Faceoff: Index, friend or foe?

Two advisors weigh the merits of passive investing.

Friend

Som Seif is President & CEO, Claymore Investments, Inc.

Benefits of ETFs

ETFs provide low-cost, transparent, tax-efficient investing. They use index strategies, so they effectively replicate a factor-based strategy, whether on a market-cap-weighted index, an alternative index like a fundamental-weighted index, or an eco-weighted index. Passive investing reduces costs and keeps turnover low. You also know exactly what the fund invests in.

ETFs have the same regulatory structure as mutual funds. The only difference is they trade on an exchange. With a traditional mutual fund, you buy and sell directly from the mutual fund provider, and as cash goes in and out on any given day, the fund increases or decreases.

With an ETF you put your order on the stock exchange. You have the flexibility to buy or sell at any time. You can use margin orders, stop-loss orders, limit orders, and things like that. With a mutual fund you can only trade it once a day, and you get the end-of-day price.

Big institutions now use ETFs for core or tactical exposure. We’re also seeing retail investors use them for strategic or tactical asset allocation, or to replace a single stock or mutual fund exposure.

For the first time, you have a product that’s used at all levels at the same price. When retail investors buy a mutual fund, they pay more than large institutions. But with ETFs, retail investors are getting wholesale pricing and access to strategies the biggest institutions in the world are using.

Appropriate for all investors

They’re a multi-purpose tool that any type of investor can use. ETFs can complement or replace traditional, higher-cost active mutual funds. A lot of long-term investors are now picking some very strong active money managers and complement their work with ETFs, instead of buying, say, five mutual funds.

For investors who like to pick Canadian stocks, and are able to put together a strong basket on their own, ETFs can give these investors exposure to global markets and other asset classes if they don’t feel confident with picking individual securities.

Response to criticisms

People against ETFs fall into one of two camps. The first camp thinks active money management is superior. The other camp sees ETFs growing too quickly and doesn’t understand enough about their impact on the markets. The debate around active versus passive investing is silly. Active and passive strategies work well together. You can add value with good active money management, but most active money managers think ETFs are bad because people should go the active management route. I disagree.

Looking at the traditional benchmark indexes — market-cap-weighted indexes like the S&P/TSX 60 or the S&P 500 — people will point to the tech bubble and Nortel. My argument? As ETFs have grown, indexing has evolved, so there are a lot of unique and innovative ways to invest passively without having to take market-cap-type index benchmarks.

On the second criticism, a lot of people don’t understand how ETFs work. ETFs are just liquidizing an asset class—they don’t create new liquidity. Investors are ultimately going to find a way to get access to asset classes, and ETFs are just a way to get access to a specific area. Yet people blame ETFs for things like the flash crash [of May 6, 2010].

ETFs represent about $1.4 trillion globally. That sounds like a lot, but the mutual fund industry is over $25 trillion. So while ETFs are growing fast, the global market is much bigger. So ETFs are not impacting trading volatilities.

Through the 1980s and 1990s, this industry was built around active money management. It’s in the best interest of Bay and Wall Streets to have these managers, because if you can actually add value, brokers, dealers and traders will have jobs. Active management is a critical aspect of this industry, and people don’t want to let go.

Foe

Don Macfarlane is a Senior Financial Advisor with Assante Financial Management Ltd.

The right numbers

I agree the average mutual fund does not perform as well as the benchmark index. But this simplistic view ignores the fact that the average value of assets among the top quartile of funds measured over a 10-year period is huge when compared with the bottom or even the third quartile in the same asset class.

Consider: among the Canadian Focused category at February 2010, there were 154 funds with a minimum of 10-year returns reported. In the bottom 77 funds, only four have assets over $1 billion; none are over $2 billion. In the top 77 funds, 12 have assets in excess of $1 billion. People aren’t taking into account the weighted value of the fund. The best-performing mutual funds are usually the ones with the most AUM, a fact glossed over by promoters of the passive option.

No fee advantage

Transaction costs on ETFs, though small, are never included in any discussion around the overall performance of an ETF. Only recently have we seen published returns from third parties such as Morningstar.

Previously, we were always asked to compare mutual fund returns with the index, and were expected to believe ETFs always mimicked the underlying index.

Investors can buy no-load funds. I have not sold DSC or low-load in my practice for more than two years. And we do not charge for switches. While this is not the practice of everyone who sells mutual funds, it means the MER is the only fee that applies. We can assume fee-based practices offer F-Class funds with lower management fees and add an advisory fee, which in many cases would produce a total similar to or less than the MER on a typical retail fund.

Passive investing presupposes that markets reflect all relevant knowledge. Yet that’s not true. Active managers dig deeper and find things out about companies through face-to-face interviews, for example. An indexed mutual fund manager doesn’t meet with executives of companies they hold shares in, because they’re going to hold shares due to the company’s market weight. Same with ETFs.

Alan Radlo (now at CI Investments) and Kim Shannon (who now markets Sionna funds through Brandes Investment Partners) both predicted the Nortel collapse when the price was north of $85. At its peak Nortel represented 31% of the index, so if you’re pinned to the index with a passive strategy you’ve just gone over the hump on a roller coaster — start screaming.

Trading or investing?

ETFs have to follow the herd when there is a long trend in one stock either up or down. As a stock rises in market cap and is adjusted, the index adjusts the weighting up or down, and the ETF follows — it’s forced to react after the active managers have made their money. This knee-jerk action pushes or pulls the market for that stock up or down after the party is over. When the fall is precipitous, the pain is greater.

Some will argue ETFs constitute such a small percentage of investment activity that they don’t accelerate market declines. But if you’re aggressively encouraging more people to buy them, market share will increase and ETFs will then accelerate market declines.

Many people are buying ETFs on speculation. They’re chasing performance by playing the market, and that’s a disaster waiting to happen. If you’re buying and selling intra-day, you’re trading, not investing.

Vanguard’s intention in developing ETFs was to give long-term investors who prefer a passive approach the ability to buy the market for a low fee. If they’re used this way, there isn’t much wrong.

The three largest Japanese ETFs sold in the U.S. underperformed the Nikkei by more than 5% after the recent disaster. This was likely a function of intra-day trading by some ETF holders. Forward pricing on mutual funds, a rule imposed in the 1970s to protect smaller and less nimble investors, is not perfect, but it does treat participants equally.

Passive investments have been around for 30 years, yet account for only 10% of the industry. Wouldn’t more people be invested in them if they were so effective?

Dean DiSpalatro is Senior Editor of Advisor Group. Contact a professional advisor to discuss your circumstances prior to acting on the information above.