ETF Roundtable Report

Research and Roundtable Report

Presenters: HOWARD ATKINSON President, BetaPro Management Inc.

SOM SEIF President, Claymore Investments

HEATHER PELANT Head of iShares Canada, Barclays Global Investors Canada Limited

RICHARD GENONI Product Manager, Vanguard ETFs

An evolving global market Exchange-traded funds: are they niche fad or here to stay? Evidence strongly points towards the latter, as the number of product offerings available to North American investors has exploded over the last few years. Yet, while the uptake of ETF usage is growing rapidly, it remains quite small among Canada’s advisor community. New data from a survey conducted by Rogers Business and Professional Research Group suggest slightly less than one-third of Canada’s financial advisors are even licensed to sell ETFs.

Experts from three of Canada’s leading ETF providers, as well as an expert from one of the most influential ETF providers in the United States, came together to discuss how the ETF market is evolving and why it’s imperative advisors add ETFs to the suite of wealth management products they offer to their clients.

NEARLY HALF (48%) OF THOSE ADVISORS who currently offer ETFs to clients say they are likely to consider offering actively managed ETFs, which are active mandates within an ETF structure.

What are your thoughts on the development of the ETF space in Canada, both on its own and vis-à-vis the United States?

Howard Atkinson: I think the pickup of ETF usage in Canada has been quite good. I think if we went back to when firms started talking to advisors about ETFs in this country—which is going back about eight years—the amount of licensed advisors comfortable in selling them was probably about 10% and according to this survey we are now at about 80%. We’ve come a long way.

It’s easy to compare it to the U.S. and the metric in Canada is about one-tenth the size of the U.S., but because Canadian investors can buy U.S.-listed ETFs, I think you have to aggregate Canadian and U.S.-listed ETFs together to get a true picture of the size of the ETF market in Canada. So, there’s roughly $20 billion in Canadian ETFs, and roughly the same amount of Canadian investor money in U.S. ETFs—let’s call it about $40 billion total for argument’s sake. If Canada is about 10% the size of the U.S. market, proportionally we’re not that far off in ETF usage compared to American investors.

Som Seif: What’s happened in Canada over the last four or five years is a lot of development of product, which is necessary because the first step is to have the right product that people will be able to use to meet their needs.

The second thing is education. In the last two years I’ve seen a significant pickup in the level of education and awareness by both advisors and the end client of the benefits of ETFs and how they can be used in a portfolio. However, we’re still very early in that stage and it’s not at the level it needs to be.

The third thing is performance. When the markets are doing very well and people are making money, they don’t ask what fees they are paying and what their returns could be. They’re doing well, so they’re happy. It’s when the markets are doing poorly that people start to ask those questions.

We saw this happen in 2000, which was a critical period for the U.S. ETF business—2001 to 2004 was one of the greatest periods of growth for the ETF business in the United States. That was coincidentally during a bear market. I think in Canada, we are just entering that space and people are aware of it, so indexing is going to become more prevalent.

Heather Pelant: It’s unfortunate we’ve been thought of as a niche investment, so when you talk to advisors about some of the reasons they use ETFs, you tend to be having a conversation about low-cost MERs rather than the power of passive management.

All of our research has shown when an advisor has built a practice and they include an allocation of 2% to 10%, indexing it becomes a mindset shift versus the 1% to 2% it represents currently. We see this changing rapidly as the market shifts and the risk management benefits of ETFs begin to shine.

Richard Genoni: Looking at the source of ETF cash flows in the U.S., I would argue it’s coming mainly from individual stocks and actively managed funds. ETFs have actually grown the index slice of the pie, as opposed to stealing market share. While it’s a growing market in the U.S., representing around 700 products, as opposed to around 72 here, the results have been mixed. Fifty products in the U.S. represent more than 70% of the ETF assets under management and 40% of the products hold less than $30 million.

PRICING IS THE MOST CITED REASON an advisor will recommend one ETF over another similar product (55%). It’s followed closely by the reputation of the ETF provider, which 53% of respondents cited as an important reason to choose one ETF over another.

For advisors, what are the advantages and disadvantages of using ETFs?

Som Seif: The main reason is that they are low-cost, tax-efficient ways to get access to the marketplace. I also think one of the reasons we’ve seen growth in ETF usage is the simplicity of the product to get access to different asset classes and different markets.

These include products such as the leveraged or inverse ETF derivative strategies or products that focus on broad or specific commodities. The average retail investor can get access to asset classes previously unavailable to them or for which they can’t find good active money management.

