MUTUAL FUNDS vs ETFs: INNOVATION IN THE FUND INDUSTRY

FROM MOVING SCRAP TO PUSHING PAPER: What is the best fund option for my investments? 

SUMMARY:

 The trend within the financial planning industry is towards greater adoption and usage of exchange-traded funds (ETF).  Many advisors and investors have warmed up to their low costs, simple diversification, and potential tax advantages.  While an ETF does not always serve as a direct substitute for an individual stock, bond, or actively managed mutual fund, it has rightfully earned a place in the portfolio of many savvy investors.

 

Our dynamic economy changes by the minute with each industry moving at different speeds.  The smartest firms compete the hardest often end up with a game-changing innovation that forces a paradigm shift unto the world.  The laggards bemoan their struggles caused by a reluctance to venture into new and previously undiscovered territory while the leaders stride ahead to confidently face the next challenge.

The financial sector has taken due pressure from regulators, shareholders and others following the financial crisis for creating and selling the ‘Financial Weapons of Mass Destruction’- derivatives!  Insiders know these securities themselves are not inherently evil, but that didn’t stop the media from running with a good story.  It’s a shame that as the ETF industry was reaching critical mass in the United States their housing bubble was bursting.  It overshadowed the remarkable success of ETFs and the dynamism between investors and their wealth.  When they put cash back to work following the Great Financial Crisis, investors chose ETFs as the vehicle with stunning abundance. 

In the US, ETF inflows from 2000-2007 totaled over $500 Billion USD, raising assets under management (AUM) from $80 Billion USD to nearly $600 Billion USD.  In that period the total number of ETFs listed in the US went from 81 to over 600.  After a slight lull in 2008 & 2009, growth of total AUM and number of ETF offerings shot up over 50%, now boasting 1000+ different vehicles stewarding well over $1 Trillion USD in capital. 

Globally the story is the same for over 200 ETF providers on 54 exchanges worldwide: in the first half of 2012 ETF assets have increased by 11% from US$1.35 Trillion USD to $1.5 Trillion. In early 2013 ETP’s surpassed $2 Trillion in AUM.  This capital flow is indicative of numerous trends in the markets, many of which will be discussed here.

First a comparison of two very familiar businesses: Canadian investment funds and internal-combustion engine automobiles.  Astonishingly neither has changed much from their original incarnation.  Nips and tucks around the edges perhaps, but the obvious limitations of mutual funds & automobiles put them at risk.

POWER AND INGENUITY 

Over a century has passed since a near-deaf Thomas Edison shouted in a young Henry Fords’ ear, “Yes, that hydrocarbon, an excellent fuel!” and our cars perilously burn the same noxious petroleum.  The automobile industries’ absence of innovation has left them some vulnerable to slumping sales, government bailouts and public acrimony.  Readers of this passage familiar with the financial industry will immediately see the paralleled plight.

Both the Canadian fund management and automobile industries manage titanic amounts of financial and intellectual capital.  Heavy investment in existing operations can prohibit these goliaths from pivoting swiftly in response to changing market dynamics as plants, parts and people too familiar with time-tested procedures operate comfortably numb to new ideas and competitive threats. 

However, as the likes of Tesla, T. Boone Pickens and others embrace the emerging trends in alternative fuels, so goes various ETF providers in relentless pursuit of alternative investments.  Spirited innovation and progress has brought investors a suite of ETF options that offer diversification and value-for-money in a time of dire need.

OH NO CANADA: Funds and Fees

Fees are a 100% ‘tax’ on your capital.  While it is accepted and understood that prudent investment management is worth paying for, clients should be mindful of how fees impact their returns.  Canada is a notorious jurisdiction for mutual funds fees.  Over the past decade competition has decreased average MERs, but it remains stubbornly north of 2% overall and lags behind all of developed economies. 

Savvy investors’ aversion to these prohibitive fees created a gap that ETFs are bespoke-tailored to fill. With meaningfully lower MER’s (ranging from less than 25bps to +80bps) ETFs can provide similar market exposure at markedly reduced costs.  A hypothetical investor with $100,000 stands to pocket $1500 tax-free in unpaid fees per annum (MF fee 200bps = $2000 per year vs ETF fee 50bps = $500 per year) by switching from mutual funds to ETFs. 

Intuitively we know unpaid fees are a benefit the growth of our savings.  This money remains invested and accrues interest & dividends adding significantly to long-term capital appreciation. However, the magnitude of this positive impact is far greater during periods of ultra-low interest rates as some bond instruments may yield less than the MER of the fund!  Starting off ‘in the hole’ leaves average investors little chance of positive absolute returns in difficult markets.

