Growth
Although ETFs have been around for approximately 20 years, their popularity has really soared in recent years. What’s fuelling such rapid growth?
“A couple of things are influencing the growth of ETFs — awareness and the markets,” says Mary Anne Wiley, managing director and head of iShares distribution, BlackRock Asset Management Canada Limited. “First, awareness of the inherent benefits of ETFs and the flexibility with which they can be used in investment portfolios has been steadily growing. [This is likely] due to the amount of attention ETFs have been getting in the marketplace, as well as the surge in new ETFs and providers coming to market. Secondly, the markets — following the credit crisis in 2008-2009 — are creating an inflection point in the usage of ETFs. People are demanding safe, reliable, transparent and liquid access to the markets, something many ETFs provide.”
Investor Benefits
So what exactly makes ETFs so attractive?
“There are a few reasons why we use ETFs, and why I believe they’ve become so popular these days,” says Kathy Clough, CIM, CFP, R.F.P., portfolio manager at PWL Capital Inc. “ETFs offer low cost structures, tax efficiency, transparency and instant diversification.”
From lower fee structures to instant diversification, the benefits of ETFs are many. Let’s take a closer look at some of the features and benefits that make them so attractive.
Low cost. Perhaps the most attractive feature of ETFs is their low cost structure. Compared to mutual funds, most ETFs have drastically lower fees and expenses. In many cases, the management expense ratios (MERs) of ETFs are literally just a fraction of a per cent. For example, the iShares S&P/TSX 60 Index ETF (TSX:XIU) administers a paltry 0.17 per cent annual administration fee.
Tax efficiency. Like mutual funds, ETFs may also distribute income, dividends and capital gains (depending on the underlying securities within the fund) to fund owners. But since many ETFs track market indexes, there is often a much lower turnover associated with ETFs than with actively managed mutual funds, thereby resulting in fewer taxable transactions to the fund holders.
Transparency. Mutual funds and many other investment structures typically disclose their holdings on a quarterly basis, making it hard for investors to know exactly what securities they own. On the other hand, most ETFs publish their exact holdings on a daily basis. This greater level of transparency makes it much easier for investors to see exactly what underlying securities they actually hold, and therefore make more informed investment decisions.
Diversification. As is the case with mutual funds, most ETFs contain a basket of underlying assets and offer excellent diversification to investors with a single purchase. For example, index-tracking ETFs often contain hundreds, potentially thousands, of securities. Consider, for example, the mammoth iShares Russell 2000 Index ETF (TSX:XSU), which contains almost 2,000 individual securities — all attainable with a single purchase.
Stock-like features. Unlike mutual funds, which are purchased by investors directly from the fund company, ETFs are traded between buyers and sellers in the secondary market like stocks on a stock exchange. Hence, investors are able to trade ETFs just like they trade stocks, using limit and stop-loss orders, short selling and buying on margin. These features — and the ability to buy or sell ETFs at any point throughout the trading day — are of particular interest to active investors.
Advisor Benefits
Given these attractive features, it’s no wonder ETFs are have become so popular. Of course, an advisor may have his or her own reasons for using ETFs in client portfolios. But according to Dan Hallett, it’s the low cost-structure and lack of embedded advisor compensation (in most products) that makes ETFs particularly attractive to advisors who operate a fee-based practice.
“ETFs are quite popular amongst advisors who administer their own management fee above and beyond any product-related fees,” says Dan Hallett, CFA, CFP, vice-president and director of asset management for Oakville, Ont.-based Highview Financial Group. “The lower fees associated with most ETFs allow advisors who operate on a fee-based platform to charge a respectable fee for their advice and service, while still achieving a fair overall fee for their clients.”
