QIFL | Exchange Traded Funds

“You either master money, or, on some level, money masters you.” — Tony Robbins

An exchange-traded fund (ETF), is a marketable security that tracks a commodity, an index, bonds, or other assets. Like a stock, the price of an ETF fluctuates by changes in supply and demand throughout trading hours and trades on a stock exchange. An ETF divides the ownership of its assets (gold bars, currencies, stocks) through shares and some reward shareholders with interest or dividends. Presently, there is an ETF for almost any kind of marketable asset and for every investing strategy. The idea is that the ETF doesn’t try to outperform the market; it instead follows the market it has been designed for. For example, if the NASDAQ biotechnology index rises 1%, the iShares Nasdaq Biotechnology ETF (IBB) rises 1%, if the S&P 500 falls 2%, the S&P 500 ETF falls 2%.

The emergence of ETFs is largely because of investors’ frustration with mutual fund management fees. ETFs offer a low maintenance alternative investment tool for a low fee, which has created a significant inflow of capital into this market. Historically, mutual fund managers have generally been unable to outperform the market, which is what investors are paying them hefty sums to do. Unlike an ETF, mutual funds don’t follow an index, commodity, etc, instead, the mutual fund manager is responsible for selecting securities to increase the value of each share. Mutual funds are often criticized for their expensive management fees, as the shareholders pay monthly, quarterly or annual fees, no matter how the fund performs in the given year. The structure of a mutual fund plays some part in this, as managers generally have restrictions on what they can or cannot do. For example, some may not be able to buy equities that are below a certain price, some aren’t able to buy stocks of companies who don’t have a market capitalization of at least $400 million, and some have to have almost all capital invested no matter how the market is performing. There is also the issue of job security for these money managers. A manager will never lose their job for investing in TD Bank (TD), or Telus (TRP). When the price of these companies falls, no one questions why the manager bought Telus, they instead question what is wrong with Telus. However, if a manager buys a lesser-known and much smaller company such as Canam Group (CAM), they will certainly have to defend the selection more than if they bought Telus. If the price of CAM falls, the manager will take criticism for taking to much risk. Thus, for job security sake, managers have an incentive to invest in well-known and big companies. All of these structural characteristics pose significant challenges to the manager trying to beat the market.

In May 2016, $18.7 billion flowed out of American mutual funds and hedge funds, while there was inflow of $8.1 billion into ETFs. Investors have clearly become fed up with paying high management fees for underperformance of the market. For a passive investor who is trying to grow their capital at the same rate as the market, it makes no sense to pay a manager a high fee to fail to do this. Instead, the investor could spend time allocating capital to a small number of ETFs, or even on ETF, and maintain the growth that market is having while paying low fees.

Although ETFs are what seems to be the future of passive buy and hold investing, there are downsides to owning them. The most significant disadvantage to owning an ETF, is the fact they are stuck to the index they follow. For example, during the sharp fall of Blackberry (BB) the stock price fell 26% in one day, which contributed to an 8% decrease in the TSX Information Technology Index due to the size Blackberry once was. Had you have owned the S&P/TSX Capped Information Technology Index Fund, you would also have lost 8% of your investment on that day. A mutual fund could have avoided this if the manager was active and knowledgeable. They likely could have sold the fund’s entire Blackberry stock, or at least decreased their exposure to the drop.

To conclude, the emergence of ETFS has completely changed the once flourishing mutual fund industry. Firms are now having to lower fees and have place more emphasis on growing at the market pace to retain investors. Although ETFs do have their disadvantages in terms of the reliance on one index, they’re clearly a superior tool for a passive investor. Owning multiple ETFs is a way to construct a diversified portfolio designed to grow with the chosen indexes/securities, for a low fee. Thus, investors should strongly consider if the management fees they pay fund managers are worth the performance of their fund.

Published by the Queen’s Initiative for Financial Literacy

Article Author: Sam Fraser, Personal Finance Director




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