Lifting the veil on ETFs – Part 4 of 4

Warning about the fees and costs of ETFs
The expense ratio is not the only cost of investing in exchange traded funds. ETF shares must be purchased through a regular stock brokerage account. There will be commissions to both buy and sell ETFs. The commissions on buying and selling ETFs are the same as for buying and selling individual stocks. An investor who does a lot of trading in and out of ETFs will see a greater impact from brokerage commissions than from the expense ratios of the funds.

Unfortunately, the costs of Canadian ETFs are not as straightforward as one might think. Most investors don’t realize that iShares, Claymore and BMO (to name a few), disclose their fees in different ways, making apples-to-apples comparisons difficult.

The first point to understand is that Claymore, BMO and others only list their ETFs’ management fee on their websites. iShares, on the other hand, lists each ETF’s management expense ratio, or MER. The two terms are not synonymous. The management fee is only part of a fund’s overall MER. It’s usually the largest part, for sure, but it’s not the whole picture.

The management fee typically covers all of the administrative costs, the manager’s compensation, index licensing fees, all fees paid to the custodian (the investment firm that holds the securities), the registrar and transfer agent (the firm responsible for keeping shareholder records). These make up the vast majority of an ETF’s expenses. However, the management expense ratio or management fee also includes some additional costs, such as GST and the fees payable to the fund’s independent review committee (IRC), a legal requirement designed to protect investors from conflicts of interest. Read the Prospectus carefully to avoid unpleasant surprises!

There is also a Transaction Expense Ratio or Trading Expense Ratio (TER) that is not quoted in the Prospectus as it is only determined in arrears. Most Prospectus’ provide an estimate of this cost – but you only learn the exact amount at the end of the year and it reduces the value of your investment. This could add up to an additional 1% or so to your costs. These expenses are primarily the costs involved with trading commissions paid by the managers of an ETF as they shuffle the portfolio to keep it in line with a target index. It is important to add the TER to the MER for a more accurate picture of the fund’s costs.

Other fund expenses may not be included in the management fee, something you may only learn if you scour the funds’ regulatory filings and Prospectus. These may not add up to much, but ETF providers trumpet their low fees as a selling point and four or five basis points is enough to make a competitive difference and cost is cost. Remember, NOTHING is free!

Visit with me again in future issues of Money Magazine and this blog as I explore many of these issues in more detail including the difference between an INDEX FUND and an ETF.

With courtesy to:

Wikipedia, The Wall Street Journal, Morgan Stanley, iShares, Claymore, BMO, The Vanguard Group and the International Monetary Fund.

Lifting the veil on ETFs – Part 3 of 4

Taxation
By their nature, ETFs are tax efficient and can be more attractive than mutual funds. When a mutual fund realizes a capital gain that is not offset by a realized loss, the mutual fund must allocate the capital gains to its shareholders. These gains are taxable to all shareholders, even those who reinvest the gains distributions to purchase more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF shares on the stock market, as they would a stock), so investors generally only realize capital gains when they sell their own shares for a profit or when the ETF trades to reflect changes in the underlying index.

Trading
An important benefit of an ETF is the stock-like features offered. A mutual fund is bought or sold at the end of a day’s trading, whereas ETFs can be traded whenever the market is open. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin and invest as much or as little money as they wish.

Risks

Effects on stability
ETFs that buy and hold commodities or futures of commodities have become popular. The commodity ETFs are in effect consumers of their target commodities, thereby affecting the price in a spurious fashion. In the words of the International Monetary Fund (IMF), “Some market participants believe the growing popularity of exchange-traded funds (ETFs) may have contributed to equity price appreciation in some emerging economies, and warn that leverage embedded in ETFs could pose financial stability risks if equity prices were to decline for a protracted period.”

Regulatory risk
Areas of concern include the lack of transparency in products and increasing complexity, conflicts of interest and lack of regulatory oversight. You must take the time to do your own research before investing to fully understand these risks.

