May 29, 2012

ETFs: Pros, Cons and Misconceptions

One significant change recently on the investing landscape has been the introduction and proliferation of Exchange Traded Funds (ETFs) - also known as passive investing or index investing. An ETF (in its purest form) is a vehicle used to mirror a basket of securities in an index. In recent years, the nature and complexity of these products has changed, and the number of products available has skyrocketed – the number of ETFs available in the U.S. has increased by 350% in only four years!¹  This amount of new product growth is even more surprising when we consider that there are only a handful of EFT providers.

Some investors consider ETFs to be a good option as they perceive them as a less risky way to invest during periods of low returns, or high market volatility. Leith Wheeler is an active manager with the belief that we can add value to a client’s portfolio over time through security selection; however, we also recognize that ETFs can have a place in clients’ portfolios. Let’s explore some of the facts and myths of ETF investing.

Fact or Myth: ETFs are less volatile than the markets. Myth. ETFs by definition mirror the market, so they will not protect clients’ capital in declining markets. On a post fee basis (yes, ETFs do charge fees, albeit much lower fees than actively managed mutual funds) you will never be able to earn a higher return than an Index with a traditional ETF, but you won’t perform significantly worse than one either.  There is no potential for downside protection during a negative market period with a plain vanilla ETF. Actively managed mutual funds do have the ability to perform better in both rising and falling markets, but also have the potential to do worse – that is where the quality of the investment manager comes in.

Fact or Myth: ETFs are less risky than actively managed mutual funds.  Myth.  Because ETFs are created to replicate a market or portion of the market, if you hold an ETF, you will have exposure to all securities in that market (both high and low quality). In contrast, active managers have the ability to invest in less volatile stocks and/or choose not to invest in lower quality (more risky) securities

There is a significant difference between how ETFs and active mutual funds are structured. An ETF is typically ‘capitalization weighted’ which means the larger a company (its market cap), the larger their weight in the ETF. Actively managed portfolios tend to weight their holdings based on the investment merit of the security.  Active portfolios often own fewer securities than an ETF and typically are more ‘equal weighted’ rather than cap weighted.

Fact or Myth:  ETFs are less expensive to own.  Fact.  The true cost of owning an investment in Canada is somewhat misunderstood and quite poorly disclosed. Traditional ETFs are constructed to mirror an index, so fees are kept low since there are no research costs (as no research is provided) or Advisor or service costs (as there is no investment service provided).  However, some of the more creative versions of ETFs are now charging much higher fees than plain vanilla ETFs.  In addition to management fees, the following table compares and contrasts other costs of investing in an ETF versus an actively managed mutual fund.  The bottom line for investors is you need to know how much you are paying in fees whether they are built in or on top of management fees.

Fact or Myth: ETFs provide superior risk adjusted returns to actively managed funds. Myth. While both ETF and actively managed funds rely on capital markets to generate returns, active funds typically are ‘long only” so the direction of their returns will be correlated to the markets they are invested in. The differences in performance compared to the markets arise from stock selection, sector selection or asset mix. These variables are not present in ETFs.  While most traditional ETFs try to mirror index returns, some of the structured ETFs rely on more complex strategies. These include ETFs that make inverse bets on a sector or market, trade derivatives, execute hedged or paired trades, apply high degrees of leverage (with daily resets), and track commodities.  Additionally, ETFs can be bought on margin and/or shorted. These are innovative tools for experienced investors but potentially very dangerous for casual DIY investors.

Fact or Myth:  ETFs provide greater access to markets.  Fact.  ETFs are traded on exchanges and can mirror most global markets, so one brokerage account can provide unconstrained access to the markets. Additionally, ETFs are traded continually throughout market hours so investors can buy or sell throughout the day.  Actively managed funds are traded by their manager throughout the trading day but investors can often only buy or sell units of the fund at the end of the day. For a long-term investor, this may not be an issue, but for people attempting to take advantage of volatility in the markets, ETFs provide an opportunity.

Fact or Myth:  ETFs are more tax efficient than mutual funds.  It depends.  Equity based ETFs are more tax efficient than a high turnover (over 50%) equity mutual fund.  The ETF advantage is dramatically reduced when compared to lower turnover funds.  For Fixed Income ETFs there is little advantage compared to actively managed funds – coupon payments are taxed as interest income in both cases.  In terms of capital gains triggered on sale of units, fund families with corporate class structure provide greater benefit of deferral than ETFs or non-corporate class funds.

Fact or Myth. ETFs offer better transparency. Both. The holdings of an ETF are available on a more frequent basis than a managed portfolio so there is better visibility of an ETF’s individual holdings. However the disclosure of ongoing costs and expenses are equivalent for each structure. Where an ETF may fall short is in disclosing if, how and why proxy votes were voted on behalf of shareholders.

Summary

Markets are hard to beat.  Many active managers do not beat their respective benchmarks over periods of time.  ETF managers, by definition, cannot beat their respective markets ever.  After considering the impact of fees, the case remains the same – some managers outperform while index managers will not.

The pros (management fees, access) and cons (guaranteed underperformance, risk, product proliferation) and misconceptions (tax advantage, all in costs) mean that ETFs are perhaps not the perfect innovation for investors’ needs.  However, they can expand the toolkit for investors, but like all investments, require careful consideration to be included in a well-constructed portfolio.

1.  “New ETFs struggle for assets”, Globe and Mail, January 10, 2012

2.  Morningstar

3.  Globeinvestor.com

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. All tax decisions should be made after discussing your individual positioning with a qualified tax accountant, as everyone’s tax situation is unique. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

Jonathon Palfrey

Managing Principal, Portfolio Manager - Private Clients & Foundations

Karey Irwin

Principal, Portfolio Manager - Private Clients & Foundations