Exchange Traded Funds…Added Diversification at a Low Cost
By Mark Defalco, CFP
Over the last five years, exchange traded funds (ETFs) have had a substantial effect on the Canadian capital markets and the way we manage our money. ETFs can be used to help further diversify your portfolio and provide you with access to different asset classes at a very reasonable price.
ETFs have been in existence for over a quarter century, first being offered to corporate pension plan clients as a way for them to invest in an underlying index. Only in the last five years has the ETF world caught on with individual investors as financial institutions began to create ETFs that are attractive to a wide range of investors. The leading manufacturer of ETFs in Canada is Barclays Canada, a division of U.K. based Barclays Bank PLC, with total ETF assets of approximately $10.8 billion as at September 30, 2005.
ETFs are similar to mutual funds in that they offer unit holders individual units based on the dollar amount purchased. However, unlike mutual funds, ETFs are listed and traded on stock exchanges, just like individual stocks. If you were interested in purchasing an ETF, you would purchase the ETF through a discount or full-service broker, and the applicable commission would come off your amount invested, just like the purchase of a regular stock. ETFs provide investors with diversification at a lower cost than a mutual fund. For example, most ETFs charge a Management Expense Ratio (MER) of between 0.17% and 0.55% versus mutual funds that charge anywhere from 1.25% upwards to 3.00%. Why the large difference in cost? The answer lies in the manufacturing and distribution of an ETF versus a mutual fund.
Mutual funds are managed by professional money managers who are in charge of buying and selling investments based on the underlying investment objectives of a fund. In most cases, managers have full discretion on what they want to buy, sell or hold in the portfolio as long as they follow the investment objectives of the fund set out in the prospectus. The performance of a mutual fund is generally measured against the index that most closely matches the asset class. For example, most Canadian equity funds are measured against the S&P/TSX Index. The goal of a manager is to outperform the index consistently over time using a particular management style and investment philosophy. This form of portfolio management is called "active" management and it is the form we are most familiar with.
ETFs on the other hand track an underlying index or asset class or security. For example, Barclays Canada has an ETF that tracks the S&P/TSX 60 Index and an ETF that tracks a Gold Index. The managers of an ETF do not actively manage the fund in the sense that they do not try to beat an index such as the S&P/TSX. This is called "passive" management. ETFs are simply attempting to replicate the performance of the index at the lowest cost possible. ETF managers believe that you cannot actively outperform an index over the long-term. Active managers believe they can outperform the index over time, and they strive to do this for their unit holders. The debate between these two camps can be quite ferocious at times, with the different sides presenting their own arguments using their own empirical evidence. In truth, both sides can have valid arguments to support their respective positions, and it is easy to be swayed back and forth when each side presents their own data.
The difference in costs of an ETF versus a mutual fund lies in the manufacturing and distribution of the respective products. A mutual fund has significantly higher costs for such things as management salaries, trading costs, research costs, administration fees, etc. An ETF can avoid many of these costs because it is simply tracking an index. As well, most mutual funds are bought through financial advisors, and the mutual fund company is required to pay them a portion of the MER. ETF's do not pay advisors a share of the MER. Instead, an advisor selling an ETF would have a separate fee arrangement with the investor on an appropriate fee to charge on top of the MER of the ETF.
Without getting into a war of words as to which of the two management styles is better, it is fair to say that having a portion of the portfolio allocated to both of these management styles can help in further enhancing the diversification of your portfolio and providing stronger risk-adjusted returns.
If you are interested in learning more about ETFs, please contact your own financial planner.
|
are certification marks