Criticism
John C. Bogle, founder of the Vanguard Group, a leading international issuer of index mutual funds (and, since Bogle’s retirement, of ETFs), has argued that ETFs represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification. He concedes that a broadly diversified ETF that is held over time can be a good investment.

The Wall Street Journal reported in November 2008, during a period of market turbulence, that some lightly traded ETFs frequently had deviations of 5% or more, exceeding 10% in a handful of cases. According to a study on ETF returns in 2009 by Morgan Stanley, ETFs missed their 2009 targets by an average of 1.25 percentage points, a gap more than twice as wide as the 0.52-percentage-point average they posted in 2008. Part of this so-called tracking error is attributed to the proliferation of ETFs targeting exotic investments or areas where trading is less frequent such as emerging-market stocks, future-contracts based commodity indices and junk bonds.

Lifting the veil on ETFs – Part 2 of 4

Stock ETFs
The first and most popular ETFs track stocks. Many funds track national indexes.

Bond ETFs
Exchange-traded funds that invest in bonds are known as Bond ETFs. They thrive during economic recessions because investors pull their money out of the stock market and move into bonds (for example, government treasury bonds or those issued by companies regarded as financially stable). Because of this cause and effect relationship, the performance of bond ETFs may be indicative of broader economic conditions. There are several advantages to bond ETFs such as the reasonable trading commissions, but this benefit can be negatively offset by other fees and costs.

Actively managed ETFs
Most ETFs are index funds and as such, there is no “management” involved. Some ETFs, however, do have active management as a means to hopefully out-perform the nominal bench-mark index. Actively managed ETFs are at risk from arbitrage activities by market participants who might choose to front run its trades as daily reports of the ETF’s holdings reveals its manager’s trading strategy. The actively managed ETF market has largely been seen as more favorable to bond funds, because concerns about disclosing bond holdings are less pronounced, there are fewer product choices and there is increased appetite for bond products.

Leveraged exchange-traded funds (LETFs), or simply leveraged ETFs, are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs. Leveraged index ETFs are often marketed as bull or bear funds and because of the leveraging involved, returns and losses are magnified!

ETFs compared to mutual funds

Costs
The first rule to remember – NOTHING is free! Since ETFs trade on an exchange, each transaction is generally subject to a brokerage commission. Commissions depend on the brokerage and which plan is chosen by the customer. Full-service brokers typically charge a percentage commission on both the purchase and sale and may be negotiable depending on the dollar value involved. A typical flat fee schedule from an online brokerage firm $10 to $20, but it can be as low as $0 with certain discount brokers with minimum account values. Due to this commission cost, the amount invested has great impact on costs. Someone who wishes to invest $100 per month may have a significant percentage of their investment destroyed immediately, while for someone making a $200,000 investment, the commission cost may be negligible.

ETFs generally have lower expense ratios than comparable mutual funds. Not only does an ETF have lower shareholder-related expenses, but because it does not have to invest cash contributions or fund cash redemptions these costs are eliminated. Mutual funds may charge 1% to 3%, or more. Index fund (which by the way are NOT the same as ETFs – see future edition of Money Magazine) expense ratios are generally lower, while ETFs are normally in the 0.1% to 1% range.

The cost difference is more evident when compared with mutual funds that charge a front-end or contingent back-end load as ETFs do not have any additional loads at all. Potential redemption and short-term trading fees are examples of other costs that may be associated with mutual funds that do not exist with ETFs. Traders should be very cautious if they plan to trade inverse and leveraged ETFs for short periods of time. Close attention should be paid to transaction costs and daily performance rates as the potential combined compound loss can sometimes go unrecognized and offset potential gains over a longer period of time.

