ETFs: More growth ahead

ETFs have seen incredible growth over the last few years, attracting investors and managers alike with low fees and index-tracking performance that more often than not beats the returns of costlier actively managed mutual funds. And as the variety of asset classes has increased to include everything from equities, bonds and preferred shares to commodities and currencies, it’s now possible to build complete, well-diversified portfolios using only ETFs.

For these reasons, global ETF asset growth has been on an exponential trend over the last ten years, with annual increases of 30%. Even more compelling, over the bust-boom period of 2008-2009, global assets under management (AUM) growth for ETFs was 14%, versus a negative 6.45% for mutual funds. This trend continued in the first five months of 2010, with ETFs experiencing inflows of US$57.4 billion, and mutual funds US$220 billion in outflows. We’ve only just begun

ETFs are just starting to catch on in Canada, even though the first-ever ETF appeared here with the TSX’s 1990 launch of the Toronto 35 Index Participation Fund (now the XIU, following Blackrock’s purchase from the TSX in 2000). With $31.5 billion in AUM as of December 2009, ETFs currently represent about 4.4% of the $719 billion mutual fund industry in Canada — but the number is growing fast, at a 90% annual rate over the last ten years.

In 2008, ETFs were the only investment offering in Canada with positive cash inflows of $7.1 billion, for a 40% year-over-year increase in new investments. And though markets were in the midst of a correction in 2008, this still resulted in a growth in value of $1.08 billion or 8.38% in AUM, compared with a loss of $154 billion (a 20% drop) in AUM for mutual funds. And the growth continued in 2009, with ETF AUM increasing $12.1 billion or 62%. In contrast, mutual fund AUM over the same period grew by just under 20%. With such an ongoing trend, it’s difficult to imagine any sort of dip in ETFs’ popularity in the years to come. A recent Cogent Research survey of 1,500 U.S. brokers and advisors appears to confirm this.

According to the survey, although mutual funds will continue to capture most of the investable assets, by 2011 advisors expect to allocate 14% of their client portfolios to ETFs, compared to the current 8% and the 5% reported in 2007. Allocation to mutual funds, on the other hand, is expected to drop to 27% from the current 30% and the 35% recorded in 2007. ETFs are clearly taking business away from mutual funds. And this means more clients will be inquiring about ETFs in the future.

Fees

Canadian mutual funds charge hefty fees – the highest in the world, according to a 2007 study entitled “Mutual Fund Fees Around the World” by Khorana (Citigroup), Servaes (London Business School) and Tufano (Harvard Business School).

The study looked at fees charged in 2002 by 46,580 funds around the world, including 3,674 Canadian funds, and found Canadian mutual funds had an average total expense ratio (TER) — roughly a fund’s MER plus its trading cost ratio – of 2.20%. This compares to a global average TER of 0.95% and a U.S. average TER of 0.81%.

And this trend doesn’t appear to have changed. In 2009, the ten largest Canadian equity funds had an average MER of 2.32%, plus a trading cost ratio (TCR) of 0.24%, for a total cost of 2.56%. In response, many investors are looking to ETFs as a cost-effective alternative. For example, one can buy an ETF that tracks the TSX 60 index (with Blackrock’s flagship XIU) for a management fee of 0.17%, or the U.S. market with Vanguard’s total stock market index ETF for a puny 0.07% MER, representing a substantial savings over mutual funds. And as most ETFs are passive and thus have a low turnover, their TCR is usually nil to extremely low.

There are three main reasons ETF fees are lower:

Most of them passively track the underlying index, saving on management fees. With mutual funds, buyers and sellers of units turn to the mutual fund company to match their trades and manage all inflows and outflows internally – an added cost for the company that’s passed on to unitholders. But because ETFs are exchange-traded, buyers and sellers meet on an exchange at no cost to the ETF supplier. Also, unitholders don’t subsidize future transaction costs while they hold the units. In other words, ALL unitholders pay for a mutual fund company’s ongoing matching costs, including present holders who aren’t trading their units. ETF suppliers are generally less lavish than mutual fund companies with their marketing budgets. The streamlined approach is one less cost to be passed on to the investor.

Performance

Of course, if you own the index, you can’t beat it. In theory, the best you can hope for with an ETF is the index’s performance minus its MER. So do the additional fees for an actively managed mutual fund deliver extra performance? The answer appears to be no.

