ETFs have same issues as mutual funds

A report released Tuesday by Morningstar Canada placed a large amount of blame on advisors for high mutual fund fees. But the same issue applies to exchange-traded funds.

There is a quite a bit of academic evidence to suggest that passive investing over a long period of time, within a well-constructed diversified portfolio, will outperform a similarly constructed portfolio of active mandates. More generally, the argument about whether to use ETFs over mutual funds comes down to fees.

Some advisors like Jason Pereira, a founding partner of Woodgate Financial Partners and a planner with Investment Planning Counsel, think the discussion about ETFs in the financial media can be misleading. Lower fees alone do not make a good financial plan, and he suspects there are instances where ETF strategies can be more costly to a client.

If clients choose to work with an advisor, they need to assess how much they are paying for advice. In the case of ETFs, part of the cost could be transaction commissions.

“I have no problem with ETFs from a philosophical standpoint. I think my problem comes from the marketing of ETFs and some of the key points raised in ETF literature,” Pereira says. “One point always raised is the fees — which is true, they are nice and low. But advertisements fail to remind people you have to pay commission on this when you buy and sell them.”

Once again, clients have to consider how much they want to pay their advisors and in what manner they want to pay them. One of the key reasons for trailer commissions is that clients are supposed to get competent financial advice. While this should include strong tax and insurance planning, these elements are sometimes ignored.

Clients need to know what they are paying for and decide for themselves whether they are happy with the service their advisor provides, Pereira says.

“If you’re doing it yourself with a large discount brokerage, sure it’s cost-effective. If you’re doing it with an advisor or broker, these guys need to get paid,” Pereira says. “If you think you are going to go in pay half a percent on commission and never flip over this portfolio again and lo and behold the broker is going to provide you with advice — that’s not going to happen.”

Pereira, who is not an IIROC-licensed advisor who can directly buy and sell ETFs, learned this lesson firsthand when he started to inquire how much it would cost for a client to create an ETF portfolio using a full-service brokerage.

After checking a number of potential full-service brokerages, he was quoted prices that ranged from 1% to 1.9%. Perreira couldn’t believe some brokers were looking to charge almost as much as 2% in upfront commissions to create the portfolio.

“If you’re charging an upfront chunk for an ETF portfolio and you compare that pricing to the pricing you can get for high-net-worth clients, you can get institutional pricing from the mutual fund companies,” he says. “We can drive a portfolio in excess of $1.5 million — which obviously is not every client — to as low as 1% to 1.25% and they’re getting proven active management.”

Preet Banerjee, senior vice-president of Pro-Financial and a strong advocate of index strategies, says he’s seen abuses where advisors have clearly negated the cost-effectiveness of using ETFs.

“Ultimately we return to the theme of the competence level of the advisors. There are advisors who are riding the goodwill of ETFs because they are covered so favourably in the media,” Banerjee says. “A client will go to his advisor and say, ‘I hear all these great things about ETFs,’ and the advisor will say, ‘Oh great, I can sell ETFs if you want.’ He can still employ all the same old tricks that may not be in the client’s best interest.”

One abuse in particular Banerjee has observed is advisors who charge their own high-management fee to mimic a wrap product offered by a mutual fund provider using ETFs.

“[Some advisors] will take your wrap fund and take the eight components in and just buy the corresponding ETFs. They will hold it in a fee-based account. I’ve seen them charge 1.75% for a client advisory fee and then with the ETF product it could be an extra 50 basis points to come in at 2.25%,” he explains. “All the advisors did in this case was line their own pockets.”

The right index

No cost savings are achieved with a badly constructed portfolio. In isolation, an ETF may be cheaper than a mutual fund counterpart, but that doesn’t make it the right product for every client.

There is vigorous debate over ETFs that track the Canadian marketplace. Canada has very narrow cap-weighted indices, where certain sectors or even individual stocks can dominate the weight of the index. This creates considerable cyclical risk for a client who chooses to only use an index-linked ETF to represent their Canadian equity exposure.

Consider that last summer, energy and materials represented more than 50% of the weighting of the TSX Composite Index. That’s a lot of downside risk to expose a client’s core holding too.

“Index-linked ETFs don’t stop you from losing money,” Pereira says. “You would have lost exactly what the market did, if not more. There is this misconception that people would have avoided what happened in the market by being in ETFs. Here’s my counterpoint: 100% of ETFs underperform the index in a given year. You can’t own the actual index without paying something.”

A good Canadian equity manager will protect a client’s portfolio on the downside. In fact, a good number did during the downturn in the fall. According to Standard & Poor’s Indices Versus Active Funds Scorecard (SPIVA) for Canada, 53.2% of Canadian Equity active funds outperformed the S&P/TSX Composite Index in the final three months of 2008. The amount of money some of these managers saved could potentially outweigh the underperformance of a benchmark during a bull-market.

Banerjee says there are some ETF products that track sectors which have only a handful of stocks. One ETF in the Canadian market tracks the tech sector which is comprised of essentially five names.

“It only holds five stocks. If you’re paying a commission that has an ongoing fee, it would have been better to buy the five underlying stocks, assuming the same flat commission rate for advisor,” Banerjee says.

That’s not to say indexing can’t work in the Canadian market, but clients and their advisors have to put in some work to find the right mandates and diversify and manage risk in the portfolio. There are now thousands of index products in the Canadian market. Having an advisor select the right ones deserves compensation.

For example, clients can get a fundamental index of the Canadian market, which tries to root out some of the cyclical problems with cap-weighted indexes, Banerjee, whose company sells fundamental index funds, says.

Fundamental indexing removes the link to stock market price by weighting names in the index based on a composite of fundamental factors, which includes sales, dividends, cash flow and book value. An investor gets a weight that should be representative of the indexes’ most profitable companies rather than a weight assigned to what the market collectively guesses prices will be in the future.

“The best example is go back to January 2001, when Nortel was 26.01% of the TSX 60,” Banerjee says. “It’s very possible for one stock or a couple of stocks to dominate the index. Nortel would have only been 9.21% of the fundamental index because it didn’t look at the market capitalization. It just looked at the audited financial statement. We basically hold all the same stocks and the weightings are tilted towards the profitable companies.”

(05/14/09)