CE Course: An in-depth look at ETFs, Part 2

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The questions for this course were written by Mark Yamada, President & CEO of PŮR Investing Inc., a registered portfolio management and software development firm specializing in disruptive strategies for investors, their advisors and pension plans.

PART 1: Look under the hood

Swap-based ETFs offer price and performance advantages—for a price

By Scot Blythe

There are currently two swap-based ETFs in Canada. In Europe, they represent about 50% of ETF assets, according to Howard Atkinson, CEO of Horizons Exchange Traded Funds, which created the two Canadian ETFs.

Most Canadian ETFs hold the underlying shares of an index. With large-cap indexes, they hold shares in all constituent companies. In illiquid markets, the ETF may hold a sample of the constituents.

Swap-based ETFs provide a way around this latter constraint. Exposure to the constituents of an index is synthetic, obtained by means of a futures contract or a customized derivative—namely, a swap. And swaps even have advantages in more liquid markets.

Savvas Pallaris, an independent capital markets researcher who wrote a report on swap-based ETFs, notes 75% of passive institutional exposure to the S&P/TSX 60 is through synthetic rather than cash replication. This changes the cost structure, performance and risk profile of the ETF.

Swap-based ETFs are cheaper because they don’t have to trade the underlying shares. Instead, a bank delivers the total return value of an index to the ETF, for a price. That price is low for two reasons (see “Two reasons why costs are lower”).

Two reasons why costs are lower

• The structure of a swap. The ETF isn’t investing all its capital in the underlying stocks. Instead, it posts collateral, and that collateral earns a return— likely the going interest rate. The ETF exchanges or swaps the return it earns with a bank. The bank delivers a floating return, one that depends not on current interest rates, but on the difference in the total return of a stock index from one period to the next. It could be positive or negative. (It’s sort of like swapping the returns it could earn from a fixed-rate mortgage with the returns it could earn from a variable-rate mortgage.) Here, the bank benefits from a lower cost of funds compared to what the ETF provider has to pay for the swap. It can borrow at the interbank rate, rather than interbank plus 100 basis points, so it has a cushion of cash that can be used elsewhere to earn profits.
• Economies of scale. The bank also manages similar portfolios for other investors and also trades in the same securities for its own account. That reduces its cost of hedging. It has inventory. And it has taxable returns that can be reduced. These, in turn, reduce the cost of the swap contract.

“The banks are able to offer total-return [swaps] off Canadian benchmarks like the TSX 60 at extremely competitive rates—negative rates in many cases,” says Atkinson. “This is what would happen if you were a large institutional investor and you went to [an organization] like Ontario Teachers’ Pension Plan and said you wanted to do a total-return swap.

“It’s a quite competitive market and the banks have bid themselves down to the point that they will do it for less than zero. The counterparties are making money on this. They’re just not charging per se for the swap when it comes to Canadian equities.”

They would charge, however, for swaps based on U.S. equities and that fee is currently set at a maximum of 30 basis points.

Swap-based ETFs are cheaper in two other ways that affect investors. There are no trading costs, and the ETF doesn’t own the shares, so there’s no need to rebalance. It’s up to the bank to track the index. Also, because it doesn’t own the underlying shares, the ETF doesn’t receive the dividends. Instead, dividend payments are added directly to the value of the swap. Hence, investors don’t face a performance drag in waiting to reinvest the dividends, nor do they face tax on those dividends.

Pallaris compares HXT and XIU, the iShares competitor for tracking the S&P/TSX 60. The management fee for HXT is seven basis points. There are no operating costs. The management fee for XIU is 15 basis points and operating costs are capped at 2 basis points. Those costs will add to the tracking error.

Pallaris also estimates a 62-basis-point saving for investors from not having to pay taxes on dividends. That’s for Canadians with non-registered accounts. Foreign investors receive no dividend tax credit, so their savings are even higher with a swap-based ETF. The same holds true for Canadians who hold foreign ETFs in a taxable account. Pallaris calculates a Canadian holding a swap-based ETF that targets U.S. stocks would realize a tax saving of 93 basis points.

