Despite weak markets and sinking demand for many investment products, exchange-traded funds are grabbing a growing piece of the action as clients pay more attention to costs and their impact on returns.

“The popularity of ETFs is increasing rapidly,” says Esko Mickels, a fund analyst with Toronto-based Morningstar Canada. “They have become much more than a cheap way of buying an index weighted by the market cap of companies. ETFs are encroaching on the traditional mutual fund space.”

There are only a handful of players in the $17-billion ETF industry in Canada — including Barclays Global Investors Canada Ltd., Claymore Investments Inc. and BetaPro Management Inc. (all based in Toronto) — and they are all experiencing strong sales growth.

But the interest in ETFs is inspiring product innovations and attracting new players. BetaPro affiliate AlphaPro Management Inc. has introduced Horizons AlphaPro ETF, which adds a layer of active management to index investing. And Toronto-based Invesco Trimark Ltd. has launched a group of four target-date portfolios that add a dash of PowerShares ETFs to a mix of Invesco and Trimark funds. Toronto-based BMO Asset Management Inc. has also entered the market with seven ETFs.

That brings the number of Canadian-listed ETFs tracked by Morningstar to 100. About three-quarters of them are less than three years old.

According to the Investment Funds Institute of Canada, in 2008, more long-term assets flowed into industry leader Barclays’ $14-billion family of iShares ETFs than into any single mutual fund company. Barclays posted net sales of $4.4 billion in 2008, almost double the $2.4 billion invested in long-term funds offered by runner-up Dynamic Funds Ltd. of Toronto.

“The ETF playing field has become increasingly diverse,” says Iassen Tonkovski, an analyst with Investor Economics Inc. in Toronto, “providing ETF investors with more options to ride out the current market turbulence. Furthermore, the simple and transparent nature of ETFs presents an attractive option during times of uncertainty and heavy market volatility.”

ETFs are designed to follow an index, either a market index such as the S&P/TSX 60 (in which companies are weighted by their market capitalizations) or a fundamental index that weights companies based on assets, earnings, dividend payouts or other factors.

Because of ETFs’ passive management style, these instruments — which are traded on exchanges much like stocks — charge lower management fees than mutual funds, although unitholders’ costs can be affected by commissions charged on the purchase and sale of ETF units.

Lower fees are a plus, particularly in today’s environment. The stock market downturn has caused many clients to question the fees they are paying for active management of mutual funds, Mickels says, especially if those funds have failed to beat the market. ETF demand is coming mainly from traditional mutual fund buyers, he adds, as well as traders of individual stocks. For example, instead of buying a handful of bank stocks, your client can buy a financial services sector ETF and get a slice of the industry with a single purchase. Or do something similar for Canadian gold companies or global agricultural companies.

In addition to accessing entire markets or selected asset classes and sectors, buyers of ETFs can also focus on investment styles, such as growth or value, or on products offering regular monthly income. As well, there are funds-of-funds in the ETF category, offering diversification across several global stock and bond indices through a single ETF.

And one family of ETFs — Horizon BetaPro bull and bear ETFs — offers inverse and leveraged exposure to 14 stock, bond, currency and commodity indices, allowing investors to capitalize on trends on both the upside and downside, and amplify the returns of the underlying indices by 200%. These products have proven to be popular, garnering $2 billion in assets under management since their launch in January 2007.

ETFs differ from mutual funds in several key areas:

> Because ETFs trade on exchanges, investors have access to intra-day liquidity at current market prices. But there are no redemption fees, as there can be with mutual funds sold with deferred sales commissions.

> Because ETFs are generally passive investments, clients can easily see the securities that are held in an ETF, as well as their weightings. Any change in the portfolio is typically posted daily on the ETF provider’s website. Regular mutual funds publish holdings once a month or, in some cases, quarterly.

@page_break@> ETFs tend to have a lower portfolio turnover and are thus more tax-efficient. Unlike regular mutual funds, in which unitholder redemptions can trigger stock sales and capital gains, the ETF structure eliminates the impact of unitholder activity on capital gains distributions. Furthermore, there is no portfolio drag created by managers holding large cash positions, as there can be with mutual funds.

> ETF management expense ratios are typically lower than those of both actively managed and index-based mutual funds. For example, Barclays TSX-listed iShares have MERs ranging from 17 basis points to 70 bps, substantially lower than that of the average mutual fund. Morningstar says the average Canadian equity fund has an MER of 2.4%; the average foreign equity fund has an MER of 2.8%.

“We had six years of amazing stock market returns, and that was where everyone was focusing,” says Heather Pelant, head of iShares at Barclays. “But when returns started to unravel, people started asking different questions. ETFs are a lower-cost and more efficient way of investing than traditional mutual funds. ETFs allow you to control costs, and that can enhance return.”

Some recent developments, however, tend to blur the line between ETFs and mutual funds.

Claymore, for example, offers a class of ETFs that pays a trailer fee to advisors and adds this 75-bps fee to the MER. Claymore Global Infrastructure ETF has an annual management fee of 65 bps, while the additional amount applicable to advisor-class units is 75 bps, for a total management fee of 1.4%.

Although trailer fees erode some of the cost advantage for the ETF client, ETF MERs are still significantly less than that of a typical mutual fund, says Claymore president Som Seif. Fee-based advisors may stick to the regular version of ETFs and add their own service fees.

Seif calls the trailer fee option “a big innovation” for the industry. “We’re here to offer flexibility,” he says. “ETFs are fantastic for clients. And if clients ask for ETFs, the advisor shouldn’t push the product away because the advisor can’t get paid.”

Claymore recently began offering pre-authorized contribution, dividend reinvestment and systematic withdrawal plans on its $1.2-billion family of 22 Canadian-listed ETFs — features that have traditionally been available only to mutual fund investors. These innovations mean Claymore ETF unitholders will be able to add or withdraw small amounts through these plans without having to pay trading commissions. And dollar-cost averaging, a convenience that mutual fund investors have long enjoyed, is now available to ETF investors.

That is only the beginning of the innovations in the ETF field. AlphaPro’s Horizons AlphaPro ETF is tackling active management using technical analyst Ron Meisels, president of Phases & Cycles Inc. of Montreal. Meisels will try to beat the S&P/TSX 60 index by overweighting or underweighting companies, adding a layer of top-down research.

Invesco Trimark’s target-date retirement payout portfolios are multi-fund portfolios that take advantage of Atlanta-based Invesco Ltd.’s acquisition of the PowerShares ETF group in 2006. PowerShares ETFs are based on “intelligent” indices constructed around fundamental company variables rather than market caps. This Canadian-sold product is suitable for mutual fund-licensed advisors who are not licensed to trade securities such as ETFs. IE



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