The ETF carpetbaggers
There’s no question that exchange-traded funds (ETFs) are hot right now. But there are some growing problems with this supposedly cheap and simple form of investing that everyone needs to be aware of before plunging in.
For starters, the line between ETFs and closed-end funds has become extremely fuzzy. ETFs are theoretically passively-managed portfolios designed to track a specific benchmark index. Their results should closely approximate those of the benchmark, less the management fees. Closed-end funds, on the other hand, are actively-managed portfolios that trade on a stock exchange. The managers have a free hand to invest in whatever they want, within the context of the fund’s mandate, without slavishly following the dictates of an index. Typically, their fees are higher than those of ETFs. The distinction between the two blurs, however, when ETFs are created to track indexes that don’t exist – and that’s exactly where this burgeoning business is heading.
Make no mistake about it: there are mega-bucks involved here. A recent article in The Wall Street Journal said that the assets of ETFs in the U.S. have risen 500 per cent in the past five years. Compare that to a growth rate of 50 per cent for mutual funds over the same period and you get an idea of how investors’ habits are changing.
We don’t have comparable numbers for Canada but there is evidence that a similar phenomenon is occurring here. Barclays Global Investors Canada, which dominates our ETF market with its iShares brand, reported iShares assets under management of $15.3 billion at the end of February. That represents an increase of almost 40 per cent from the year before. In contrast, the member companies of the Investment Funds Institute of Canada (IFIC) showed a net gain in total assets of 15.3 per cent in the same period. Barclays Canada is clobbering them in growth terms. Barclays is still way behind mutual funds-leader RBC in terms of assets under management (RBC has about $75 billion in its funds), but even at RBC’s excellent 21 per cent growth pace the gap is closing.
Barclays currently offers 21 iShares funds in Canada with three more scheduled to launch in May. Most are based on legitimate indexes such as the S&P/TSX Composite Index, the Scotia Capital Universe Bond Index, and the S&P/TSX 60 Index. But a few look very thin when you probe beneath the surface. An example is the iShares CDN Tech Sector Index Fund (TSX: XIT). To claim that we have a legitimate “tech sector” in Canada is a bit of a stretch as the composition of this fund’s underlying portfolio shows. Only nine companies are represented of which two, Research in Motion and Nortel, between them account for almost 48 per cent of the portfolio. To call this an “index fund” based on those holdings is a long reach.
But if you think that’s marginal, take a look at what’s happening in the States. Across the border, the frenzy to take advantage of this new gold rush has spawned a crop of ETFs that are based on nothing more than the imagination of their promoters.
For instance, what are we to make of the recently launched line-up of HealthShares ETFs? They’re offering funds based on, among others, the “Metabolic-Endocrine Disorders Index”, the “Autoimmune-Inflammation Index”, the “GI/Gender Health Index”, and the “Ophthalmology Index”. What exactly are these indexes? They’re the brain-children of XShares Group LLC, which promotes and distributes these funds. The only reason for these “indexes” to exist is to legitimize the HealthShares funds as ETFs. Otherwise, they would simply be closed-end funds, without the cachet and consumer acceptance that the ETF label brings with it.
This is just the tip of a very large and growing iceberg. In an article titled “The Weird World of ETFs” published in February, BusinessWeek cautioned that ETFs “now provide exposure to even the narrowest – and sometimes most outlandish – investment niches”. As examples, the magazine cited new ETFs based on everything from carbon emission credits to nanotechnology.
I see all kinds of problems with this disquieting trend. The first and most obvious one is that there is no real track record on which to base an investment decision. Sponsors of this new breed of ETF claim that they carefully back-test the artificial indexes they create, but who knows what assumptions go into those calculations.
A second concern is that history shows that the narrower the base of any kind of fund, the riskier it is. By creating ETFs based on market segments that are so small that only a few stocks can fit in (many of them being small or micro-cap issues), the industry is building a much higher potential for loss into its products than many people may realize.
Finally, there is the issue of cost. One of the big attractions of ETFs is that they’re supposedly cheap to own once you’ve paid the brokerage commission to acquire them. The iShares CDN Large Cap Index Fund (TSX: XIU), which tracks the 60 Index, has an MER of 0.17 per cent. In contrast, the published fees for the new HealthShares products are 1.09 per cent, much higher than you would pay for an ETF based on a recognized index. HealthShares is currently discounting its fees by 0.34 per cent but there is no way of knowing how long that will last.
This is not to say that ETFs are a bad place for your money. Rather, it’s a caution light. The carpetbaggers are descending on this sector, bringing with them a whole new range of products, some of which have an aura of snake oil around them. You need to be selective when choosing ETFs. Stick to those based on broad, well-established indexes and you should be fine. But steer clear of the emerging mine field on the fringes. There’s lots of trouble lurking there.