Too much of a good thing

With more than 200 ETFs in Canada, are these choices helping or harming investors?

A couple of years ago, I was in a small Quebec community where the only places to eat were a McDonald’s and a Subway. My French is lousy, but on my first day I had no trouble ordering a Big Mac. The next day I tried Subway. When I asked for a jambon et fromage, I was avalanched with choices. What kind of bread? Cheese? Sauce? Onions, olives, tomatoes? The following day I went back to McDonald’s—simply because it was easier.

Most of us believe more choice is a good thing. But recent academic work on decision-making has found that’s not necessarily true. When people have a smaller number of options, they’re usually able to evaluate the strengths and weaknesses of each. However, when faced with a dizzying variety, the quality of their decisions drops dramatically.

That’s the situation advisors and their clients face today as the menu of ETFs gets longer. What started out as healthy market competition has turned into a confusing maze most people aren’t equipped to navigate. That leaves your clients at risk of making poor investment decisions.

The growth of the ETF industry over the last seven years has been astounding. There was just one ETF provider in Canada at the end of 2005. iShares, then owned by Barclays Global Investors, had the market to itself after its only competitor, TD Canada Trust, shelved its small family of ETFs due to “lack of investor interest.” TD exited just as the market was about to snowball.

Claymore and Horizons launched their first ETFs in 2006 and 2007, respectively, followed by BMO Financial Group in 2009. And this year alone, XTF Capital, PowerShares and RBC Global Asset Management have all joined the party, while Vanguard has filed a prospectus for six new ETFs to launch this fall.

We know clients aren’t good at choosing among a dozen investment options, let alone hundreds.

The number of Canadian ETFs has grown to well over 200, and it won’t be long before that total exceeds the number of stocks in the S&P/TSX Composite Index. This crowded marketplace means new entrants will have to compete in one of two ways. First, they can undercut their competitors on price, but that’s a tough road to travel. The second option—which has become the norm—is to create increasingly unique, exotic and complex products.

We know clients aren’t good at choosing among a dozen investment options, let alone hundreds. In her 2010 book, The Art of Choosing, Sheena Iyengar, a Toronto-born professor at Columbia Business School, describes a study she did in conjunction with Vanguard. Iyengar and her colleagues looked at employer-sponsored retirement plans and found the highest rate of participation (75%) among employees who had just four funds to choose from. If employees had a choice of 12 funds, the participation rate fell to 70%. And those who had a menu of 59 possible funds? Just 60%.

I’ve seen this analysis paralysis in many investors I’ve corresponded with. They know their portfolios are a mess (usually a random collection of mutual funds and individual securities) and they want to adopt a low-cost, efficient strategy using ETFs. Yet when it comes to choosing specific funds, they’re not equipped to compare all the choices, so they do nothing.

I’m not sure the growing number of ETFs is helpful for advisors, either, as they increasingly have to field more and more questions from clients: “I keep hearing about these ETFs. Shouldn’t we be using them in my portfolio?” This creates awkward discussions for MFDA-licensed advisors, who aren’t allowed to use them, and for commission-based advisors, who aren’t compensated for selling them. (Most ETFs do not pay trailers, although some from Claymore and Horizons do include them.)

Advisors already have more than enough good products to build well-diversified, low-cost portfolios for their clients. Having more ETFs in the toolbox may encourage these advisors to tinker with complex strategies, none of which are likely to add long-term value.

Advisors can help their clients understand that there is nothing magical about ETFs. The knock against mutual funds is that many are too expensive, but there are low-MER mutual funds just as there are high-cost ETFs.

It’s time to turn the focus away from product structure and look instead at specific details. What is the fund’s fee? What strategy does it use? How well has it delivered on its promises? And, most important, is it appropriate for the client?

ETFs were revolutionary when they first appeared in Canada more than a decade ago: they created radical new opportunities for investors and advisors. But Canadians don’t need more ETFs. What they need is professional help with their investing goals, tax planning and risk management; and they need to be taught how to avoid self-destructive behaviour. That’s where a good advisor adds value.

Dan Bortolotti is a senior editor and columnist with MoneySense. He is also the creator of the Canadian Couch Potato, selected by the Globe and Mail as the country’s best investing blog in 2011.