The ETF outlook

While the gap is starting to narrow between the $25-trillion mutual fund industry and the $1.5-trillion exchange-traded fund (ETF) market, global retail and institutional markets are still in early stages of adoption.

“If you look at U.S. trends, periods of extreme volatility have led many retail investors to increase their usage of ETFs,” says Michael Cooke, head of distribution, PowerShares Canada.

The forecast for exchange-traded products ranges from about $2 trillion for the U.S. (according to BNY Mellon/Strategic Insight) to $4.7 trillion globally (according to McKinsey) in assets under management to the end of 2015.

Beyond that time frame, the number will be easily surpassed, says Mark Yamada, president of PUR Investing Inc., who uses ETFs to manage risk.

“ETFs are a better way of delivering a fundamental investment product,” he says. “And the fact that they’re only 6% of mutual fund assets in Canada—closer to 9% to 10% if you estimate Canadian investors’ holdings of U.S.-traded ETFs—suggests the only thing standing between a better product and the end investor is the advisor.”

The consequences of lower fees

Yamada’s assertion is unwelcome for advisors whose mutual fund MERs seem oversized next to significantly lower MERs charged for ETFs. Going forward, this disparity should lead to an unbundling of investment management services and products, he says.

“The good news for the end investor is that unbundling will mean pricing not just the product, but also placing a value on advice,” he says. “In a fee-based account, with the advisor charging, say, one percentage point a year for either financial planning or investment management, the nature of the relationship is going to become more transparent.”

The MER of a mutual fund, he says, isn’t always disclosed clearly, and mutual fund holders really don’t understand what they’re paying, and to whom.

Undeniably, investors today are more price-sensitive, adding to ETFs’ popularity.

In a nutshell: The basics on ETFs

ETFs follow a specific index for a commodity, financial instrument or sector. A market maker buys securities in the same proportion as the index and exchanges them for creation units, which are offered on a stock exchange. Fluctuations in creation units don’t impact the Net Asset Value per Share (NAVPS), so ETFs can be intraday traded. Index components are visible at the start of any trading day, providing transparency. There are generally no drawdowns or return-of capital distributions, so ETFs are more tax-efficient than a similar mutual fund. Thanks to passive management, MERs are often lower than similar mutual funds.

“Clients are asking for them, and clients’ accountants are asking for them because they know ETFs are a more efficient way of delivering basic investment returns,” says Yamada.

Advisors, meanwhile, are catching up with the reality and responding to shifting investor demands.

“As asset allocation and overall portfolio fees become more important, a growing number of advisors are combining active and passive exposures in portfolios,” says Cooke.

Combining the two is a great way advisors and investors—both retail and institutional—can plug holes in investment portfolios. “Institutions are looking to buy ETFs to fill gaps of exposure in their portfolios, and retail investors are no different,” says Yamada. “The easiest thing for an advisor to do is to look to the ETF market for the lowest-cost exposure they can’t find through the direct securities market.”

Terri Troy, CEO of HRM Pension Plan in Halifax, says ETFs may play a larger role in institutional portfolios going forward. “ETFs are an important tool for our portfolio,” she says. “To date, we have used Standard & Poor’s Depositary Receipt, or SPDRs [an ETF that tracks the S&P 500] and Vanguard Emerging Markets to get exposure to the broad U.S. and emerging equity markets on a cost-effective basis.”

Troy says ETFs play a significant role in the management of her plan’s assets because they “facilitate timely movement between asset classes and [provide the] ability to efficiently focus on broad markets or subsets of markets.”

Two sides of the same coin

While there’s no denying the ETF industry will continue to grow steadily, market pundits say that growth will not necessarily cannibalize the mutual fund market.

Yamada says they are two sides of the same coin. “ETFs are the next iteration of the mutual fund,” he says. “If an investor wants to buy an ETF directly from the marketplace they can. ETFs offer much more flexibility and transparency than mutual funds, and a much cleaner delivery mechanism.”

The growth of fee-based platforms is also contributing to the growth of the ETF industry.

“As more IIROC advisors move towards a fee-based model, [they are] further aligning their interests with those of their clients and [are] charging a flat fee to effect portfolio construction and asset allocation decisions using low-cost building blocks,” says Cooke.

Yet investor thrift and the need for instant gratification won’t kill active management. “The world will always be inefficient, and will always allow for good security selection and active money management, as a complement to this growing appetite for index solutions,” says Cooke.

Mary Anne Wiley, managing director and head of iShares distribution at BlackRock Canada, agrees it’s not a case of either/or. “You’re going to see them coexisting as equal options at least five-to-10 years from now; I don’t think ETFs will ever get rid of mutual funds,” she says. “When you’re in a fee-based model, the advisor is being paid for the assets they’re managing, not by trailers or commissions. ETFs drive down the overall cost of investing for the end client, which makes the advisor look good.”

Wiley does admit that “active management is very difficult” and that “ETFs are diversified, low cost and easy to trade, [and] will continue to drive dollars into [the] ETF [market].”

Even ETF manufacturers have started to combine active with passive models. Yamada concedes there’s practicality to it.

“Advisors who believe in active management can put clients into a passive core portfolio, and buy active management products around the outside. The investor pays for passive strategic allocation at a low price and gets a try at outperformance around the periphery.”

With popularity comes tighter scrutiny. Like mutual finds, the future size and shape of the ETF market will depend on the force of regulatory oversight. There is cause for concern. ETFs got bad press during the flash crash of May 6, 2010. And a U.S. Senate subcommittee hearing in October examined various types of ETFs and their potential for systemic risk.

While ETFs, for the most part, have been exonerated, it has done little to convince regulators.

“The regime is going to get a little tighter,” says Yamada. “Scrutiny will be a little bit greater; when we look to the future, standards of disclosure may be more rigorous for new products.”