There is plenty of room to run for ETFs in Canada. The distribution of investable assets heavily favours mutual funds.  BMO estimated recently that only 5-7% of fund allocations are in ETFs.  The massive expansion possibilities for this market have banks and stand-alone ETF providers (now 7 in total, offering 200+ ETFs on TSX) jostling for market share in a burgeoning arena. The industry has exploding in popularity with AUM growth rates of 20% year-on-year over the past 5 years; few question that this trend will continue.

LOW COSTS: BUNDLING 

Another cost advantage arises when considering brokerage commissions on purchase and sale of ETFs vs. stocks.  If an investor seeks exposure to the Technology sector they may purchase dozens of different individual securities prior to achieving sufficient diversification.  An ETF tracking a similar basket, or index, of tech companies can be acquired with a single transaction and achieve instant diversification.  The simplicity and savings are driving factors in ETF adoption.

USING ETFs FOR ANALYTICS

Perhaps an unintended benefit of ETF adoption is their value as a tool for gauging market sentiment.  For example, comparing sector-specific ETFs against one another over time becomes a valuable tool.  By measuring the relative strength of these securities and reporting their activity to other investors many small boutique research firms have flourished.

 

FLASH CRASH & PAPER CLAIMS

Some are critical of ETFs going as far as to blame them for the flash crash.  Others, often precious metal fans, portray ETF providers as straw men who may or may not hold the underlying security in question.  Their effort to undermine ETF’s is largely misguided.  Like the mutual fund industry ETFs are heavily scrutinized by regulators and savvy investors.  As they approach $2 trillion in assets worldwide people are displaying their trust in this asset class — by buying ETF shares.

Investment management firms and financial institutions are churning out new ETFs with increasing breadth and specificity.  The combinations are endless allowing unimaginable diversification with great ease.  Advisors have constructed index ETF portfolios with 6 or fewer holdings that give the investor access to 1500+ underlying securities for as low as 10-20bps.  Active ETF’s are have also emerged where for a slightly higher MER, say 60-80bps, you gain the added professional management and asset allocation from a firm (or individual) acting as sub-advisor to the issuer.  Competition further driving down fees (as we’re witnessing in the US) suggests a structural change in the investment fund industry is upon us. 

…

ETF’s at Work: TAX ADVANTAGES BY CREATING ASSETS WITH TACTICAL PLANNING

Sound tax planning is a cornerstone of good investing. Paper-based returns are flashy, but the bottom line — after-tax returns – pay the bills.  Generate alpha for show, tax plan for dough.  Many are familiar with tax-friendly options for mutual fund investors with non-registered assets.  Corporate class funds for example helpfully eliminate deemed dispositions during tactical re-balancing of a portfolio.  How can ETF’s be utilized in a tax friendly manner? 

Tax Loss Harvesting:  this strategy is a swap of like-for-like asset to record a capital loss.  It is a risk- and asset allocation-neutral rebalancing with low costs and high potential rewards, in this case using corporate bonds (a segment of the market which is heretofore uninhabited by most retail investors and many advisors). 

Through greater liquidity, access to institutional bond pricing, and reduced risks via broad issuer diversification overall returns can be enhanced.  In practice corporate bonds can be difficult to access and complicated to manage.  Using a bond ETFs as an alternative to holding individual corporate fixed income securities provides transparency and aids accurate forecasting of expected yield-to-maturity.  Many pay a monthly floating distribution are offered with maturities ranging from 2013 through to 2021 providing a full range of options for short- and long-term goals. 

 Assume you own the Target 2017 Corporate Bond Index ETF and in November you are stuck with a 10% loss.  Sell Target 2017 to crystallize the capital loss and immediately repurchase Target 2018 Corporate Bond Index ETF with the proceeds. 

 

This allows an investor to:

1. remain in the market,
2. create a tax asset (capital loss to offset future/previous capital gains)
3. avoiding being penalized by the superficial loss rule
4. rebalance by shifting one-year down the duration curve. 

 

Because you utilizing the proceeds for the purchase of a very similar, but not identical, security your overall risk level and asset allocation change only marginally. 

 [Note: The interpretation of likeness between ETFs is critical. If deemed identical this strategy would not have merit.  This strategy is thus limited to those instances where longer-dated versions are sufficiently different according to local tax code.  You could employ this tactic successfully by sliding further away from 2018 into 2019, or 2020, etc versions.]