The risks

Of course, there is no free lunch. Swap-based ETFs come with a different set of risks, which has raised alarm in Europe. Two different issues have been highlighted. One is the quality of the collateral. In a cash replication strategy, the ETF owns the underlying securities. In a swap-based strategy, the ETF provider posts collateral against the contract.

In Europe, researchers at both the IMF and the Bank for International Settlements have noted the collateral basket can be very different from securities targeted by the ETF, because it is chosen by the counterparty.

For example, in Europe, the collateral for one MSCI Emerging Markets ETF consists mostly of developed market bonds, of which only half were rated A, or higher. But that’s not the Canadian structure, notes Atkinson. The ETF is fully cash-collateralized. Collateral is not usually an issue except in times of economic crisis. That’s when banks default and their assets get tied up in bankruptcy court.

Again, the Canadian practice is different. Once the marked-to-market gains portion of the Net Asset Value (NAV) exceeds 10% (effectively 110% of investor capital), the ETF provider is forced to reduce specific counterparty exposure back below 10%. If the counterparty risk exceeds 10%, “we must add another counterparty and/or unwind part of that swap, where the counterparty would deliver a portion of the marked-to-market gain of the  ETF so that we’re under the 10% threshold,” explains Atkinson.

If the NAV increased 10% from its original value and the counterparty went bankrupt, investors would still be able to access the principal value of the ETF.  This means on a $100 investment, instead of it being worth $110, the ETF would be worth $100. The credit risk only applies to gains, and then only up to 10%.

Bankruptcy is unlikely, but could happen. Outstanding balances are settled periodically, and always when they get close to 10% over the initial NAV. So most likely, any potential loss resulting from counterparty failure is under 10%. “[Part of the swap would unwind] when there’s a gain and the counterparty has to deliver part of the total return to the ETF,” says Atkinson.

That’s in a rising market, where the counterparty owes the ETF money. In a falling market, where a bank is more likely to be under siege, the ETF would owe the counterparty money.

Thus, in a rising market, “there could be a loss to the investor—that is capped at 10% of the marked-to-market gain of net asset value. When you use a swap-based versus a physically replicated ETF, you’re trading off the very remote possibility of a small counterparty loss, with the certainty of better tracking and better after-tax performance.”

That’s why it pays to look under the hood of the ETF.

PART 2: Not an oxymoron

ETFs have gone active. What you need to know

By Donna Green

Active ETFs have only been on the market for six years, but that’s been enough time to cause a stir in the marketplace.

In August 2005, Claymore Investments launched what it billed as the world’s first actively managed ETF, Claymore Canadian Financial Monthly Income. Since then, actively managed ETFs have proliferated. Horizons Exchange Traded Funds Inc. now boasts 18 actively managed ETFs—eight of which are available in advisor series—and two closed-end funds with assets of over $1 billion as of October 1.

“Going forward you will be able to purchase any active manager as a mutual fund or as an ETF,” suggests Reg Jackson, a VP and Portfolio Manager with National Bank Financial in London, Ont. To Jackson, ETFs are just another delivery mechanism.

Claymore converted its inaugural active income ETF to a passive index in 2009, but re-entered the active space in March 2011 with the actively managed Claymore Advantaged Short Duration High Income Fund ETF, which now has $160 million in AUM.

Advisors should be watchful for differences between active and passive ETFs. ETFs have lower MERs and are generally more tax-efficient than mutual funds. However, what you’ve come to expect from passive ETFs when it comes to portfolio and pricing transparency is not true of most active ETFs.

Cost

MERs on active ETFs made in Canada range from 0.43% to 1.24% (advisor-class ETFs excluded). This compares favourably to no-load F-class mutual funds with MERs broadly spanning 0.50% to 1.85%.

Yet, as Dan Hallett, vice president of HighView Financial Group, notes, commission and bid/ask spreads on ETF trades need to be factored into the overall cost of an ETF.

“Quite a few active ETFs in Canada have performance fees, a layer most other products don’t have. In some cases, the benchmark used in the performance fee calculation is a mismatch relative to the actual mandate.”

Hallett cites Horizons Alphapro North American Value ETF as an example. It has a North American mandate but it is benchmarked to the S&P 500, which only tracks American stocks. A Horizons representative stated HAV has “historically had very little exposure to Canada.” Also, only six out of the 18 actively managed ETFs at Horizons have performance fees associated with them. Claymore’s single active ETF has no performance fees.