Heather Pelant: ETFs address some of the problematic issues in the investment industry, such as questionable product design, lack of transparency, incomplete advice, media hype, tax inefficiencies and investor inertia. To me, a lot of these are dealt with head-on when you bring this kind of a tool to the marketplace.

Richard Genoni: In the U.S., the flood of new products to market has created a seemingly endless menu of choices. While this can be a very positive thing, we question taking a good thing too far. The abundance of available products can create investor confusion in deciding which of the available products is best suited for the client’s particular needs. The challenge is to not only understand from the top level what an ETF is trying to do, but also how it fits in the client’s underlying portfolio in terms of underlap or overlap in certain countries and sectors of the markets. This is where financial advisors can add value. They must wade through the sea of available ETFs to understand the true nature of the products, and they can ensure that their clients invest in ETFs with the lowest costs, highest after-tax returns and tightest benchmark tracking.

There are advisors who are not fans of “passive management” and view ETFs essentially as that. Can advisors use ETFs in conjunction with an active strategy?

Richard Genoni: Worldwide, active management is embraced far more often than index management. Even at our firm, roughly half of our $1.3 trillion of assets under management are in actively managed funds. We see a place for both products in a client’s portfolio. We frequently talk about advisor alpha, which is achieving alpha through the use of beta products. You can do that by properly weighting ETFs, either on a tactical or strategic basis.

Howard Atkinson: Too many advisors equate advice to active management. I would suggest advice equals client interest. Advisors should be asking, ‘How do I intelligently combine both types of investing? What’s going to help manage a client’s portfolio risk the best, and give them the best return?’ It shouldn’t really matter what investment discipline it comes from.

I think 2009 will be the breakout year for active ETFs. They do exist now, but I think you are going to see more of them entering the market. Ironically that will actually highlight the benefits of some of the indexed-linked ETFs, which will outperform some of these new active ETFs.

Heather Pelant: When institutions are constructing a portfolio, the first thing they are going to ask is, ‘How much beta do I need?’ Then they ask, ‘Do I have the active managers who can add outperformance in the space?’ If the answer is yes, go ahead and do your due diligence and pursue the active manager. If they answer no, you go back to beta. So there is a whole different framework that institutions use to get to an end result which is a combination of the two, and we are seeing advisors beginning to adopt this strategy.

Som Seif: What institutional investors are not doing is paying high fees for active management where it doesn’t add value. If an active manager is not going to add value in a specific asset class, they’re going to go to a passive solution and search for active management and alpha in another class where they can get it, and they will pay extra for that.

The Advisor Panel Survey shows the vast majority of Canadian advisors using ETFs are using ones linked to Canadian indexes. Canadian indexes tend to be quite narrow and concentrated in only a few sectors. Shouldn’t advisors be looking to diversify their ETF exposure?

Som Seif: I don’t think any Canadian should have only 3% of their portfolio in Canada, which is the market weight of Canada globally. They generally need and should have a much higher exposure. It is important to understand that there are a number of ETF products that provide exposure to international and global markets for Canadians to choose from. There isn’t just one type of exposure to one index.

Index selection and weighting methodology are very important. You can go with an S&P TSX 60 Index, you can go with the capped composite, you can take a fundamental index approach or you can go with a dividend approach. Each will give a different look to how stocks are weighted.

ETF SURVEY FINDINGS

Only 39% of Canadian financial advisors are aware that trailer fees on ETFs are available in Canada. Nearly half of advisors say if an ETF pays a trailer, they would be more likely to use them within commission-based accounts. Only 8% of those advisors who are not licensed to sell ETFs expect to get licensed over the next 12 months. Advisors must have a securities license to offer ETFs directly to clients. Only 29% of the respondents had this license, meaning more than two-thirds of Canadian advisors cannot buy and sell ETFs for their clients. However, 37% of advisors who identified themselves as financial planners or insurance specialists have a referral arrangement in place with an advisor who is licensed to sell ETFs.

Heather Pelant: Canada has a great and relatively complete set of ETFs that track Canadian indexes. Fully one-half of the monies Canadians have in ETFs reside outside Canada with ETFs that trade on U.S. exchanges such as the NYSE and the Nasdaq.

Looking at the development of the ETF industry worldwide, we’ve seen a proliferation of new and sometimes very narrowly focused funds. Advisors are encouraged to look closely at the underlying holdings of the funds and the company sponsoring the ETF to ensure it has the diversification they are seeking. Ask lots of questions.

Richard Genoni: I would be worried that too much money is being placed in the TSX. I certainly understand home country bias, but the 10 largest stocks make up 50% of the index, and three sectors make up 75% of the index. You will be drastically underweight in important sectors, such as healthcare, when looking at it from a global basis. So, if your core is the TSX 60, there are other ETFs that you can layer to help even those bets out. Another alternative is to add exposure to a broad global ETF.

