The trailer fee, long a marketing staple of mutual funds, is coming to the world of exchange-traded funds, an innovation that may help ETFs challenge mutual funds as mainstream products.
New ground was broken on Sept. 8 by Toronto-based Claymore Investments Inc. <\/b>, when it launched three new ETFs on the Toronto Stock Exchange<\/b>: a Canadian dividend and income fund, a U.S. fund; and a Brazil, Russia, India and China fund. Claymore has also promised to launch a global fund, Japan fund and an oilsands-sector fund shortly.
The products are intriguing in their own right, but what\u2019s especially interesting is that they were launched in two flavours \u2014 with both common units and advisor-class units.
Traditionally, ETFs have been the resolutely low-cost investing option. They appeal primarily to institutions looking for a cheap way to trade on the market. Their retail allure has been more limited to shrewd do-it-yourselfers that are well aware of the return-destroying impact of management costs and expenses. Only a handful of enlightened advisors have put their clients into ETFs, despite the fact that there might not be much in it for the advisors.
The new Claymore funds aim to make ETFs more mainstream retail products by expanding distribution with the advisor-class units that will charge investors 75 basis points more than the funds\u2019 management fees (which range between 60 and 65 bps), and flow the revenue through to advisors as trailer fees.
The move to pay trailers on ETFs is interesting. On one hand, it may open many more advisors\u2019 eyes to the virtues of ETFs compared with mutual funds and other more expensive managed products. On the other, the chief virtue of ETFs is that they are low-cost, so charging clients an additional 75 bps somewhat negates that advantage.
Moreover, it brings the disadvantage of embedded compensation to the ETF world. Although advisors deserve to be compensated for their labour, the problem with embedded compensation such as trailer fees is that advisors are paid whether or not they provide any ongoing advice or service, which is ostensibly the justification for the trailer.
If compensation is automatic, the rational, profit-maximizing advisor would logically devote more attention to gathering new assets rather than serving existing clients. Many advisors may well earn their 75 bps, but they are effectively subsidizing free riders who don\u2019t lift a finger to earn their trailers.
That said, if trailers are what is needed to spread the ETF gospel, so be it. After all, you can have the best product in the world; but if you don\u2019t have distribution, you\u2019re as good as dead.
Many companies have learned that lesson the hard way. VHS killed Betamax because of better distribution, not because it was a superior technology. The same applies in the financial world. So, if it takes trailer fees to get ETFs into the hands of investors, they may be better off paying 1.4% for an ETF than if they had paid 2.5% for a similar mutual fund.
But will trailers be enough to help ETFs catch on with more retail investors?
TD Mutual Funds<\/b> has already failed in the ETF business because it couldn\u2019t attract enough assets to its funds.
The reigning ETF king, Toronto-based Barclays Global Investors Canada Ltd. <\/b>, hasn\u2019t seen the need for trailers to sell its funds. Indeed, it has no intention of following Claymore to court the mainstream distribution channels.
Howard Atkinson, BGI\u2019s head of business development for ETFs, says the company doesn\u2019t comment on its competitors\u2019 products as a matter of policy. He adds, however, that it has no plans to offer its iShares with a built-in trailer fee.
In fact, BGI has done just the opposite. Atkinson notes that the company inherited some ETFs in the U.S. five years ago that had built-in 12(b)1 fees (the U.S. equivalent of trailer fees) of 25 bps. BGI scrapped the fees and reduced the funds\u2019 expenses by the same amount.
\u201cToday, iShares around the world are sold without any embedded fees,\u201d Atkinson says. \u201cWe believe strongly in transparency, and unbundled fees for investment management and advisory services is part of that transparency.\u201d
Claymore also sees itself as a champion of transparency. As much as BGI is Claymore\u2019s direct competition in the ETF game, the traditional mutual fund industry is its real target.
@page_break@FEES NOT EMBEDDED<\/b>
Som Seif, president of Claymore, stresses that his firm\u2019s products are both more transparent and more accessible than mutual funds. Its advisor fees are explicit rather than embedded in an MER, he says. As well, investors will have easy access to its common-class units, unlike difficult-to-buy F-class mutual funds that have high investment minimums.