Tax efficiency

Because they are exchange-traded, ETFs don’t sell their holdings to fund redemptions. This feature is inherently tax-efficient and both passive and active ETFs enjoy this advantage. Apart from this, Hallett notes, active ETFs are no more or less tax-efficient than actively managed mutual funds of a similar age, trading frequency and mandate.

There are, nevertheless, tax-efficient active ETFs. Stephen Verbeek, an investment advisor with RBC Dominion Securities in Hamilton, Ont., points out the covered-call writing active ETFs in the Horizons family are highly tax-efficient. He uses one gold-based yield fund, which gives his clients tax-advantaged income from an asset class that typically doesn’t provide cash flow.

He’s converted his clients’ gold holdings into this fund, thereby generating them 6.5% annual income. Horizons expects initial distributions will consist primarily of return of capital. It’s currently a closed-end fund expected to convert to an ETF by July 31, 2012.

Portfolio transparency

Passive ETFs publish their portfolios daily. This is seldom true of active ETFs: most active managers want to keep their trades under wraps to prevent front-running and freeloading. Horizons publishes its complete actively managed portfolio holdings every month.

Similar to mutual funds, Horizons is required to disclose the top 25 holdings on each fund on a quarterly basis, and the entire portfolio semi-annually. Horizons discloses the underlying portfolio on all of its actively managed ETFs to its market makers on a daily basis to ensure tight bid/asks to NAV are maintained throughout the day. Claymore publishes its sole active ETF portfolio daily.

Pricing

Without knowing the net asset value of an ETF, it’s not possible to determine whether you are buying at a premium or a discount to the underlying basket. In Canada, only Horizons Betapro and Index ETFs and Claymore ETFs have intraday NAVs available.

In the U.S., each ETF’s NAV is updated every 15 seconds. “In Canada we are running blind,” says a B.C. advisor. “The ETF companies [for the most part] insist on posting end-of-day NAV value only.

“With a mutual fund,” he adds, “I’m getting an end-of-day price with no bid/ask spread. An unpopular ETF will have a big bid/ask spread. Lower management fees, yes, but what if there is a half percent spread?”

Horizons’ senior vice-president of national sales, Faizan Dhanani, says their intention is to report the actively managed funds’ intraday NAVs in the future. Claymore’s fund intraday NAVs are available on Bloomberg and Thompson feeds, and Dan Rubin, Claymore’s vice-president of marketing, says NAVs should be on Claymore’s website before the end of 2011. The Claymore website currently provides only end-of-day NAVs.

The freedom of anonymity

Despite pricing irritations, our anonymous advisor uses Horizons Seasonal Rotation ETF because he likes the unique approach of capturing historically demonstrated seasonal trends, and he’s happy to find this in an exchange-traded product for one reason: the lack of pressure from sales reps.

“The mutual fund industry sells its funds with relationships,” says the B.C. advisor. “I need to keep one step away from them.”

Also, mutual fund trades cannot be anonymous. With an ETF, the advisor can make the trade without identifying his office, and without short-term trading fees.

PART 3: Spice or spoiler

Are leveraged ETFs smart investments or fast ways to lose money?

By Lisa MacColl

ScotiaMcLeod advisor Peter Lambert describes an ETF as a “duckbilled platypus—it has qualities of stocks and mutual funds. It gives investors exposure to a variety of stocks that comprise an index, and provides a passive investment vehicle that is designed to follow the movement of an index.”

Leveraged ETFs take the idea of an ETF one step further. Instead of providing an investment return that mirrors the index performance benchmark, an LETF tries to achieve a multiplier of the daily performance of the index, usually double or triple. And, to achieve this, they employ derivatives, futures and options to achieve the investment goal.

“Leverage magnifies returns and losses,” notes Jaime Purvis, executive vice president, national accounts for Horizons Exchange Traded Funds. “Clients need the appropriate risk tolerance to make sure they are comfortable with the risk.”

