Discovering the Benefits of ETFs

Transcription

1 Discovering the Benefits of ETFs THE MORTON GROUP

2 Table of Contents Introduction 3 1. ETFs Can Provide Significant Cost Savings 4 2. ETFs Provide Trading Efficiency and Liquidity 5 3. ETFs Provide Easy Diversification 7 4. ETFs Provide Transparency 8 5. Access to Alternative Investment Strategies 9 6. Access to a Wide Range of Sectors and Global Exposure ETFs Help Control Currency Risk ETFs Provide Tax Efficiency 12 Conclusion 14 About The Morton Group 15 2

3 Introduction As a high net worth investor, you will have many concerns when it comes to managing your wealth. Am I paying a fair fee for service that is equitable for all parties involved? What liquidity constraints may my investments require? Am I well diversified? Do I know what I m actually invested in? What options are available to me? The Morton Group believes that ETFs provide the optimal investment vehicle in addressing these concerns. In this ebook we will discuss the top eight reasons why utilizing ETFs might be the best choice for you as a high net worth investor, and also attempt to quantify the financial benefits compared to other investment options. THE MORTON GROUP 3

4 1. ETFs Can Provide Significant Cost Savings Cost matters. Let s assume you take two equal-sized portfolios that will both generate an annual 5% return gross of fees: Portfolio A will be invested in a mutual fund that carries a 2.25% MER and has an embedded trailer fee to an investment advisor Portfolio B will be invested in an ETF that has a 0.35% MER plus an investment-counseling fee of 1.00% to a portfolio manager for a total MER of 1.35% After 10 years, Portfolio B will have generated a return that is 12% greater than that of Portfolio A due to the impact of lower fees. On a million dollar portfolio, this cost savings could increase the portfolio value by $100,000. ETFs generally have a lower MER (Management Expense Ratio) compared to many actively-managed mutual funds. This discount exists because the majority of ETFs are passively managed, track a rules-based index, and do not require the expense of a manager providing individual stock analysis or forecasting. Not all ETFs are passively managed: some employ active management, which can drive up the MER. In instances like this, issuers are indifferent if their strategy is accessed through an ETF structure or mutual fund structure as the fees to the manager will generally be equal. High Net Worth Investors can retain a professional portfolio manager to manage their ETF selection, portfolio management and risk controls at a substantially reduced cost compared to that of an actively managed mutual fund as illustrated by Portfolio B in our example. A second cost saving aspect of ETFs is that fewer trades may be required to build a diversified portfolio. Investment accounts can generally be charged fees under two different structures: Fee-Based you pay an annual fee based on a % of assets Transactional you pay a commission for each buy & sell that takes place in your account If you are required to pay a transaction commission for each trade, and are building a portfolio of stocks within a specific sector, each individual stock purchase (buy) will be charged a separate commission. Alternatively you could use an ETF that owns all the stocks in a given sector and, with just one purchase/ transaction commission, gain ownership to all of the ETF s underlying stocks. Over time these savings in transaction fees can make a material difference in your long-term returns. 4

5 2. ETFs Provide Trading Efficiency And Liquidity An ETF trades like a stock on an exchange and can be bought and sold at any time throughout the trading day. Trading ETFs versus Mutual Funds Many mutual funds offer daily liquidity at the market s close each day. If you choose to sell your position, you are guaranteed to receive the fund s net asset value at the market s close, but at the time you enter your sell order this exact net asset value may be unknown to you. Let s say you had a $500,000 position in a mutual fund that reaches your target selling price of $10.15 during the morning. However, if by the end of that day the closing price drops to $10.10, this would equate to receiving $2,463 less than you had expected. This generally is not an issue for many investors, as you would receive the exact value of the mutual fund at the market s close. However, had you been able to transact intraday through an ETF, you could determine the exact price you would be receiving at that exact moment and base your decision to sell accordingly. Trading ETFs versus Hedge Funds Some hedge funds may require a full three months, advance notice in order to sell a position. This causes you to lose the ability to rapidly modify your portfolio should anything materially change in the markets or your personal investment situation and time is of the essence. If you had a $500,000 investment in a hedge fund with quarterly liquidity and decided to liquidate your position, you would be required to stay invested until the end of the three-month notice period. If the hedge fund experienced a -5% return over the course of the upcoming quarter, this would result in a $25,000 decrease in your value by the time you get your position sold. Hedge funds also have the ability to gate redemptions. This permits hedge fund managers to reject redemption requests until they have sufficient liquidity to make good on your sell order. This gate was utilized in 2008 and 2009, creating an uncomfortable position for you as a hedge fund investor; you thought you had liquidity only to see it disappear as the capital value of your investment dropped. 5

