Gaining volume

Over the past couple of years, ETFs have gained traction among advisors, as offerings have been rounded out. But how many ETFs can Canada support? We took this question to Som Seif, president of Claymore Investments.

Q: What’s the volume share of ETFs trading on the TSX? A: At the beginning of the year it was about 3%. In the United States, ETFs represent about 25% to 30% of trading, but in October it shot up above 40%. They are now trading at about 35% to 40% of the whole volume in the United States. It’s amazing, and I think it’s only going to continue.

Institutions trade them – 70% to 80% of the daily ETF volume has always been institutions, but the majority of net sales are retail now. That flow is coming because you’re seeing the traditional buyand- hold investor utilizing ETFs more and more.

Leveraged ETFs have also increased volume quite dramatically because of day trading. The average turnover on those things is in around two to three days – that’s the average of the entire complex, meaning they would trade their entire asset base within two to three days.

Q: Is there any need for new ETFs in Canada? A I think 90% of the toolkit is in place. ETFs have their benefits, but where they fail is when they start to get too “nichey,” which we’ve seen in the United States.

Canada can’t afford to create these products, we don’t have the scale to make ETFs very small. There is about a 10:1 ratio difference between Canada and the United States. If I have a $100 million ETF in the United States, that can be profitable for me, but the equivalent ETF in Canada would be about $10 million. I can’t make that profitable for me.

The U.S. market can afford to make them, because they have the scale and scope to make them profitable, and interested Canadians can buy them.

You can’t break even on an ETF with under $40 million to $50 million dollars [AUM].

Q: Isn’t that similar in size to a closed-end fund? A: Break-even on a closed-end fund is zero, because they pay zero costs. That’s the biggest problem with closed-end funds because the repercussions of a small deal are minimal. The investor gets screwed, not the provider. The reason closed-end funds tend to have roughly a $20 to $30-million minimum is because the investment bankers have put in this $20 million minimum to close your deal, because that’s the amount of liquidity that’s required in the market – the number of units that are required.

With an ETF, all of the costs are capped, so we’ll pay any expenses, regardless of size of the fund. Below a $50-million threshold we’re earning less than we’re paying. That $50 million actually includes things like upfront costs.

The biggest barrier to this industry is that this is an expensive business to run. You can’t run this business with only $500 million in assets. Being a $500 million ETF player is just not fun at all.

Q: What’s your relationship with Claymore Investments in the U.S.? A It’s our parent company. It provided us with the capital we needed to start this business and the back-office support and leverage of IT and all the rest, but we’re a very distinct separate business.

When I set up the business in Canada, I made a point of saying you can’t take a business and try to set up as what works in America will work in Canada. As similar as we are to the U.S., we’re still very different, especially in our investment practices. You have to have a Canadian view and design things from a Canadian perspective, from a Canadian tax structure and investment perspective.

Q: At what point will you achieve profitability? A: We’re profitable now. We actually achieved profits in the first year of business, but then I changed our entire business model and moved in 2006 towards ETFs. That was a total transition. We had to go through a period where we were leaving a profitable business and entering a business where we would be a pure start-up once again. It was challenging – 2006 and 2007 were challenging years. We had significant growth in 2007 and 2008 was even better.

Running an ETF shop even at $1 billion is not fun. You don’t want to be a $1 billion ETF player. You want to be a $2 billion, $5 billion or even $10 billion player. This is a business where economies of scale really matter. This is not a potential $1 billion firm, you cannot persist as a $1 billion shop.

Q: You were originally a closed-fund firm? A: We launched a couple of closed-end funds and raised a couple hundred million dollars early on. It’s a very different infrastructure, you don’t have the cost of running the funds, you have a very small team. I essentially on my own launched our first fund and brought in some other people as wholesaler support. By the end of the year, we had about $600 million in assets.

Q: Are you going to continue to offer closed-end funds? A: No, but I say that with an asterisk. With closed-end funds, there is the opportunity to bring unique, innovative products to market that are unlike anything anywhere else. You can get access to assets not usually available through traditional mutual funds. These are more illiquid securities and products that have more taxstructuring. These could include private equity and alternative assets. These are all areas investors do want and probably need exposure to, and closed-end funds offer that.

I’ve been adamant during the last two years of our transition in saying that industry is dying. I’ve said that industry needs to change. All the industry players need to rethink the closed-end fund business. As long as the structure stays the way it is, we’re not going to be interested in doing any business in that area.

Q: In your experience, what’s the reaction of advisors to ETFs? A: Usage among advisors remains quite low, but it is growing quite dramatically. When we first entered the business, ETFs were primarily used by your traditional fee-based advisor. ETFs fit very nicely into a fee-based business, where you’re not getting paid by commission, but rather you’re paid by the client, and you then buy whatever it is you want and you generally have incentive to buy whatever is the lowest cost.

We’re finding a great deal more advisors are looking to use ETFs in replacing funds. Traditionally, the commission-based advisor hasn’t been structured to do business that way. That needed to change.

Q: How much of your business is represented by the advisor class funds? A: In terms of total assets, it’s probably about 10% to 12% of our assets, but in terms of flows, about 20% of our sales flow is coming from the advisor class ETFs. More of that has come in the last couple weeks or months than in the last year.