The investment goal of an LETF is to provide a multiplication factor to the daily performance of the index it follows, usually two or three times. “These ETFs are designed to deliver two times the daily performance of their benchmark,” says Purvis. “The majority of these ETFs have a correlation to the benchmark of 0.9999%, essentially perfect. An LETF’s investment objective is limited to daily returns in order to ensure that the investor can never lose more than his or her principal investment.”

Bull LETFs seek to provide two or three times the performance of an index, while Bear LETFs seek to provide two or three times the inverse performance of an index benchmark. “Inverse ETFs allow you to profit from negative price movement in an asset class,” Purvis says. “Those movements can be substantial. In fact, the best-performing ETF in Canada over the last three years has been an inverse LETF.”

Daily reset of the LETF can have a significant impact on the investment. “Many clients hold LETFs for a longer period than they are designed for,” says Oliver McMahon, head of product development for iShares. He attributes this to investors’ misconceptions.

“People believe LETFs give this leveraged return over a multi-day period, and they invariably don’t. These products are designed to [be held] for a short period—you should only own these intraday. Few people can outperform the marketplace by owning these products over a multi-day period.”

Lambert adds the LETF may not track the index exactly if there is a great deal of volatility in the underlying index. “These vehicles should be treated with a short timeframe in mind. With double or triple, you can lose your money very quickly, although you can only lose what you initially invested. A lot of people really don’t understand these things.”

If people invest in LETFs and don’t understand the daily reset, the capital can be eroded very quickly. “These are a short strategy investment. It’s a hard concept for most investors to understand.”

For example, Client A buys 1,000 units in a LETF that provides 2 times the benchmark.

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	Unit open	Market performance	Fund performance	Unit change	Unit close
Day 1	1,000	-10%	2 x -10%	-200	800
Day 2	800	-10%	2 x -10%	-160	640
Day 3	640	+20%	2 x 20%	+ 256	896

Client B buys 1,000 units in an Inverse LETF that provides 2 times the benchmark

	Unit open	Market performance	Inverse Fund performance	Unit change	Unit close
Day 1	1,000	-10%	2 x 10%	200	1200
Day 2	1,200	-10%	2 x 10%	240	1440
Day 3	1,440	+20%	2 x -20%	-576	864

“It’s absolutely essential that the LETF’s investment objective is limited to daily returns to ensure that the investor can never lose more than their principal investment,” Purvis says.

In order to achieve the stated investment objective, LETFs often employ derivatives, futures and options, which Purvis acknowledges adds a layer of complexity to understanding their operation.

Composition of index

Diane McCurdy of McCurdy Financial in Vancouver says advisors need to do their homework before recommending LETFs.

“If you can’t explain the investment in simple terms, you either don’t understand it well enough, or the investment is outside of the client’s risk profile.” She says the transparency of ETFs is a good thing, but some advisors don’t look closely enough at the companies that make up the index, especially when dealing with global LETFs.

“There may be only a handful of companies in the index for a global LETF, and it can be difficult to find information about them.” She notes a typical prospectus for an LETF is five-to-eight pages, and the use of derivatives makes them complicated for the average investor.

Further, both clients and investors don’t always understand the impact of the daily reset on the investment. “The number one rule of investing, in a client’s mind, is don’t lose the capital. With the aging population, they may not have time to earn it back.”

Investment rationale

Purvis says advisors need to have a clear investment objective for the client before recommending LETFs.

“If you want to eliminate the market risk of a portfolio, you can take an inverse position on the market and use the ETF as a hedge,” he says. “An inverse leveraged ETF allows you to use half the capital to get twice the hedging position, making it an effective hedging tool for many portfolios.”

And, since most investors have a buy-and-hold philosophy, adding LETFs to a portfolio means the advisor will have to do a lot of explaining. McMahon says investors need to refrain from holding LETFs over multiple days, and need to fully understand the daily reset and balancing that goes on.

“For the right investor, leveraged ETFs can be the Tabasco to add spice to the portfolio. The problem is, not everyone can take the heat,” says Lambert.

