Mutual fund defence falls short

One fund company recently published an advisor brochure containing several arguments aimed at discouraging investing in ETFs that look good at first glance but miss the point and crumble under mild scrutiny.

Here are some of the arguments that brochure makes:

> Price. The brochure begins by showing how dollar-cost averaging into one of the more expensive ETFs on the market will cost 2.3% in Year 1, thanks to a $24 fee per trade.

Ironically, the industry that preaches long-term thinking can’t see past its own nose. It fails to show that over five years, the cost averages 1.3% annually in total for management and trading costs. The brochure also ignores the much cheaper option of using DCA to get into an index mutual fund combined with an annual switch into an ETF.

The brochure eventually gets to the real point: that investors needing advice have to pay for it one way or another. Once the cost of advice is added to an ETF’s management expense ratio, the ETF’s cost advantage is significantly diluted.

But for do-it-yourself investors, who neither want nor need advice, the cost advantage of ETFs remains compelling.

> Performance. Stating that the pro-ETF case has focused on the concentrated Canadian market, the brochure notes that eight of today’s 10 biggest global stock funds have beat the MSCI world index over the past decade.

Although this method is very crude — i.e., using today’s biggest funds is biased — the point is valid today even when using more sound methods. The problem is that the numbers may well look very different a year from now.

In a sidebar — which should have been the main focus — the brochure highlights that the ability to trade ETFs as many times as you wish has resulted in poor investor returns. Investors appear to trade more often when the barriers to trading are low. And this has detracted from the returns otherwise available from ETFs.

> Transparency. Another argument is that ETF transparency isn’t up to mutual fund standards. This suggests that ETFs’ disclosure of daily holdings is only part of the transparency equation and can’t help investors determine how an ETF would perform. This is where I had to contain my laughter.

Looking up a popular ETF on www.sedar.com, I found virtually all of the disclosure documents required of mutual funds — i.e., management report on fund performance, investment review committee reports, financial statements, etc.

But ETFs also have to comply with the rules of the stock exchange on which they are listed. Add in my often-expressed view that mutual funds have become less transparent over the past few years, and it becomes clear that this point on transparency shouldn’t be uttered within earshot of your clients.

Still, none of the required disclosures for either type of fund will help most investors determine their prospects.

> Diversification. The brochure ends the defence of mutual funds with the old tale of how Nortel Networks Corp., at its 2000 peak, made up 45% of the S&P/TSX 60 index. But capped-index ETFs were introduced to prevent the repeat of such high concentration in one stock.

The brochure also fails to highlight that a certain fund manager working for the fund company that issued this brochure was in charge of a $1-billion fund in 2000 that bought a bunch of Nortel and let that stock ride up to a similarly dangerous 25% of assets.

ETFs’ low fees make them attractive for do-it-yourself inves-tors. For advice-seekers, there is no need to resort to thin arguments because a stronger case exists for active management.

Perhaps we should stop thinking about the active/passive debate in an all-or-nothing context. Instead, we ought to consider the benefits of marrying the best of both worlds. IE

Dan Hallett, CFA, CFP, is president of Windsor, Ont.-based Dan Hallett & Associates Inc., which provides a mutual funds recommended list and investment research to financial advisors across Canada.