The market change in the last three months has been quite amazing. With regards to the psychology of investors, and the psychology of advisors, things have changed. I expect interest in ETFs from advisors to continue in 2009.

We’re seeing a general migration towards our product and that’s made us extremely happy. As negative as the market is, we’re seeing increased product demand. It says a lot in light of what has happened over the last few months that advisors and investors are still coming back to give us money.

Q: How much of that is a cash-equitization strategy? A: Not much of it was cash equitization. iShares has seen about $4 billion in inflows over the last four months, that would have been primarily cash equitization. We’ve benefited from tax-loss selling occurring, but you wouldn’t see as much cash equitization with Claymore products as you would at iShares.

The portfolio managers who trade every two to three weeks, they are going to trade more with iShares. You won’t see the benefits of Claymore’s value-add fundamental approach over a three-week period as you would over a longer period.

We do see inflows from taxloss selling. Most of the guys tax-loss selling are tax-loss selling mutual funds. That money is not going to go back to a mutual fund. They’re not selling a crappy mutual fund, going into an ETF, and then going back to a crappy mutual fund.

Q: There are many advisors trying to play a “wait and see” approach, particularly using dividend-yielding investments. Are they putting money into ETFs as a stop-loss solution until they feel more comfortable about the markets? A: Absolutely. I think instead of seeing guys take individual stock risk, they’re choosing to take basket risk. When you look at what has happened to stocks like BCE, etc., there is just so much risk in the market right now. Investors get worried and say to themselves, I don’t just want to hold BCE right now. I want to hold 30 or 50 dividend-paying companies. That way they don’t have to wake up in the morning and see some takeover decision take their assets down by 40% or 50%.

What I think is the most important thing about ETFs is that you always hear about guys moving from stocks or mutual funds into ETFs. You don’t hear anyone who is invested in ETFs complaining that they are done with ETFs.

That’s the beauty of it. It’s one of those products that once an advisor or investor starts using them, they actually start using them for good. It becomes a product on their shelf that plays an important part of their business.

Q: How much are bid-ask spreads something to worry about for longer-term investors? A: When I buy a mutual fund I put my money in at the net asset value (NAV). That money is then going to go and get invested at a bid-ask spread of the market. There is an execution cost no matter how you look at every single product.

With an ETF it’s right in front of your face. With a mutual fund, it gets paid by the fund, which is then flowed through to you through the fund expenses. People are cognizant of the spreads, but we’ve found once an advisor understands how an ETF works and how liquidity actually works and what the bid/ask spread actually equals then they understand it.

Q: What about distributions from non-capitalization-weighted ETFs such as your RAFI products, which weight a company’s share in the index by other factors. Don’t you have rebalancing costs? A: No, all of our RAFI ETFs have had zero distributions since we launched them. This is during a period where iShares has had significant capital gains distributions. XIU had distributions this year, we had zero.

Q: How do you manage that? A: We’re much more focused on tax management in our shop. We manage our losses and our gains together. We do a lot more of that stuff internally.

The only product we had a taxable distribution in last year was our BRIC ETF. That product had a 71% gain last year and a 20% realized gain from currencies. With all of that, we were able to decrease the distribution down to 4%.

Q: What’s your market share of the Canadian ETF market? A: Right now we’re at about 6%. Our goal is to capture a minimum of 10%, but we’re aiming for more than that. We’re not going to be number one. Barclays is a fantastic player with a great lineup of products. A lot of our products and their products complement one another.

Our goal is to bring in highquality product that will go after and compete against underperforming mutual funds.

Q: When you talk to investment counsellors in particular, they see a lot of the value of ETFs in being able to get exposure to non-correlated asset classes. What would be the best way to get into those spaces? A: This is the important thing about investing in ETFs. Why Canadians need to be investing in ETFs domiciled in Canada is because you’re trading in Canadian dollars.

Say I travel to the U.S. and I have a $100 Canadian, I’m probably going to pay 1.5% up front to convert that into U.S. dollars. When I come back, I’m going to pay another 1.5%.

Let’s take an example of a lowcost ETF. Everyone talks about cost and how Canadian ETFs are so expensive, we’ll let’s compare them to a U.S.-based Vanguard ETF. Vanguard ETFs are really cheap, they’re about 10 basis points.

Q: What’s the real cost for an investor in Canada to buy one of those? A: If I’m a Canadian and buy one of those Vanguard ETFs, I may think I’m paying ten basis points but I’m actually going to pay well above that. If I buy it and hold it for three years, I’m going to 1.5% up front to convert my Canadian dollars into U.S. dollars, I’m going to pay 10 basis points for three years, and then I’m going to pay another 1.5% on the way out. That investor just paid 3.3% over three years, that a cost of 1.1% per year to hold that ETF. That’s much more expensive than buying a Canadian-based ETF that doesn’t have those conversion costs.

Do Canadians need more ETFs? They need ETFs that are traded in Canadian dollars that get them away from the U.S. estate tax issues – if they want to buy a U.S.- domiciled ETF – currency trading concerns and it gets them away from tax inefficiency concerns like international withholding taxes. If it’s a traditional core equity based or fixed income investment savings vehicle, it is important for Canadian investors that product is domiciled in Canada.

Those products are coming because there is need for them.