Lifting the veil on ETFs – Part 1 of 4

Recently, one of the big 5 banks did a customer survey on ETFs and one of the questions was: “What do the letters ETF mean?” The responses shared were interesting to say the least! Most thought they stood for Emergency Task Force! Another group though it was an abbreviation for Energy Transfer Fund (like a carbon offset trading scheme I presume), some said it was an Environmental Trust and still others suggested Electronic Transfer of Funds. Apparently, less than 5% correctly identified the letters as meaning Exchange Traded Funds! Interesting to say the least since ETFs are attracting lots of attention these days, for various reasons – some accurate and others not.

They’re still quite new and would-be investors are bound to have lots of questions. In this article, I am only going to touch on the generalities of ETFs and some of the more common versions. Future issues of Money Magazine and this blog will delve more deeply into each area discussed here.

An (ETF) is an investment fund traded on a stock exchange much like a stock. It holds assets such as stocks, commodities or bonds and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index. ETFs may be attractive as investments because of their apparent lower costs, potential tax efficiency and stock-like features.

What is an index?
You probably know terms such as the S&P/TSX Total Return Index (the most quoted Canadian index) or the S&P 500 Index in the US on the news. Those are indexes. An index is a selection of stocks or bonds that represents a given market. Each index has rules about how many securities are included and how they are weighted. Indexes are mainly used to measure changes in the market they represent. Remember, an Industrial Average (such as the Dow Jones Industrial Average {DJIA} is NOT an index, but that is a subject for another review!).

An ETF combines the valuation features of a mutual fund which is bought or sold at the end of each trading day for its net asset value, with the tradability features of a stock or bond which trades throughout the trading day at varying.

Structure
ETFs offer investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds except that shares in an ETF are bought and sold throughout the day through a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value, or NAV. Instead, brokers purchase and redeem ETF shares directly from the ETF.

Index ETFs
Most ETFs are index funds that attempt to replicate the performance of a specific index. They may be based on stocks, bonds, commodities or currencies. An index fund seeks to track the performance of an index by holding in its portfolio either the contents or a representative sample of the securities in the index. Some index ETFs, known as leveraged ETFs or inverse ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the performance of the index.

Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called “replication”. Other index ETFs use “representative sampling”, investing perhaps 80% to 90% of their assets in the securities of an underlying index and investing the remaining 10% to 20% of their assets in other holdings such as futures, option and swap contracts and securities not in the underlying index. There are various ways the ETF can be weighted, such as equal weighting or revenue weighting.

Investment Industry needs independent players!

The most recent print issue of Money noted that the big Canadian banks managed to earn $31.7 billion in 2012, just a few years after there was grave concern that they’d even remain solvent.

“There is no question that Canadian banks play a vital role; locally, provincially, nationally and inter-nationally. Without the banks, our economy could simply not function efficiently or effectively. But are the banks getting too big and going too far to gain market share and profits at the expense of their own customers?” (Quote from Spring 2013 issue of Money Magazine.)

In November of last year I published a piece entitled Banks own the investment industry! A good thing? In many respects allowing the banks to provide everything from our mortgage to investment services is incredibly convenient. But at what price? It has become near impossible for many smaller investment dealers to stay in business. Fraser Mackenzie is a recent victim of an industry that requires scale in order to compete:

At their shareholder meeting on April 29th, 2013 it was decided: “Our assessment of the current business climate has led the owners to conclude that deploying our capital in the continuance of our regulated investment dealer businesses can no longer generate an acceptable rate of return. Institutional interest in early stage mining and oil & gas companies, sectors to which we have been heavily committed, has dried up: as has the associated trading in the equities of early stage resource companies. Furthermore, the regulatory cost burden is increasing at a time that industry-wide revenues are declining. On balance, it makes sense for our shareholders to re-deploy their capital.”

Indeed, well over half of the total value of trading done on the TSX in a typical month is conducted by the banks.