Seif says Claymore decided on a 75 bps trailer based on its reading of the market. \u201cWe feel this is competitive with a mutual fund [typically having a 1% trailer],\u201d he says. \u201cAdvisors can make a decision based on the merits of the product.\u201d
Initially, Claymore expects that the advisor-class units will be the bigger seller. Seif estimates that they may account for 60% of sales in the first 12 months or so.
\u201cBut over time, we see a major shift toward fee-based business and investors self-directing investments. So, we think the common class will be the long-term product with greatest demand,\u201d he adds.
It remains to be seen whether advisor-class units will get the attention of advisors. Industry analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. <\/b>, says that most fund dealers aren\u2019t licensed to trade securities, so they cannot sell ETFs. As well, securities-licensed advisors are moving more toward fee-based accounts, which don\u2019t use products with embedded compensation.
That said, transactions still make up the majority of most investment advisors\u2019 revenue, and the common units could be used in fee-based accounts, so there should be plenty of scope for Claymore to do well with the venture.
What would constitute success?
Seif declines to be specific, allowing only that it\u2019s fair to assume that the venture would be profitable with at least $100 million in assets per fund. However, he says, the break-even point is much lower.
The promise of trailer fees may be enough to get the Claymore ETFs on the radar of many advisors, but the merits of the product will probably be what generates sales. For this reason, the company hopes to deliver more than the plain-vanilla ETF.
The BRIC fund will provide exposure to the hot markets of Brazil, Russia, India and China via the BNY BRIC select ADR index. The dividend and income fund will follow the Mergent Canadian dividend & income achievers index. The oilsands fund will track the sustainable oilsands sector index (created by Calgary\u2019s Sustainable Wealth Management Ltd. <\/b>).
The other Claymore ETFs employ so-called \u201cfundamental indexing,\u201d which uses four criteria \u2014 sales, cash flow, dividends and book value \u2014 to weight companies in an index rather than just market cap. FTSE Group<\/b>, which operates numerous fundamental indices, claims that, based on a methodology created by Research Affiliates LLC<\/b> known as the FTSE RAFI index series, such indices have outperformed capitalization-weighted indices by up to 2% since 1962 (see page 36).
The argument for fundamental indexing is that it provides some of the advantages of both active and passive management. By using fundamentals rather than just prices to weight stocks, a fundamental index can limit exposure to stocks that run up to unsustainable levels and maintain exposure to names that may be temporarily out of favour. At the same time, the fact that the index is still rules-based keeps emotion out of the portfolio and keeps turnover costs low.
Claymore isn\u2019t the only firm that is launching products that follow the methodology. One of its chief rivals in the U.S., PowerShares Capital Management LLC<\/b>, just launched a series of 10 new sector ETFs on Nasdaq<\/b> that are based on the FTSE RAFI indices.
Hallett says the fundamental indexing ETFs are interesting products, but the jury is out on whether they offer benefits over and above simple indexing.
\u201cThe industry, as it so often does, has taken what should be a very broad-based and simple investment strategy and has made it confusing for most people to implement properly,\u201d he says. \u201cIt is so far following in the footsteps of the [actively managed] mutual fund industry. The introduction of trailers is simply the latest step in that direction, but it is by no means the first step.\u201d
Of course, navigating such complexity is where advisors can make a difference.
In terms of management fees, the new fundamental indexing funds come at more or less the same price as that of simple index ETFs. At 60 to 65 bps in management fees, the Claymore ETFs charge just a handful of bps more than most of the funds offered by BGI. An exception is BGI\u2019s flagship iShares on the S&P\/TSX index, which charges a mere 17 bps.
The Claymore rates are comparable not only with BGI\u2019s other Canadian ETFs, but with the vast array of ETFs on offer in the U.S. \u2014 a claim that few, if any, Canadian mutual fund companies can make about their U.S. counterparts.
If nothing else, fresh blood in the Canadian ETF market is a good thing for investors. It provides an alternative to existing ETFs, offers choice about how to buy them and compels a competitive response from the traditional mutual fund industry. \tIE<\/b>
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