6 Trading ETFs versus Fixed Income This liquidity advantage is most pronounced when transacting in fixed income based ETFs such as high yield bond ETFs. High yield bonds are generally quite illiquid and trade on fixed income desks as opposed to transparent exchanges. Therefore, competitive pricing and accurate inventory are likely unknowable. On a $500,000 bond portfolio, a difference of 0.50% in pricing can result in $2,500 being paid in excess. High yield ETFs can be purchased through transparent exchanges, ensuring you always receive the most competitive price when transacting in the high yield corporate debt market. Trading ETFs when underlying Stocks or Bonds have no liquidity An ETF investment in a non North American index can be bought or sold even though the underlying exchange has closed for the day because it exists in different time zones, or perhaps even extreme events that cause an exchange closure. If you wish to sell your ETF with a non-trading underlying exchange, a market will be made based on a best estimate of fair value. If you feel a substantial drop in value may occur before the underlying investment opens for trading again, you can decide if the estimated fair value makes sense to sell your positions immediately instead of waiting for the underlying market to open. The caveat here is that while liquidity has been created from an illiquid security, the efficiency of this trade diminishes the longer the underlying exchange has been closed. Trading ETFs versus Private Equity Private equity, by its very nature, has poor liquidity. Investors understand that their minimum investment time frame is multiple years. There are currently ETFs in registration that seek to replicate the activities of private equity pools. These ETFs will purchase the publically traded positions held by the major private equity managers. These new ETFs will have instant liquidity accompanied by substantially lower fees. In summary, if your risk controls dictate the need to have intraday transactions, only ETFs provide this instant liquidity advantage. 6

7 3. ETFs Provide Easy Diversification Picking stocks that will outperform over time is an extremely difficult task. Single securities can be subject to significant risks from scandals in news headlines, executive mismanagement and a plethora of unknowns. These risks can derail your investment plan and cause permanent loss of capital. Instead of trying to determine which single stock would make a good investment, consider an allocation to a sector ETF to increase your diversification and reduce risk. A sector ETF can give you exposure to a basket of stocks within a specific sector or industry, diminishing the risk of single company setbacks. Some examples of the diversification available through ETFs: Sectors / Industries Technology, Healthcare, Consumer Discretionary, Banks, Solar, Clean Energy, Industrials Market Capitalization Small Cap, Mid Cap, Large Cap Investment Type Government Bonds, Corporate Bonds, Preferred Shares, Convertible Bonds, Treasury Inflation Protected Security (TIPS), Emerging Market Debt Countries Canada, America, Mexico, Brazil, UK, Australia, Japan Regions North America, Latin America, Europe, Australasia, Far East (EAFE), World Alternatives Hedge Fund Replication, Managed Futures, Volatility, Commodities, Seasonality 7

8 4. ETFs Provide Transparency Transparency is important, as knowing what you own is a vital building block of portfolio construction. Without transparency you could be unknowingly exposing your portfolio to concentration risk. Let s compare transparency between investment structures: ETFs continually disclose all of their holdings. Actively managed mutual funds (both equity and fixed income based) publish all of their holdings on a quarterly basis. By the time you receive this information it could be very dated. Index based mutual funds offer full transparency as they are not active and must hold securities that duplicate the relevant index. They are differentiated from ETFs only by the fact that index mutual funds are liquid daily, rather then during stock market hours. Hedge funds may or may not offer any insight into their holdings. It is not uncommon for a hedge fund to operate as a black box. Private Equity operates similar to hedge funds in an ad hoc manner. Transparency is perhaps less important with a private equity investment as you are unable to change your investment holding, even if you desired to do so. The transparent reporting of holdings within an ETF give valuable insight and allow you, as an investor, to determine if this is the desired exposure you wish for your portfolio. 8