My guess is their actual market share of all trading is far above half if we were to also include trading platforms not part of the Toronto Stock Exchange. The banks keep growing, and the regulatory burden also grows more onerous. In my estimation, the larger financial companies relish regulation as an additional barrier to entry. Regulatory oversight is a minor inconvenience to the big banks, whereas for less diversified specialty businesses (mutual fund companies, standalone investment dealers, investment managers) the added expense can be devastating.

Obviously there are huge benefits to scale – but do consumers really benefit or are these economies of scale all kept as bank profits? MER’s for their proprietary mutual funds might appear very reasonable, but it’s impossible to determine whether or not the plethora of fees I pay for other services are subsidizing these seemingly lower expense ratios. Transparency is near impossible. Although many banks did collapse as a result of the the financial crisis, the massive rebound in the profitability of those surviving banks (even though they lost ridiculous amounts of capital doing stupid things with asset backed securities, derivatives trading etc.) suggests that those everyday fees paid by consumers and businesses must exceed the marginal cost of providing these services by quantum leaps and bounds.

Another concern I have – besides the demise of competition in the financial services industry – has to do with motivation. It’s true that every business is designed to make money, but in days of yore a mutual fund company, investment manager or stock broker had to have happy customers in order to succeed. If they didn’t help the client make money, the client would go somewhere else. I believe that as each independent firm disappears, so does choice. Making a great deal of money from you no longer requires you to be served well. What are you going do? Go to another bank?

The prime directive (to borrow an expression from Star Trek) of the financial services behemoths is profits. The financial advisor’s role is to enhance corporate profitability. Financial advisors today are increasingly handcuffed not just by regulatory compliance, but also ‘corporate’ compliance. Wouldn’t an investment specialist whose only mandate is to do well for his client be more properly motivated (and less conflicted professionally)? Would your investment objectives be better served by an independent advisor who is rewarded only because you the client are earning profits (and not because you are earning his employer more revenues)?

It isn’t necessarily true that an independent advisor is any better than one employed at a bank. I personally know of hundreds of outstanding advisors working at banks and insurance companies. But it must also be true that a satisfied, properly motivated, objective and focussed financial professional will do a better job whether he/she is at an independent or a bank.

We can’t begrudge the banks their success but left to their own devices, they’d all have merged into one by now. In December of 1998 then Canadian Finance Minister Paul Martin rejected the proposed mergers of the Royal Bank with the Bank of Montreal and CIBC with the Toronto-Dominion Bank. We know from our U.S. history that government and regulatory authorities are frequently frustrated by the political muscle (lobbyists, lawyers) of the large financial firms. Ultimately having one gigantic Canadian bank – providing all our financial services, investment needs, insurance requirements – might (or might not) be a worthy corporate ambition, but it’s hard to imagine such a monopoly being good for the likes of us. After all, just consider the progress that has been made in telecommunications since Bell Canada (or AT&T) was forced to reckon with serious competition.

The banks need independent players. Not only should banks discourage the obliteration (by bullying or by absorption) of non-bank competition, they should use their political muscle to keep the regulators from picking on Independent players. Government agencies cannot help themselves – if they are impotent against the strong they naturally attack the weak – even though when all the weak are dead the regulators would have no jobs. You don’t need a police force when there’s nobody you can effectively police.

Independent players create minimum standards of service and ethics, and fuel industry innovation. In every instance, the independent is a bank customer too. Mutual fund and investment managers pay fees to banks, buy investment banking offerings, custodial services and commercial paper and also trade through bank facilities. Independent dealers provide services and financing to corporations deemed too small to matter by larger financial companies; that is, until these businesses grow into large profitable banking customers. Put another way, why not adopt the Costco model where smaller independents can shop for stuff to sell to their own customers, and higher end specialty shops and department stores can all remain standing, rather than the take-no-prisoners approach of Walmart?

Let’s hope that the few surviving independent firms can be allowed to thrive, and if we’re lucky perhaps new players will arise to provide unique services to Canadian clients and homes for advisors who are inclined to specialize in managing and not just gathering assets.

Mal Spooner