Comparison of ETFs versus LETFs

ETF	LETF
Lower MER compared to mutual funds	Lower MER compared to mutual funds
Investment objective to mimic performance benchmark of stock market index	Investment objective to provide a multiplier usually two to three times of the daily performance benchmark of stock market index
Allows intraday trading-stock price as at transaction price, rather than end-of-day settlement price	Allows intraday trading-stock price as at transaction price, rather than end-of-day settlement price
No daily reset.	Daily reset of exposure to the index in fund to allow for rebalancing
Transparent investment. A list of stocks that comprise the index is readily available	Transparent investment. A list of stocks that comprise the index is readily available
Market maker does in-kind transfer of stocks to provide creation units. No impact on NAVPS of fund.	Market maker does in-kind transfer of stocks to provide creation units. May also use cash, derivatives, options and futures to meet daily performance objective. No impact on NAVPS of fund.
N/A (no daily reset)	Non-recourse leveraging. Most an investor can lose is initial capital investment.
Usually no drawdown or return of capital distributions to investors — only tax implications are usually capital gains	Usually no drawdown or return of capital distributions to investors — only tax implications are usually capital gains

PART 4: Finding your niche

Weighing the diversification benefits of micro-niche ETFs

By Rayann Huang

Unlike traditional broad-based ETFs, micro-niche ETFs are based on specific sectors. Since Canadian equities markets are highly concentrated in three sectors—materials, energy and financial services— micro-niche ETFs let investors tap into sectors or asset classes to which they’d otherwise have limited access. These specialized funds—from the First Trust ISE Cloud Computing Index Fund (SKYY) to the Claymore S&P Global Water ETF (CWW)—are quickly gaining investors’ attention.

Frank J. Restorick, an investment advisor at Money Power Group Raymond James, says micro-niche ETFs that offer access to alternative asset classes with low correlation to traditional stock and bonds can be an effective portfolio diversifier. (These asset classes include real estate, healthcare, agriculture and commodities.) Micro-niche ETFs that hold stocks, meanwhile, will likely have similar correlation to the equities market. However, they can give the portfolio a tilt in order to harvest higher returns—at higher risk.

Tom Bradley, president of Steadyhand Investments, agrees micro-niche ETFs can be effective portfolio diversifiers, but takes issue with investors who overlook the valuation of such funds.

“The value [any investment] adds to the portfolio has to go beyond diversification,” he says. “People get carried away, whether it’s top-down trends or industry trends. ETFs [make it] easy to access [those trends] but when you move a level up from buying individual securities, sometimes investors forget about valuations.”

Kathy Clough, portfolio manager at PWL Capital Inc., steers away from using micro-niche ETFs in client portfolios. For her, the higher risk they bring  isn’t worth it, particularly when broad-based ETFs with a range of market cap companies can provide the diversification she seeks.

“We add our tilts in the risk elements that have shown to provide compensation over the long term,” she says. “We’ll put tilts on with smaller-cap and/or value companies that have been shown to compensate for the extra risk.”

The higher risks associated with niche ETFs means Restorick limits their allocation to 2% to 3% of the overall portfolio. If the fund offers portfolio diversification, he’ll raise the limit.

“With a 50% weight in equities, you [can] put 5% or 10% of that in two theme strategies as a tilt or overweight,” he explains. “If [that theme is] commodities, you may go a little higher if you’re using it for a diversification tool.”

With ETFs invested in nascent markets with few issuers, getting good investments can be challenging. A few holdings may represent a large proportion of the fund, leading to concentration risk. “For example, about 40% of the iShares Global Gold ETF are in three holdings,” Restorick notes.

And, in a small market, the ETF may not be a pure play. The fund’s holdings may be diluted with securities from related industries rather than fully and directly invested in a specific sector. Restorick doesn’t believe this taints the ETF—it’s just the nature of being in a narrow market still in its infancy, he says. Still, investors should know the underlying investments.

Further, narrow sectors often mean fewer investors in the market, so some niche ETFs will be less liquid, and the spread between the bid and ask prices will likely be wider, says Restorick.

While traditional investments typically have long track records, most micro-niche ETFs have existed for fewer than five years. So advisors should look at the valuations of the top five-to-10 holdings to get a sense of the return and risk projections. “The right client [must be] sophisticated enough to understand the risk, as well as have a large enough account and the time horizon to take on that risk,” says Restorick.

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