Howard Atkinson: I think the point for advisors is that ETFs work equally well whether you are looking at domestic or international exposure. It’s one trade, you get a listed portfolio of stocks and you can buy it from whatever North American exchange it is listed on.

There is ample breadth within North America with more than 500 ETFs to choose from. Whether you are looking at allocating amongst equities, bonds, currencies or commodities— just to name a few—they are there and they are easy to use.

Are there problems with buying U.S. products when it comes to currency hedging issues and complications with U.S. estate tax?

Richard Genoni: Those tax issues are real, but must be considered on a case-by-case basis. There are certain options an advisor can take—like setting up personal holding companies—to get around some of those issues. Investors should consider all-in costs when making a decision on the right ETF—this includes expense ratio, bid/ask spreads, tax efficiency and tracking error. The benefit of tapping into the U.S. market is that you’re able to access the liquidity and broad array of available products.

Howard Atkinson: From an advisor standpoint there are two major issues with owning a U.S. ETF. As an advisor talking intelligently to their clients, they have to understand the currency and tax ramifications. On the currency side, it’s all well and good if U.S. ETFs are cheaper, but if I’m a Canadian who goes out to buy an ETF in U.S. dollars, and I convert my currency, foreign exchange can be as much as 150 basis points each way. That’s 10 times the MER to go in and 10 times just to go back out. Your cost advantage is blown out the window.

Also, if you do have U.S. dollar exposure, that is fine if that’s what you want. If you don’t, fortunately for Canadian investors, all three major Canadian providers do offer products that are U.S. dollar-hedged.

On the tax side, U.S. ETFs are U.S. property and thus potentially subject to U.S. estate tax. In addition, distribution from U.S. ETFs are treated as income for tax purposes in the hands of Canadian investors and can be subject to withholding taxes. Canadian ETFs, even those tracking U.S. benchmarks, are treated as Canadian property and distributions retain the tax characteristics of the underlying cash flow.

Som Seif: Another issue is servicing. A U.S. ETF has been created for U.S. investors and U.S. regulations do not allow them to be servicing a client. While an accredited advisor may call a U.S. provider in the U.S., a Canadian ETF investor (or end client) may not because they don’t usually have offices here in Canada, they are not supposed to be able to talk to you. SEC regulations do not allow them to talk to you. U.S. ETFs are designed and registered for U.S. residents.

Heather Pelant: My team in Canada spends about 50% of their time talking about U.S. iShares and they are incredibly comfortable and they do provide the support. We also have a distribution centre in Jersey City that answers inbound calls from Canadians.

If an advisor decides to construct an ETF portfolio, what sort of criteria should they be looking for?

Heather Pelant: It’s not an easy decision. For example, if you are putting together a portfolio in the U.S., there are 12 large-cap value options. I don’t think with the Canadian families of funds the choice is quite as onerous, but it’s onerous nonetheless.

First and foremost, we say that not all ETF providers are created equal. The first question we suggest asking is, ‘Who is the provider that backs the ETF? Who is the company that stands behind it?’

Advisors need to do a total cost analysis of the ETF. There’s a new calculation that doesn’t just stop with the MER, it also includes the cost of the spread and the trading costs associated with the ETF. It’s a relatively new formula, but avid users of ETFs have embraced it. They create a spreadsheet that looks at all the various buckets and options and even go as far as looking at the price to earnings ratio.

ETF ROUNDTABLE ADVISOR SURVEY

Rogers Business and Professional Research Group surveyed 405 Canadian financial advisors to understand how many are using ETFs in Canada, and if they do, how and why they use them. Clients play a very important role in initiating the discussion about ETF usage. More than a third (35%) of those advisors who recommend ETFs say clients are asking more about ETFs than they were last year. For advisors who are licensed to sell them, the comfort level in ETFs is very high (81%). Cost savings (i.e., lower fees and MERs) were a key reason advisors recommended ETFs over other investment products, said 77% of licensed respondents. The majority of advisors that recommend ETFs (59%) say they use ETFs to get targeted exposure to alternative asset classes, such as timberland or agriculture. For those advisors who do offer or recommend ETFs, on average 21% of their clients have ETFs in their portfolios. On average, ETFs represent 18% of the portfolio composition for clients that use them. The results of this survey are reflected in the questions posed to our panel of experts. Survey MethodologySurvey Type: Oonline SurveyFielding dates: August 15 to September 8, 2008Margin of Error: ± 5.0%, nineteen times out of twentyTotal number of respondents: 405

Richard Genoni: This all goes back to education. With the increasing number of available products, it’s that much harder to understand the differences between each ETF. For example, if you’re trying to define large-cap exposure, should that be the top 300 names, the top 500 names or the top 750? As you construct a portfolio, advisers should look under the covers at what the index is trying to do and decide whether that exposure fits the portfolio gap you are trying to fill. If it does, then look at how well the fund tracks the index.

