ETFs are wonderful. There’s a reason why we use them in all our client portfolios. However, it’s not like we’ve discovered a well-kept secret: ETFs are now more than a $100 billion industry in Canada, which has been growing almost 20% annually over the past decade. It’s obvious why: ETFs provide more transparency, tax efficiency and, particularly, lower costs than mutual funds.
However, they’re not perfect.
Below are my concerns, which also highlight the pitfalls to avoid when investing with ETFs.
1. Take the market-mastery sales pitches of smart beta and actively managed ETF providers with a grain of salt. Because plain-vanilla ETFs are now so low cost that they’re, for all intents and purposes, free (a 5 basis point fee for an ETF amounts to a cost of only 50 cents per $1,000 invested), ETF providers have issued more and more higher-cost ETFs with an ‘active’ overlay to juice their margins. The Canadian ETF space is now about 1/3 actively managed and this area continues to grow. The average fee for actively managed ETFs is 0.85% vs. passive ETFs at 0.57%—an almost 50% premium. Certainly some of these ETFs have merit, but investors must be aware that a ‘strategy’ is being applied to the ETF and that this strategy will, at times, fail. Also, investors must ask themselves if the active management is necessary. For instance, why pay for a pricey ‘low volatility’ ETF when portfolio volatility can be controlled simply by adjusting bond weightings in the asset allocation.
2. ETFs have become highly specialized. With more than 6,000 exchange trade products listed globally it stands to reason that there will be many that are narrowly focused. On the market currently are ETFs that specialize in robotics, cyber security, livestock and beef futures, Catholic values (no pornography amongst other sinful businesses) and Nashville (yes, as in the home of the Grand Ole Opry). The ETF market is becoming very…what’s the word? Granular. Investors must be honest and ask themselves if they truly understand the highly specific areas that they’re investing in. Keep this in mind as you eagerly await the first medical marijuana ETF (it’s coming; Horizons just filed its prospectus).
3. Timing of new ETF issuance is not always advantageous for investors. ETF providers are in the business of sales. Fair enough, but just as a company typically only launches an IPO when its industry is red hot (read: expensive), so too do ETF providers with their product launches. For example, a new Bitcoin ETF is seeking approval from the Securities and Exchange Commission and may be released shortly. I’m not going to argue the merits of Bitcoin, but it should come as no surprise that Bitcoin relative to the US dollar is challenging its all-time highs (see chart). Also, the potential volatility of many new ETFs is not always clearly disclosed. It might surprise some investors, for instance, to learn that Bitcoin has been roughly 20x more volatile than the S&P 500 over the past five years.
Bitcoin ETF may be released near all-time highs
Deviation: Bitcoin 20x more volatile than S&P 500
Source: Turner Investments, Bloomberg. Standard deviation measures the amount of variation or dispersion for a particular index or security. In other words, it measures the risk of owning that index or security.
5. Leveraged and derivative-based ETFs, even now, aren’t fully understood by investors. This is not entirely the fault of the ETF as it is only doing what it was designed to do, but many investors are still unaware of the downside of these derivative-based products even after all the media coverage of ‘daily rolling contracts’ and ‘volatility drag’. For example, we have new clients arrive all the time holding VIX (volatility) ETFs that have sat in their portfolios for years. A VIX ETF is meant to be tactically traded (a virtually impossible task, by the way) not bought and held. The most popular VIX instrument, the iPATH S&P 500 VIX Short-Term Futures (VXX), held over five years has lost 99% of its value! So, ensure that you fully understand how an ETF should be used before buying. Derivative-based/leveraged ETFs also aren’t cheap having an average MER of almost 1.5%—more than double the industry average.
ETFs are wonderful products and have driven costs down across the entire investment industry, but they come with their own baggage and complexities. There are now more than 15 ETF providers in Canada. Fifteen years ago there was essentially one. And mutual fund companies are getting more involved in the space: AGF, Dynamic and Manulife are just a few of the fund companies launching ETFs this year. So, ETFs are only going to get more complex with more providers promising that they’ve built a better mouse trap.
Take care that you don’t get your fingers caught. Or find a financial advisor who’s learned better and safer ways to get the cheese.
Doug Rowat,FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.