Exchange traded funds an in-depth look

Transcription

1 Exchange traded funds an in-depth look Over the past couple of years, financial services media coverage has promoted exchange traded funds (ETFs). Much of the information in the news about ETFs is grounded in facts. Unfortunately, the sources of information are often individuals or organizations that directly profit from ETF business. Intentionally or otherwise, some of the information misrepresents the potential benefits of ETFs or confuses investors by suggesting they have unique benefits unavailable with other investments. Other articles cloud the issue with claims of riskmanagement benefits, which are not inherent in the investments themselves. Another main focus has been on cost and fees. ETFs are promoted as very cost-efficient or tax-effective, or both. ETFs are generally available at low costs; however, clients cannot typically invest in an ETF for the advertised price. ETFs are usually associated with transaction fees and/or fees for service and distribution that drive up the cost for individual investors. ETFs are relatively tax-effective. Units are bought and sold between investors on a stock exchange. Often the fund does not sell securities to meet redemption pressure, which reduces portfolio turnover. However, the funds provide some income distributions that are taxable, and many traditional investments have lower taxable distributions than ETFs, or none at all. ETFs are, like most investments, appropriate for some investors. This article puts ETF information into context by balancing the promotional bent surrounding their media coverage. Introduction and definition An ETF is an investment traded on a stock exchange, which means many of its features are commonly associated with stocks. As an individual security, an ETF can be bought or sold anytime the market is open, and can also be sold short. ETFs often have associated derivatives, like options. In practice, an ETF most closely resembles a stock, not a mutual fund. An ETF is a pool of investments. The pool gathers money by selling units to market makers (often large brokerage firms) that take the place of investors on the sell transaction. These market makers sell their units into the market. This is how the ETF becomes available for sale to the public. Once the units are in the hands of investors, they buy and sell to each other through the stock market, so the ETF itself does not typically have to raise cash when investors want to sell. Transaction fees and/or account fees associated with trading ETF units depend on the service used. For more information, contact your sales and marketing centre. This material is for information purposes only and shouldn t be construed as providing legal or tax advice. Every effort has been made to ensure its accuracy, but errors and omissions are possible. All comments related to taxation are general in nature and are based on current Canadian tax legislation and interpretations for Canadian residents, which is subject to change. For individual circumstances, consult with your tax professional. This information is provided by London Life Insurance Company and is current as of September, 2010 London Life and design are trademarks of London Life Insurance Company. Reprinted with permission from London Life Insurance Company.

2 ETF mutual funds should not be confused with ETFs themselves. Mutual funds that invest in ETFs are similar to any other mutual fund, and are very different from an actual ETF. In Canada, Invesco Trimark introduced an ETF mutual fund in 2009 and BMO Guardian Funds launched theirs in Issues with product promotion based on cost In Canada, management expense ratios (MERs) on ETFs average around 50 basis points some are less and others are more. Stated MERs are not what a retail investor pays; they also pay per trade to buy ETF units from (or through) a discount or full service broker. Alternatively, investors can also access them through a broker-advisor who charges a wrap account fee. Average management expense ratio of ETF is about 0.50 per cent. ETFs in Canada MER ishares S&P/TSX Completion Index Fund 0.55 ishares S&P/TSX SmallCap Index Fund 0.55 ishares Dow Jones Canada Select Growth Index Fund 0.50 ishares Dow Jones Canada Select Value Index Fund 0.50 ishares S&P/TSX Capped Energy Index Fund 0.55 ishares S&P/TSX Capped Information 0.55 ishares S&P/TSX Capped Financials Index Fund 0.55 ishares S&P/TSX Capped Materials Index Fund 0.55 ishares S&P/TSX Capped REIT Index Fund 0.55 ishares S&P/TSX Income Trust Index Fund 0.55 ishares Dow Jones Canada Select Dividend Index Fund 0.50 ishares Jantzi Social Index Fund 0.50 Source:

3 Mutual fund ETFs cost more ETF mutual funds are not low cost alternatives to ETFs. The table below shows they can be expensive compared to ETFs themselves. Invesco PowerShares fund category MERs PowerShares FTSE RAFI Canadian Fundamental Index 1.79 PowerShares FTSE RAFI U.S. Fundamental Index 1.65 PowerShares FTSE RAFI Global+ Fundamental Index 1.89 PowerShares FTSE RAFI Emerging Markets Fundamental 2.11 PowerShares Global Agriculture 2.01 PowerShares Global Gold and Precious Metals 2.01 PowerShares Global Water 2.01 PowerShares Global Clean Energy 2.01 PowerShares Golden Dragon China 1.86 PowerShares India 2.04 Source: Invesco PowerShares funds brochure

4 Understand the source Because of media attention on ETFs, some investors incorrectly assume these investments are beneficial and appropriate for everyone. An ETF is one investment option that may be used in an overall diversified portfolio. Any time an investor chooses an investment, he or she needs to ensure it fits their risk tolerance and objectives. Naturally, some articles report the advantages of ETFs and downplay the shortfalls, the authors of which can be aligned with companies that benefit from an increased awareness and ETF sales. When reading about ETFs, investors should consider the source of the information. Only modest investor demand When it launched its ETF funds, BMO revealed in a survey that 56 per cent of Canadians had never even heard of ETFs. Of the remaining 44 per cent who have heard of them, the majority had just recently heard of them. Only seven per cent of respondents claim to be quite familiar with the product. 37% 7% 56% Source: Survey, Leger for BMO ETF launch, April 2010 Never heard of ETF Somewhat familiar with ETF Quite familiar with ETF Most ETFs are index funds Most ETFs are index funds. This fuels the active management versus passive index investing debate and can further confuse investors about the merits of these investments. Index funds aren t straightforward Many investors consider index funds safe because they assume they know in what they re investing. You think of indexes like the S&P/TSX composite index (S&P/TSX), Nasdaq, Dow Jones, Nikkei, etc. However, there is no guarantee an investment is tracking one of the well-understood indexes. An index can be just about anything. Consider the Wilder Nasdaq OMX global energy efficient transport index, or the DEX real return bond index, which tracks only five bonds. Both are indexes, and both are benchmarks for ETFs available as mutual funds. These funds may be appropriate for the right investor, but no one can assume indexes are easy to understand or transparent. It s not always easy to know what you re getting even if a fund is an index fund.

5 There are thousands of indexes Indexes are a way of tracking selected stocks. Stocks can be selected using a proven methodology, an untested theory, or even chance. This means you can t assume a Canadian index ETF tracks the S&P/TSX composite index, for instance. An index fund follows an index, but you need to know which one. Russell Indexes alone has created over 16,000 of its own, but only a few are used by the average investor or financial advisor. Only one ETF available in Canada (as of September 2010) tracks the S&P/TSX the ishares Canadian Composite Index. ETFs and indexes get even more complex: Most funds cannot exactly replicate the index because the fund s manager can t buy the exact underlying securities (for instance, the same bonds aren t always available). This creates discrepancies in returns when comparing the fund to the benchmark. As a result, funds can have different return and risk characteristics than their benchmark index. It s difficult to quantify how different they can be because there isn t much history on the ETFs and many of the indexes. ETFs are not designed to match the index Not all active managers beat their benchmark indexes all the time. Recently, Investment Executive reported 1, 75 per cent of Canadian equity active managers outperformed the S&P/TSX in first quarter; 2010 is a stock pickers market. That s just one quarter, but the article continues: Large cap managers in Canada have outperformed the S&P/TSX benchmark by 53 basis points on average per quarter over the last 10 years. Clearly, some active managers do beat their benchmark indexes. By definition, index funds or ETFs rarely outperform or even perform as well as their benchmark indexes. Their goal is to replicate the index, but they also charge fees. Therefore, they will generally underperform by the amount of fees. For example: Index returns MER reduces return by ETF returns 4.8 per cent (0.5) per cent 4.3 per cent Active management doesn t win all of the time, but it does win some of the time. 1 Source: Investment Executive, May 5, 2010

6 Performance versus index An index fund or ETF will rarely match its index for three primary reasons: Fees reduce performance relative to the benchmark. The ETF may not own the same shares as the benchmark index in exactly the right proportions all the time. The return is based on price movements of the ETF, which are based on supply and demand for ETF units, not on the value of the underlying investments. When an ETF is bought, the market price is decided by buy and sell orders. Evaluating performance To evaluate a fund s or investment manager s performance, the CFA Institute recommends more than five years of performance history. This is considered a well-established benchmark to evaluate an investment s risk and return characteristics. Currently, most ETFs don t have five years of history. Considering ETF returns and risk vary from the index it s designed to track, we need to understand how an ETF performs over time. We can t rely on the index to drive investor returns and investors need to understand how well the ETF does what it says it does. This chart shows all 158 Canadian ETFs: About half of ETFs report one-year returns, only 25 per cent report three-year returns, less than 10 per cent report five-year returns, and only one reports 10-year returns. Rate of return reporting period 1 month 3 month 6 month Yearto-date 1 year 3 year 5 year 10 year How many ETFs (out of 158) report returns Source: Morningstar Research Inc, June 2010 Less than one per cent of ETFs have a history of longer than five years. How does this compare to other investments? As of June 2010, Morningstar reported 10-year returns for 30 per cent of mutual funds reported (1,050 of 3,582) and for 33 per cent of segregated funds (467 of 1,416) 2. Only one ETF has a 10-year history and it tracks the TSX 60 index, not the broader S&P/TSX composite index. 2 Source: Morningstar Research Inc.

7 Over the last 10 years, this ETF s performance has lagged the benchmark by 22 basis points on average, more than its management expense ratio of 17 basis points. In 2009, the returns were 47 basis points lower than the benchmark 3. The return history of this ETF supports our hypothesis that ETFs returns usually not equal or outperform the benchmark index due to one or more of the three reasons listed above. Tax-effectiveness The tax-effectiveness of ETFs is based on the fact that many of them track an index, which is adjusted annually. This means the funds may only need to be rebalanced once per year. Less frequent rebalancing can mean fewer transactions, which can result in fewer capital gains to distribute. In addition, ETFs trade like stocks; they re bought and sold between investors, so the fund doesn t generally have to sell securities to meet redemption requests. The result is the same fewer transactions can mean fewer realized capital gains and lower distributions. Many reports that discuss the tax-effectiveness of ETFs fail to emphasize that ETFs do pay distributions, as shown in the following quarter-one 2010 distribution summary. This is an excerpt, but is indicative of the bigger picture. Dividends from the underlying securities can result in income, and there may be some turnover when the fund is periodically rebalanced. ETF name Date Distribution Frequency Industrial elect sector SPDR 03/31/10 $ Quarterly Technology select sector SPDR 03/31/10 $ Quarterly Consumer staples select sector SPDR 03/31/10 $ Quarterly Utilities select sector SPDR 03/31/10 $ Quarterly Health care select sector SPDR 03/31/10 $ Quarterly Consumer discretionary select sector SPDR 03/31/10 $ Quarterly SPDR S&P metals & mining 03/31/10 $ Quarterly SPDR S&P pharmaceuticals 03/31/10 $ Quarterly SPDR S&P retail 03/31/10 $ Quarterly SPDR Barclays capital 1-3 month T-bill 04/12/10 $0 Monthly Source: 3 Source: Morningstar Research Inc.

8 Tax-effectiveness and ETF investment funds Keep in mind that the tax-efficiency discussed above doesn t extend to ETF mutual funds. ETF mutual funds receive distributions from the ETF, which are distributed to unitholders. Unlike ETFs, the mutual fund has to finance unitholder redemptions, so the fund may have to sell ETF units, which triggers gains or losses, and could also result in distributions. More tax-efficient solutions available Investors who want lower taxable distributions and a tax-effective investment solution should consider corporate class mutual funds. Many of these funds have a long-term track record and a history of tax-efficiency. Corporate class funds help reduce taxes paid in three ways: 1. There is potential to receive lower taxable income. 2. If there is taxable income, investors pay less tax on it because of the type of income (capital gains and/or dividend income). 3. Rebalancing or switching among funds doesn t trigger immediate capital gains. Of these, the third is often overlooked. Regardless of whether securities in the fund need rebalancing, individual investors still need to rebalance their portfolios, which affects tax-efficiency. Corporate class funds can be rebalanced within the corporation without triggering gains a critical feature for investors who want to manage risk. This benefit isn t available with an ETF or most ETF investment funds.