Howard Atkinson: I would suggest the name of the provider is not the most important issue. We’ve seen in the market recently that big institutions have failed, none of them in the ETF space at this point—hopefully that doesn’t happen. But I think you want to be looking at ETFs that have significant assets under management and trade robustly. The assets are in trust and can be protected no matter what happens to the provider. In the event of an ETF provider failing, somebody will likely take those products on and they will continue to operate.

Som Seif: In the end, it’s the same way you choose a mutual fund provider. You don’t just go and give your money to a mutual fund provider that has $5 million dollars of assets that has just started out Starrettwith a bunch of funds. Most people will kick the tires and make sure it works. Advisors are going to do their due diligence, and that is effectively where the advisor’s work comes in, to make sure that they are investing with the right companies, the right people, the right credibility and the right infrastructure.

PRESENTERS
HOWARD ATKINSON President, BetaPro Management Inc.	SOM SEIF President, Claymore Investments
HEATHER PELANT Head of iShares Canada, Barclays Global Investors Canada Limited	RICHARD GENONI Product Manager, Vanguard ETFs

BARCLAYS GLOBAL INVESTORS Barclays Global Investors (BGI) transformed the investment industry by creating the first index strategy in 1971 and the first quantitative active strategy in 1978. After more than three decades—and with one of the best long-term track records of any active manager—we remain a leader in creating investment solutions that consistently deliver on their promise. This success has helped us become one of the largest asset managers in the world and the largest manager of ETFs—known as iShares Funds—with over 200 ETFs available across the world representing over US$400 billion in assets. Through our 10 client-service offices worldwide, we cover 50 of the world’s equity markets, 18 bond markets and 50 currency markets. Barclays Global Investors Canada Limited (Barclays Canada) is an indirect subsidiary of Barclays PLC and part of BGI, a division of Barclays PLC. As at December 31, 2007, Barclays Canada managed over $74 billion in Canadian assets and in other assets for Canadian clients, including over $17 billion in the TSX-listed iShares Funds. Barclays Canada has offices in Toronto, Montreal and Vancouver.

CLAYMORE INVESTMENTS Claymore Investments, Inc. is a privately held financial services company offering unique investment solutions for financial advisors and retail investors. Claymore is an innovator in exchange-traded funds (ETFs), institutional funds and closed-end funds, often leading its peers as the first-to-market provider of intelligent investment strategies. Claymore Investments, Inc. is the wholly owned Canadian subsidiary of Claymore Group, Inc, a U.S. entity. In total, Claymore entities have provided supervision for approximately $18.4 billion in assets as of June 30, 2008. Led by an experienced management team, Claymore brings together what it believes to be best-in-class asset managers and index providers to create innovative investment solutions that are used to establish strategic partnerships with investment professionals.

HORIZONS BETA PRO ETFs Horizons BetaPro ETFs are managed by BetaPro Management Inc. (“BetaPro”), an innovative financial services company and Canada’s sole provider of leveraged and inverse leveraged ETFs. Horizons BetaPro ETFs allow investors to profit or protect in bull and bear markets. The company currently manages over $1.75 billion through 28 ETFs. BetaPro is an associate of Jovian Capital Corporation, a publicly traded management and holding company with interests in a variety of financial service firms specializing in wealth and asset management listed on the TSX (JOV). The Jovian Group of Companies operates as a national financial services organization with approximately $14.6 billion of client assets.

VANGUARD Since its beginning in 1975, Vanguard has grown to become one of the world’s largest investment management companies, with more than C$1.3 trillion in U.S. fund assets under management as of June 30, 2008. Vanguard provides an array of investment products, including a full range of low-cost ETFs and mutual funds designed to help financial advisors grow and preserve the wealth of their clients. In addition to our many investments and client-focused services, our commitment to financial advisors includes innovative practice management solutions that can help advisors attract and retain clients, build their practices, and enhance their professional development. Most investment firms are either publicly traded or privately owned. Vanguard is different: We’re client-owned. We make every decision with only our clients’ needs in mind. Our unique structure, along with our commitment to provide outstanding performance, provides financial advisors with many opportunities for building their businesses and enhancing their client relationships. Connect with Vanguard at advisors.vanguard.com or contact Michael DeFlavia at 1-610-669-3060.

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