What about advisors who wish to incorporate ETFs into their practice but don’t operate on a fee-based platform? Advisors who employ a more transactional model will of course participate in the same trading commissions with ETFs as associated with stocks. Furthermore, several providers now offer ETFs with embedded compensation by paying advisors trailer fees. For instance, Claymore Investments Inc. now offers an “advisor class” series on several ETFs which pays advisors a trailer of 75 basis points. Of course, this incremental cost is evident in the fund’s MER. For example, the Claymore Canada Fundamental Index ETF (TSX:CRQ) has an MER of 0.65 per cent, whereas the advisor class unit (TSX:CRQ.A) has a corresponding MER of 1.4 per cent. Although the higher MERs may not be attractive to some investors, this model may be more appropriate for advisors who do not run a fee-based practice yet subscribe to a buy-and-hold investment philosophy.
Potential Disadvantages
| ETF Providers in Canada Some of the most common ETF providers in Canada include: |
| iShares Funds – the largest ETF provider in the world and leading ETF provider in Canada, iShares has more than 350 ETFs and over $300 billion in assets under management. www.ishares.com |
| Claymore Investments Inc. – 31 ETFs across broad asset classes including core equity, global sectors, fixed income and commodities, with approximately $6.5 billion in assets under management. www.claymoreinvestments.ca/etf |
| Horizons Exchange Traded Funds Inc. – approximately $3 billion in assets under management and more than 70 ETFs listed on the Toronto Stock Exchange. www.hbpetfs.com |
| BMO Financial Group – a diversified family of ETFs including a broad range of investment solutions, BMO ETFs are managed and administered by BMO Asset Management Inc. www.etfs.bmo.com |
| Invesco PowerShares – approximately $60 billion in assets under management, and over 120 ETFs worldwide, trading on exchanges in Canada, the U.S., Europe, and Asia. www.invescopowershares.com |
“While ETFs can offer investors some great advantages over other traditional investment products, one area in particular where ETFs may be inferior to mutual funds is where investors need to make regular purchases or redemptions,” says John DeGoey, CFP, associate portfolio manager at Burgeonvest Bick Securities Limited in Hamilton, Ont.
Consider the case where an investor wishes to set up a monthly pre-authorized contribution (PAC) plan to facilitate a dollar-cost averaging (DCA) strategy or, similarly, a client who is drawing income from a portfolio and wants to set up a systematic withdrawal plan (SWP) and make regular monthly redemptions. “Because of the trade commissions associated with each sale or purchase, using ETFs in these situations can be quite costly and ineffective,” adds DeGoey. “A mutual fund may actually be a more appropriate investment vehicle, as initial and subsequent purchases and sales can be made without trade commissions or transaction fees.”
The difference between mutual funds and ETFs also raises a very important concern from a regulatory standpoint: advisor licensing requirements. In order to sell ETFs, advisors must be securities-licensed through IIROC. Hence, advisors on the MFDA platform simply do not have the ability to use ETFs in client portfolios. However, there are several firms that now offer a potential workaround in an ETF (or basket of ETFs) inside a mutual fund wrapper. Although not technically an ETF, and therefore not possessing all the benefits of ETFs, a mutual fund of ETFs may be an attractive solution for MFDA advisors.
Another obstacle cited by many advisors is not necessarily product-related but, rather, a concern related to the growing ETF industry. The original goal of ETFs was to provide broad exposure at a reduced cost. And while that may still be the goal of many ETFs today, we’re seeing more and more innovative products coming to market.
“What started out as a simple offering has become a complex, sometimes confusing, array of choices,” says Hallet. “For example, an investor who wishes to gain exposure to the overall TSX performance must decide between fundamental index construction, traditional market cap, or equal weighting — to name a few. While it’s good to have options, too many choices can prove problematic for advisors and investors alike.”
Make no mistake — the growing ETF market is alive and well. Although there were less than 50 ETFs in Canada just five years ago, that number has ballooned to over 200 available today. But as Kathy Clough points out, it’s not only about the number of products available, but also the nature of those offerings. “As the ETF industry continues to grow, we’re seeing products become increasingly complex, such as a synthetic product offering double inverse exposure to an underlying asset,” she explains. “That can pose a potential problem when investors start using products they don’t truly understand. It’s important that both investors and advisors perform their due diligence before proceeding with any particular investment products — ETFs or otherwise.”
