Assessing the landscape

A It’s true that there is very much a growing area of ETFs with active strategies, [a.k.a.] smart beta or factor strategies. But the reality is that more than 80% of assets, especially globally, have been going to ultra-low-cost ETFs that track mainstream, broadly diversified indices. If the global economy remains on a good footing and all these macroeconomic headlines that are related to trade and geopolitics subside and turn out to be much ado about nothing, the prospects are still good for [the ETF sector’s] growth and for positive investor outcomes over the very long term.

Q ETFs are sometimes viewed as a silver bullet in terms of generating returns, but they can also lose money. Do you think investors understand this?

A ETFs are not a silver bullet against the No. 1 problem that plagues investors, and that is their own behaviour. For better or worse, human beings have a tendency to “performance chase”- to compare their results with the outlier, best-in-class [investment fund], which may very well have been lucky. Investors also have a tendency to avoid risks that, in their life circumstances, would be prudent to take. These are the classic problems that underpin all of investing, whether you are using a directly held stock-and-bond portfolio or a managed mutual fund or ETF.

ETFs are held up as champions of the investor class because of their incredibly low cost and liquidity, and they do solve a lot of problems. But when it comes to underlying global problems or investor behaviours, in some cases, [certain] ETFs may exacerbate them. That’s because, in some cases, ETFs are often sold by the same fund companies that wish to profit from investor behaviour. There are a lot of ETFs out there that are part of investment fads, but then again, [the companies selling such ETFs] are in the business of making things that people want to buy. So, the problem is already there; it’s certainly not caused by ETFs.

Q Are financial advisors and manufacturers of ETFs doing a good enough job of educating investors about the downside of ETFs as well as the advantages?

A ETFs are at the forefront of truly educating investors about practices that are in their best interests — controlling costs and knowing what you’re buying. Lift the hood of an ETF and understand what stocks and bonds are inside it. If it’s an index-tracking ETF, do some due diligence about how that index works. I wouldn’t say every single investor needs to know the niceties of every single index rule, but that’s why we’re ETF research analysts and we do that as a service for our clients.

ETFs predate the “fintech” buzzword, but that’s what [ETFs] are. They are a form of algorithmically traded baskets [of securities]. And because they’ve always had trading technology in the background, the companies that offer them, because they are so technologically inclined, have really done a lot in the form of, [for example,] disclosure on their websites, white papers they have published, fact sheets for their funds, videos and webinars. I really do think that if you’re talking about the mainstream, large ETF companies have really shifted the tide in the way investors are educated.

Q Does that extend to the fees that investors pay for ETFs?

A I don’t want to say that every ETF is ultra-low cost. The reasons we love ETFs is because they are low in cost, very transparent, highly diversified and tax-efficient. There are ETFs out there that are not all of those things. In fact, there are ETFs that are none of those things. But, by and large, the big ETFs — the ones that are popular; where the most assets are going — are very transparent and are ultra-low in cost. And when I say “low in cost,” I mean disruptively low in cost.

Mutual funds in Canada have been charging something north of 2%, all in, if you count advisor compensation and so on. But there are ETFs out there that charge as low as three basis points, which is 0.03%. The difference between that and 2%, over a long term — when you are compounding for a long time — is astronomical. In fact, more than half of your money can disappear over a 30- or 40-year compounding period and be eroded by fees if they are as high as 2%.

When I deal with students, I show how the difference between 5% and 7% [as an example of a reasonable market return] compounded annually is the difference between one dollar turning into $11 and $1 turning into $30. That seems like a small percentage difference, but the magic of compounding really means that if you can control fees, then that’s an enormous benefit to the investor. And I think that’s why there have been so many assets gravitating toward ETFs.

Q Are there situations in which mutual funds are better?

A The fact that ETFs can be traded so frequently is a double-edged sword. It promotes the kind of investor behaviour that we, in our capacity as analysts, try to discourage, which is excessive trading. It’s nice to be able to trade intra-day, but trading multiple times a day? All the academic research shows that that tends to act as a drag on [the investor’s portfolio] performance. You don’t need to sell or even buy on every single headline. Mutual funds, with their lag in selling time [due to net asset values set only at the end of the day] act as a speed bump to some of the worst excesses of investor behaviour.

Q Do we have too many types of ETFs being marketed? Are there too many flavours?

A It’s a valid concern. There are about 800 ETFs in Canada and 2,000 in the U.S. But, at the same time, nobody bats an eyelash at the number of mutual funds. There are about 8,000 mutual funds in Canada. And that’s not a problem. So, I think it’s not a fundamental concern or risk to see this many [ETF] products. If anything, it might cause some investor confusion, but I think that risk is minimal; it’s certainly not a systemic issue.

Q Can you comment on the relationship between this newer, more technical type of investing and traditional, advice-based models of investing?

A The [value] of advice is really huge, and I hope it doesn’t go away. I think it’s a major part of the services that our industry offers and I think that there are many, many add-ons to the service of advice in general that are extremely important.

ETFs are highly amenable to that service because of their very low fees and transparency. In Canada, there is a migration to a fee-based service. We have seen a range of these [arrangements, for which, for example], a 1.25% fee would be normal. And if you then place a client into a well-diversified, very balanced portfolio of ETFs charging 30 to 50 basis points, the overall fee charged to the client is still much lower than it would be in the mutual fund world.

This model makes the fee much more obvious. Paradoxically, the ultra-low cost of ETFs only serves to highlight the fee charged by the advisor. If the advisor is charging 1.25% and is placing the client into an ETF portfolio that charges, on a weighted average basis, 0.25%, then the client is overall being charged 1.5%. Perhaps that is reasonable, but then the client might say, “I am paying my advisor five times as much as the fund companies.”

Q What do people get wrong about ETFs?

A The No. 1 issue is trying to educate investors that the liquidity of an ETF is not related to the [trading] volume of that ETF on the screen. People who are accustomed to trading stocks recognize that if a stock trades only a handful of shares per day, or zero shares, then that’s an illiquid security and buying and selling it might affect the price. ETFs don’t behave that way. An ETF’s liquidity [is driven] internally by its underlying basket [of securities]. That is a pretty crucial point to understand.

Q Any other issues you’d like to address?

A The blurring of the lines between mutual funds and ETFs. There are more and more active [investment funds] coming to market. There are more and more mutual funds launching F-versions of their mutual funds. There are ETFs that are less transparent than what we’ve grown accustomed to in terms of their disclosure because there are active [portfolio] managers who are concealing what they think is their “secret sauce” or [growth]-generating strategies.

In the coming years and decades, I think that we will see a complete migration of asset-management technology into ETF-like structures. Already, we are seeing headlines [that state] mutual fund companies have really not been selling their products and it’s only ETFs that are growing in the world. In Canada, certainly, the distinction between mutual funds and ETFs may be harder to tease apart.