The passive approach of ETFs has actually been, historically, a performance advantage over actively managed mutual funds. The latest Standard & Poor’s SPIVA Scorecard (March 2010), which compares the performance of actively managed mutual funds of different categories against the relevant index benchmarks, shows a continued dismal performance of Canadian mutual funds versus their passive benchmarks.

For example, as of March 2010, 96.74% of actively managed Canadian large cap funds underperformed the TSX over a five-year period with an average annual return of 4.47% after fees, versus 7.41% for the index. And over the last three years, 89.06% underperformed the TSX, with an annual return of -2.44%, versus -0.03% for the index.

According to SPIVA, Canadian equity mutual funds underperformed their indexes in all categories for the one-, three- and five-year periods, except in the Canadian-focused equity and U.S. equity categories for the one-year period. And this trend has actually been worsening steadily since the third quarter of 2004, when 35.9% of equity funds beat the TSX Composite over a five-year period.

ETFs aren’t perfect either, though. Passively tracking an index may sound simple, but it’s not, and tracking errors do occur. Many corporate bond index ETFs have had persistent tracking errors in recent years, while certain emerging markets ETFs also had serious tracking difficulties in 2009 (though Vanguard’s VWE emerging markets ETF was dead-on).

These errors are sometimes due to the tracking methodology; other times they’re due to the nature of the index itself. The DEX corporate bond index, for example, includes many very illiquid bond issues that make recreating it in the markets challenging. And of course, if one opts for an active manager to avoid the risk of tracking error, one must take on active management risk — a solution probably worse than the initial problem, based on the track record of actively managed funds. In addition, actively managed ETFs may be the next wave. If so, the ETF/mutual fund debate won’t be a passive/active debate; the lines will get blurred.

Structural changes needed

Because of their many benefits, we can expect ETFs to represent a much greater share of managed assets in the future. But some structural issues within the advisory industry need to be addressed if ETFs are to take centre stage alongside today’s more mainstream managed products. One such issue is how to incorporate ETFs into various business models. Advisors need a full-service licence to use ETFs, making them out of reach for MFDA financial planners, who represent a large segment of the industry.

Also, mutual funds still have some advantages over most ETFs. First, they pay trailer fees, providing an income stream to advisors. Cash management is another advantage: T-series funds, pre-authorized purchase programs and dividend reinvestment plans are appreciated by both advisors and clients. Such tools are practically nonexistent with ETFs except through Claymore, which offers such services to some brokers. Certain brokerage firms also offer some cash-management options such as DRIPs to their clients, but these are independent of any ETF supplier’s involvement.

Integrating ETFs is a challenge for the securities-licensed broker as well. Although they may be licensed to sell exchange-traded securities, there’s still the issue of trailer fees and cash management. While licensed brokers have the option of charging commission, most ETFs are designed to track passive indexes and are more suited to a strategic-allocation, buy-and-hold approach with limited tactical skews. The low turnover of such an approach isn’t rewarding on a commission basis.

That said, some mutual fund companies have started offering ETFs wrapped into a mutual fund product for a have your cake and eat it too proposition.

Last November, Invesco-Trimark launched a suite of the recently acquired PowerShare ETFs in a trailer-paying mutual fund shell, making them MFDA-friendly and offering various cash-management functionalities. BMO followed suit this April, offering six mutual funds invested in portfolios composed of a selection of the ETFs they’ve been launching since May 2009. These funds also come in the popular corporate-class structure, and even in F-series!

Another solution is to incorporate the management of ETF-based portfolios in a fee-based account, though some advisors may feel their job is easier when fees are taken off the NAV, thus attracting less attention. DSC schemes are also out of the question.

Overall, ETFs can offer the best of all worlds for most investors: transparency, easy diversification, low cost and liquidity. They can also represent the worst of all worlds for certain advisor/planner business models: transparency, no trailer fee, no DSC schemes, and lower turnover.

Yet ETFs are here to stay and more and more clients will demand their advisor or planner include them in their service offerings. Clients will also demand more transparency, making it a valuable business asset. So advisors and the industry as a whole should seek to adapt sooner rather than later.

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Guy Lalonde is an investment advisor and portfolio manager at National Bank Financial, based in Pointe Claire, Quebec.

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