Clearly, Cough’s concern highlights the importance of continuing education for both investors and advisors. As the ETF industry continues to grow, the innovation of products and their respective structures will too. In order to properly serve their clients, advisors need to step up to the challenge and ensure they stay on top of the ever-expanding suite of ETF products.
Types of ETFs
There’s a wide range of ETFs available today. The ETF offering available to investors includes much more focused products, actively managed funds and complex derivative structures. Let’s look at some of the more common types of ETFs.
Index: Many ETFs are designed to track a major stock market index, such as the S&P/TSX 60, S&P 500, or MCSI World Index. The goal of an index-based ETF is not to outperform but rather to mimic or replicate the performance of an underlying index. Note, however, that not all market indexes, or index ETFs, are created equally. For example, the Claymore Canadian Fundamental Index ETF (TSX:CRQ) is based on company fundamentals (such as total cash dividends, free cash flow, total sales and book equity value) rather than a traditional index construction based on market capitalization.
Sector and commodity: Industry and sector ETFs focus on a particular market segment, such as healthcare, information technology, natural resources, or financials. Although sector ETFs may be actively managed, most are designed to track an individual sector index. The iShares S&P/TSX Capped Consumer Staples Index Fund (TSX:XST), for example, is a passively managed fund that seeks to replicate the performance of the S&P/TSX Capped Consumer Staples Index. Commodity ETFs typically consist of derivatives, such as futures contracts, which allow investors to track the performance of specific commodities like oil or gold. For example, the Claymore Gold Bullion ETF (TSX:CGL) mimics the performance of the price of physical gold bullion.
Fixed income: Whether it’s international, corporate, or various levels of government, fixed-income ETFs offer investors both the traditional benefits of bonds coupled with the trading features of stocks. Mary Anne Wiley observes a trend toward income and yield, partly due to an aging population. “Millions of baby boomers are now starting to retire, and they’ll be looking at income-generating investments in the hopes of providing themselves an income stream while diminishing the level of risk in their portfolio,” she says. “But retirement needs are just one part of the equation for increased income appetite. Regardless of one’s status in life, they are devoting a portion of their portfolios to fixed-income investments to add diversity and stability to portfolios. At the same time, ETFs offer a simple and easy way to access the fixed income space. One can access hundreds of bonds in just one trade.”
Currency: trading in the foreign exchange (FX) market can be a daunting task involving complex transactions. On the contrary, currency ETFs provide investors easy access to international currencies without the complexities of trading in the FX market. While some foreign currency ETFs are designed to offer exposure to a basket of multiple currencies, most currency ETFs track a single foreign currency. The Horizons Australian Dollar Currency ETF (TSX:ASD), for instance, gives investors direct exposure to Australian currency.
Leveraged and Inverse: Inverse ETFs are designed to create a short position, thereby offering the investor an inverse reaction to the direction of the underlying index or asset. Leveraged ETFs, on the other hand, provide investors with an increased level of exposure, such as 200 per cent of the daily investment performance. In fact, some ETF providers offer both inverse and leveraged exposure in a single ETF, such as the Horizons BetaPro NYMEX® Crude Oil Bear+ ETF (TSX:HOD), with attempts to provide investors with double inverse performance of NYMEX® light sweet crude oil.
Although the ETF product offering is extensive, ETFs are not a one-size-fits-all solution. As with any investment product, before recommending a particular ETF to a client, it’s important that advisors be thorough in their research and due diligence. By evaluating product specifics, as well as client goals and unique circumstances, advisors can be sure they’re choosing appropriate investment products and making recommendations that are suitable for their clients’ portfolios.