9 5. Access To Alternative Investment Strategies Sophisticated institutional strategies, such as managed futures and commodities, can be accessed at low cost through ETFs. Hedge Fund Replication ETFs are available to broaden portfolio diversification and exposure in order to access alternative sources of return. Managed Futures Volatility Commodities Inverse Hedge Fund Replication Inflation Protected Funds These alternative strategies, when in ETF form, experience the same daily liquidity as all ETFs and are not subject to the redemption schedule some hedge funds may adhere to. As a result of the growing scale of ETF strategies being offered, they can be accessed by high net worth investors at a management fee level that is similar in pricing to that of institutional investors. The effect on savings with these ETFs fees, compared to the comparable Commodity Trading Advisor (CTA) or Hedge Fund fee, is most pronounced when comparing the impact of the 20% performance fee. For example, a $500,000 portfolio with a 20% performance (net of fixed MER), so the hedge fund would be owed 20% of this 20% return, which is 4%. Purchasing a comparable ETF with no performance fees would equates to the saving of approximately $20,000 in fees. 9

10 6. Access To Wide Range Of Sectors And Global Exposure There is an ETF for almost any investable theme. Groupings can be by size, region, industry, and even environmental sustainability. With a single purchase, you can access an entire market. For example, buying a single position in a Total World Stock ETF gives fractional ownership of 4,871 stocks from all over the world! All World ETF Developed World ETF Emerging Markets ETF U.S. ETF Japan ETF Technology ETF Healthcare ETF Semi Conductor ETF Software ETF As a Canadian investor, why should your investments exhibit a home country bias? ETFs allow for true global diversification, which can be efficiently allocated throughout your portfolio. Sometimes a home country bias may be the best investment, but with ETFs you have the flexibility to determine your desired exposure globally. 10

11 7. ETFs Help Control Currency Risk Your portfolio should be constructed with a view on currency. Many ETF providers now offer currency hedged and un-hedged products, allowing Canadian investors the flexibility to control what exposures they desire. This is generally not the case with mutual funds or individual securities. For example, if you wished to invest in a country but were afraid you may reduce your return by that country s currency devaluing versus the Canadian dollar, you may be able to purchase an ETF that gives you exposure to this country in a currency hedged manner. Maybe you want to invest in a country and also believe its currency will appreciate relative to the Canadian dollar; many ETFs offer this exposure as well. ETFs simply provide choice. They are merely a vehicle for delivering your investment strategy in a clear and controlled manner. Note: This currency hedging is a moving target for the ETF issuer and they will, to the best of their ability, attempt to remove the effects of currency from the ETF s return. There is a possibility that the techniques used to hedge currency may cause an ETF to deviate (positively or negatively) from its benchmark. 11

12 8. ETFs Can Provide Tax Efficiency With an ETF, you are only liable for any gains that you participate in. ETFs have superior tax efficiency through their structure. Unlike a mutual fund, investors only pay for capital gains they achieve themselves. When you purchase a mutual fund, there may be embedded (unrealized) capital gains within the underlying portfolio. As a mutual fund unit holder, you will receive a tax slip for realized gains within the portfolio as the mutual fund is rebalanced, even if you did not own the mutual fund long enough to participate in those gains. This is one reason why investing in ETFs is structured differently. Similar to holding individual shares, what you pay for the ETF is your cost base. Using ETFs to maintain market exposure during tax-loss selling You may hold a position with an unrealized capital loss that you wish to sell to offset realized gains in your portfolio. If you wish to maintain exposure while not triggering superficial loss rules, ETFs can be an ideal investment. If you hold a single stock that you wish to realize a loss on, you could sell the stock, buy a sector ETF with a high correlation to the stock and maintain your exposure to this sector during the superficial loss waiting period. After the superficial loss period has expired the ETF can be sold and the stock repurchased. Or if you hold an ETF that you wish to realize a loss on, you could sell the ETF and buy a similar ETF from another ETF issuer with a very high correlation that may track a near identical index. Additional tax efficiency through ETNs (Exchange Traded Notes) An ETN (Exchange Traded Note) is similar to an ETF in that it gives exposure to a pre-defined index or strategy. The main difference between an ETF and an ETN, is that an ETF physically holds all the underlying shares of an index, and an ETN is a promise to pay the return of the underlying index. This promise to pay is generally backed by a major bank and carries a similar credit rating to an unsecured bond issued by the same bank. 12