9 Fund name Date Distribution Frequency Quadrus Cash Management Corporate Class 2010 $0 Monthly Quadrus Fixed Income Corporate Class 2010 $0 Annually Quadrus Canadian Equity Corporate Class 2010 $0 Annually Quadrus Sionna Canadian Value Corporate Class 2010 $0 Annually Quadrus Eaton Vance U.S. Value Corporate Class 2010 $0 Annually Quadrus North American Specialty Corporate Class 2010 $0 Annually Quadrus U.S. and International Equity Corporate Class 2010 $0 Annually Quadrus U.S. and International Specialty Corporate Class 2010 $0 Annually Quadrus Setanta Global Dividend Corporate Class 2010 $0 Annually Note: Quadrus corporate class funds distribute income in March, which is the corporate fiscal year-end. This allows us to report 2010 distributions prior to calendar year-end, with one exception; the cash management class distributes income monthly. Presently distributions are zero due to low interest rates, but may resume at any time. Long-term planning Part of the attraction of an ETF-related investment is the marketing momentum. ETFs are often reported as the latest and greatest investment product. Some investors believed this to be true for RRSP clone funds used to avoid foreign content rules in the 1990s, principal-protected notes (PPNs), hedge funds and income trusts. ETFs seem new and different to fund investors because they trade on an exchange; they can be sold short and have options associated with them. Because of these features, ETFs can be attractive investment vehicles for heavy traders and those with other short-term strategies that aren t consistent with a long-term planning perspective. With prudent portfolio building, a financial security advisor and investment representative / advisor helps identify the need, and then proceeds to the solution. He or she starts by looking at the makeup of the portfolio in terms of asset classes, then fills in each class with investments. In a planning-centred investment model, the value of ETFs is not as clear. If an investor s risk tolerance and investment goals call for some Wilder OMX global clean energy efficient transport index, then an ETF or ETF fund may be the best way to get it. The question is: How many investors really need this specific niche in their portfolios?

10 Size of the capital markets in Canada The market for ETFs may seem large in dollars, but remains a fraction of overall capital and of managed investment funds. Contrary to many reports, ETFs haven t found their way to mainstream retail investment. Capital markets $2.34 trillion Private equity, pensions and institurional, etc. ($1,484 billion) Mutual funds ($743 billion) Segregated funds ($82 billion) ETFs ($31 billion) Source: Investor Economics 2009, 2010 The basics Many successful investors know investing in the most exciting and most popular investment product of the day may not the best way to achieve investment goals. Consider Robert Kiyosaki and Warren Buffet, who are well-known for ideas such as: Have a simple plan and stick to it Only invest in things you understand Most people don t do what it takes to get rich because it s boring

11 Summary and conclusion It s hard not to notice ETFs in the media. But these investments demand due diligence in evaluation and application. Are ETFs really cheaper? If so, cheaper than what? Are they tax-effective, and if so, compared to what? Finally, is the investor getting what he or she believes? When selecting investments for portfolios take a long-term, holistic perspective and use time-tested investment solutions. While ETFs are certainly a point of discussion, it s not clear how they will fit with more disciplined approaches over the long term. Will investors use them as long-term investments despite the characteristics that make them attractive to shortterm traders who practice intraday trading, use options or derivatives, and those who take advantage of the niche or specialty nature of many indexes? How can the cost benefits extend to clients who rely on advice, since advice fees can negate the low cost structures? Many questions remain unanswered. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Quadrus Investment Services Ltd. and design, Quadrus Group of Funds, invest@quadrus and Fusion are trademarks of Quadrus Investment Services Ltd. The decision to invest in a mutual fund corporation should not be based solely on income tax considerations. You should ensure that an investment in a mutual fund corporation suits your client s objectives as well as their risk profile.