13 Because an ETN doesn t necessarily own the underlying securities, and is in effect an unsecured bond, there is a credit risk. If the guaranteeing bank experiences a reduced credit rating or defaults, your investment value could be badly affected. When investing in ETNs, ensure that you are comfortable with the credit risk you are taking. With an ETN, total return (re-invested dividends) indices can be replicated. This ETN is a promise to pay the exact amount of the total return index. As no dividends are physically paid, there are no tax consequences until the ETN is sold and a gain or loss is realized. This is in contrast to an ETF that pays dividends. If one were to reinvest all dividends received back into the ETF, a taxable account would owe taxes in each year for dividends received. While the end results in tax savings between the ETF and total return swap ETN are minor, due to dividends and capital gains being already tax-advantaged, the main benefit is that holding the total return swap ETN allows the investor the ability to defer all taxes. By deferring taxes until units are sold, you gain a greater ability to control the timing of any tax liabilities. 13

14 Conclusion ETFs provide high net worth investors with significant opportunities to save cost versus alternative investment options while achieving their goals for capital growth, wealth preservation and income generation. Here are a few additional points to summarize the flexibility and benefits offered to high net worth investors by using ETFs: A fair fee for desired exposure Investment vehicles with intraday liquidity Efficient diversification into indices, sectors, countries, regions Transparency as the building blocks of portfolio construction Access to alternative asset classes and strategies Ability to control currency exposure Tax efficiency Not all ETFs are perfect. Some lack liquidity, some track their benchmarks poorly, and some are complex vehicles requiring skill and expertise to utilize to their maximum potential. For investors seeking professional assistance through Advisor Managed Discretionary ETF portfolios, The Morton Group of Wood Gundy would be pleased to discuss your personal investment situation. We can be reached at: The Morton Group Tim Morton, CFA, First Vice-President, Investment Advisor, Portfolio Manager James Morton, CIM, Investment Advisor, Associate Portfolio Manager 150 Bloor St. W., Suite 501, Toronto, ON M5S 2X tim.morton@cibc.ca james.morton@cibc.ca

15 About the Morton Group of CIBC Wood Gundy For the past 35 years, The Morton Group has managed the wealth of high net worth Canadians. Our focus is on building and preserving the real value of client assets. Whether investors are accumulating or protecting wealth, the priority is to have their capital work efficiently with portfolios that are established to deliver the desired level of annual income and capital appreciation. Tim Morton, CFA, Investment Advisor, Portfolio Manager As Portfolio Manager, Tim is the senior advisor in management of our ETF strategies. The development of the Morton Group ETF platform began in 2007 during Tim s tenure as Chief Portfolio Manager of CIBC Wood Gundy. James Morton, CIM, Investment Advisor, Associate Portfolio Manager James co-manages client portfolios. In addition, James provides customized client reports and leads the group s research activities. The Morton Group discretionary ETF strategies are monitored, traded and reconciled by James. Christopher Keir, Investment Advisor Assistant Chris Keir is the go to person within the group when clients are in need of administrative or service assistance. Chris has worked with the group for over 15 years. 15

16 CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada. The views of Tim & James Morton do not necessarily reflect those of CIBC World Markets Inc. If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor.