Research ETFs before you buy

Exchange Traded Funds (ETFs) have become one of the fastest-growing areas of the financial market.   “Index Shares” is another similar term and many advisors use these terms inter-changeably.  Investors can participate in a broad variety of investment opportunities using ETFs. 

The original ETFs differed from traditional actively managed mutual funds as these are passive products.  For example, an investor could purchase an ETF of a well-known index such as the S&P 500 which holds the largest 500 U.S. public issuers. 

As their popularity has grown, so has the number of ETFs being created.  Some companies are creating a hybrid product with relatively low fees and some active management.  The water is getting a little murkier as new features are being added to these new products, so I caution investors to understand before they buy.

One reason for the growth in ETFs is the relatively low cost and transparency of the fees.  Investors do not want to be burdened with the cost of high fees, especially if these are hidden or embedded.   The management fee for the S&P 500 is 0.14 per cent through iShares by BlackRock (TSX symbol: XUS), and 0.15 per cent through Vanguard (TSX symbol: VFV).  These are just two symbols that track this common Index.  Other ETF examples trade directly on US exchanges and some that are currency hedged.  You should have full understanding of the tax component, risks and features before purchasing.

The annual cost of an actively managed mutual fund is significantly more than an ETF.  Mutual funds have a Management Expense Ratio (MER) that is embedded.  New regulations and rules are coming soon that will require full disclosure of all fees.  Trading costs are in addition to the normally published MER.  A passive ETF would have very little trading.  Like all services, fees are really only an issue in the absence of value. If an actively managed mutual fund is consistently performing better than an ETF, then the MER and trading costs may be fully warranted.

Some advisors may not recommend ETFs for a few different reasons.  It could be that an advisor only has a mutual fund licence and they are not permitted to discuss or provide ETFs as an option.  Mutual funds can be sold on a no-load, front-end (initial service charge) or a back-end (deferred service charge) basis. We recommend that investors ask their advisor what the initial commissions are, the ongoing trailing commissions, and the cost to sell the mutual fund investment.  Understanding the total cost of choosing an investment option should be done prior to purchase.

ETFs are very much an option that can complement a fee-based account.  Both cost structures are low and provide complete transparency.  ETFs are listed, and trade, on exchanges similar to stocks.  For transactional accounts, there is a cost to purchase an ETF, and a cost to sell them.  For fee-based accounts, there are no transaction costs to purchase or sell an ETF, however, the market value of the amount purchased would be factored into calculating your fees.

When a new client transfers in investments traded on an exchange, it is always easy to make changes.  Investors who have purchased proprietary mutual funds or mutual funds purchased on a low load or deferred sales charge may have fewer options.  In most cases, proprietary funds cannot be transferred in-kind and a redemption charge may apply to transfer in cash.  For example, say Jack Jones has $846,000 in a basket of mutual funds in his corporate investment account.  Jack is paying 2.37 per cent (or $20,050) annually in MERs to own his mutual funds.  I mapped out a lower-cost option for Jack that would decrease his cost of investing, to one per cent ($8,460).  The approach to investing involves a fee-based account with a combination of direct holdings and ETFs.  Annually, Jack would save $11,590 and have full transparency and liquidity.

ETFs can be used strategically to obtain exposure to various types of asset classes, sectors, and geographies.   Although the cost is lower, they are not immune to declines when markets get shaky.  An advisor can design a portfolio of positions that are lower risk then the market.  This is tougher to achieve with off-the-shelf  ETFs. 

Although the traditional ETF is a passive approach, we still feel that an advisor can provide advice with respect to the active selection of the ETF, tax differences, hedging options and more.   To illustrate using bond/fixed income ETFs, an investor could choose amongst many different types depending on the current environment (i.e. interest rate outlook, current economic conditions). 

An advisor can provide guidance on whether to underweight or overweight government bonds or corporate bonds and provide guidance on whether you have a short term, long term, or laddered bond strategy.  Based on your risk tolerance, should you stick to investment grade bonds or seek out greater returns with high yield bonds.  An advisor can explain some of the more complex fixed income ETFs including those holding real return bonds, floating bonds, or emerging market bonds.   An advisor can provide recommendations with respect to actively switching between these passive ETFs.

 

Split shares separate income and growth

Some investors require growth from their investments.  Others want income.   At times an investment in common shares may offer both income and growth potential.  A structure referred to as a “split share” attempts to separate these two components.

A split share is a structure that has been created to “split” the investment characteristics of an underlying portfolio of common shares into separate components.   This division may be done to satisfy the different objectives of investors.  Typically, these structures consist of a preferred share and a capital share that trade separately in the market.  Together these two securities are known as a split share.

The description may be confusing to some investors, especially since the preferred shares and capital shares trade independently.  A key component to understand is that you do not have to own both components.  Investors generally own either the “preferred” component or the “capital” component (some investors may own both). Conservative investors requiring income may find the preferred component more appealing.  Growth oriented investors may find the capital component more attractive.

In a typical split share issue, the preferred share receives all the dividends from an underlying portfolio of common shares and is entitled to the capital appreciation on the portfolio up to a certain value.  The capital share receives all the capital appreciation on the portfolio above what the preferred share is entitled to but receives no dividends.  The capital component is generally considered riskier than the preferred component.

The following is an illustration of how a split share is created and how the returns are divided between preferred and capital shares.  As an example, a split share may be created by an investment firm by using existing common shares of publicly traded companies.  Let’s use a fictional company called XYZ Bank.

We will assume that XYZ Bank’s common shares are trading on the TSX at a market price of $50.00 per share and pay an annual dividend of $1.50 (or three per cent dividend yield).  To create a split share based on XYZ Bank, an investment firm purchases XYZ Bank in the market and places them in an investment trust called XYZ Split Corp.

The trust then issues one XYZ Split Corp preferred share at a price of $25.00 for each XYZ Bank common share held in trust.  The preferred share receives the entire $1.50 dividend from the XYZ Bank common share.  This produces a dividend yield that is double that of the common share (six per cent versus three per cent) because half as much money receives the full common share dividend ($25 versus $50).  In exchange for the higher yield, the preferred share is only entitled to the first $25 of the value of XYZ Bank’s common shares that lie within XYZ Split Corp.

XYZ Split Corp also issues one capital share for each common share held in the trust.  The capital share is priced at $25 and is entitled to all the capital appreciation in the underlying shares of XYZ Bank above $25 per share for the term of the XYZ Split Corp.  As this illustration demonstrates, the two split share components are:  One XYZ Split preferred share plus one XYZ Split capital share equals one XYZ Bank common share.

There are many types of split shares as well as underlying investments.  One fact that most split shares have in common is the leverage effect.  Generally, at inception a split capital share offers approximately two times the leverage.  Unfortunately, this leverage also impacts investors in a down market.  For example, a 25 per cent decrease in the underlying investment XYZ Bank may translate into a 50 per cent decline in the XYZ Split capital share value.  A split share structure, especially the capital share component, should only be considered if an investor desires leverage.  Do you use leverage in other components of your account?  What is the position size relative to other investments in your account?  What is your time horizon versus the term to maturity of the investment?  This last question is important, as investors often require patience for leverage strategies to work in their favour.

Split shares are originally offered through a new issue.   After the new issue, both the preferred and capital shares trade in the market generally at a discount to their net asset value (i.e. the underlying common share).   Investors interested in split shares would generally prefer shares that trade at a discount as opposed to those that are trading at a premium.

Although the underlying investment(s) may have many shares exchanging hands each day, a split share may have very little trading activity.  As a result the market for split shares is generally very illiquid making the purchase or sale of split shares difficult at times particularly with larger orders.

In recent years, many financial institutions have not issued “hard retractable” preferred shares, meaning that they have a set maturity date.  Instead, perpetual preferred shares have been issued in their place, with no maturity date.  Perpetual preferred shares are interest rate sensitive.  As rates rise the underlying value of a perpetual may decline (and vice versa).  A positive component to the preferred side of a split share offering is that the structure generally has a set term resembling maturity characteristics of a “hard retractable”.  Terms for most split shares are generally five to seven years.

As with any structured product, fees are associated to set up the structure, compensate the investment firms and other ongoing costs.   Investors looking at the capital component of a split share should be asking, “why not purchase the underlying investment directly?”

As with any investment, the main decision to purchase a split share should be based on the outlook for the underlying company over the term of the structure.  Some split shares may be based on a basket of securities in one sector, index, etc.  In these cases an investor should have a positive fundamental outlook for the underlying security and its sector.

Closed-end funds grow popular

Funds allow investors the ability to obtain diversification by pooling their dollars together.  Investors must be careful to pick the fund managers they feel will do the best job.  With the number of funds steadily increasing this is not an easy task.  In addition, there are a variety of different funds available with different investment objectives, strategies, and portfolios.

The purpose of this column is to discuss investment strategies with respect to “closed-end” funds.  It is important for investors interested in funds to obtain an understanding of the difference between “closed-end” and “open-end” funds.

Open-End Funds

Most of the funds on the market place are open-end funds (OEF), which generally have no restrictions on the amount of shares the fund will issue (unless a fund manager closes the fund to new purchases). The fund will continuously issue shares and also buy back shares when investors wish to sell.  OEFs are issued by an investment company, and are subject to certain disclosure rules.  After purchasing an OEF you will generally receive a full prospectus in the mail outlining the funds investment objectives, strategies and fees.

Closed-End Funds

Growing rapidly in the market place are closed-end funds (CEF).  The initial public offering is generally done through a prospectus, similar to OEF.  This document is intended to provide investors complete information on the structure as well as all applicable fees.  We encourage investors to read this document.  As an example, the prospectus may specifically state whether the CEF may use leverage within the structure.

Important Difference

CEFs do not continuously offer their units for sale as an OEF would.  CEFs sell a fixed number of units at one time, through the initial offering.  After the initial offering the shares typically trade on a secondary market, such as the Toronto Stock Exchange (TSX).  CEFs trade on an exchange much the same way as individual equities.

Net Asset Value

OEFs are bought and sold at net asset value (NAV) directly from the fund company.  NAV is the total value of the fund’s portfolio less liabilities generally calculated on a daily basis.  As noted above CEFs trade on an exchange after the initial public offering.  As a result, they are generally bought or sold at a discount or premium to its NAV.  Although a fund company does not redeem CEF units, most disclose their NAV daily.

Discount

When CEFs disclose their NAV, these may be compared to the most recent trades in the secondary market.  Investors who look at the various CEFs offered in the secondary market may find that most trade at a discount to their NAV.  It is not uncommon to see some CEFs trading at a discount of 5 to 10 per cent or more during market volatility.  This may be a little frustrating for investors who purchased a CEF at the initial issue and are now looking at selling their units.  On the flip side, opportunities may become available for investors looking on the exchange for deep discounts (large differences between NAV and market value).

Liquidity

Some CEF investments are not redeemable for a period of time.  CEFs are generally structured so they are not required to buy units back from investors until maturity of the structure.  CEFs therefore may not be suitable for individuals who desire liquid investments.  CEFs are generally not redeemable by the company (see redemption privileges below).   Investors should use caution prior to selling CEFs on the secondary market.  Many CEFs have very little trading volume and care should be taken before entering “market” orders.  Prior to making a CEF purchase on the secondary market, investors may be able to look at the historical volumes and total issue size of the CEF.  This may provide some indication as to the future liquidity.

Volatility

As noted above, the trading volumes on CEFs may be very low.  In some cases the spread between the bid and the ask may be significant.   Once a secondary market exists for a CEF, investors are able to sell their units if there are buyers.  It is not uncommon to see a significant change in the market price of a CEF when an investor sells a large position.

Redemption Privilege

One feature that investors should consider prior to purchasing a CEF is if the offering document provides for a redemption privilege.  Some of the original CEFs do not have a redemption privilege.  We would expect some of these CEFs to possibly trade at a greater discount than those that have redemption privileges.  Most of the newer CEFs provide some form of redemption privilege.  The more frequent the redemption privilege the more flexible for the investors.  Some offering documents provide redemption privileges equal to 100 per cent of NAV.  Other less attractive CEFs may have redemption privileges equal to 90 or 95 per cent of NAV.  Individuals who have closed end funds should be aware of these redemption dates, if applicable.  The offering document generally provides full details with respect to redemption privileges.

Ongoing Management

Companies may establish a CEF (rather than an OEF) for the ease of administration.  After the initial offering, management knows the amount of funds available for investment purposes.  Administratively they do not have to be concerned about additional purchases or early redemptions.  Redemption rights by investors generally must be provided to the issuer well in advance and settlement may be longer than the normal three days.

Income Payments

CEFs may be structured in a manner that provides a regular stream of income to investors.  Some structures are more beneficial in a non-registered account if the income payments are tax efficient.

Typical CEFs

The following are the main categories of CEFs:  global equity, income and growth funds, fixed income funds, preferred share funds, income trust funds, commodity funds, infrastructure funds, and alternative asset management funds.

We encourage all investors considering a closed end fund to understand the limitations and risks.

Principal protected notes require this checklist

Principal Protected Notes (PPNs) have significantly grown in popularity over the last five years as issuers provide a partial or full guarantee of the original capital if held to maturity.

There are many different strategies and structures available to retail investors, and the products are heavily marketed and are becoming increasingly complex.

There are mixed opinions in the financial community on whether PPNs make for good investments as not all are the same and should be evaluated on their individual merits.

The potential performance of the underlying investments, time horizon, and liquidity may be significantly different from structure to structure.  Your existing investments, investment objectives and risk tolerance are key components to consider prior to determining suitability.

Here’s a general overview of how PPNs work:

They are structured products that generally have a pre-packaged investment strategy, which, at times involve a combination of fixed income and derivatives (options, forward agreements, swaps, etc.) and may use leverage.

For example, Mr. Murray invests $10,000 dollars into a principal protected note (PPN).  The issuer of the PPN invests a portion of this money in a risk free bond, which will generate sufficient interest to grow to $10,000 after a period of time, generally 5 or more years.   The bond currently costs $8,000 but will grow to $10,000 at maturity. With the remaining $2,000 the issuer of the PPN may purchase other investments and derivatives consistent with the strategy.   It is this $2,000 component that provides the investor the ability to obtain a return on their investment.   The $8,000 used to purchase the fixed income ensures you receive your initial capital back.  Other PPNs may use more complex protection strategies.

Here’s a 10-point checklist to consider:

  1. Fee Transparency:  Many PPNs advertise no management expense ratio (MER), but this can be misleading.   There are definitely fees associated with these products and some can be expensive.  With many structured products there are selling commissions and fees incurred by the company offering the PPN to set up the structure and the protection strategy.  There are also ongoing costs to manage the structure.
  2. Call Features:  Some PPns are “callable,” which is an advantage for the issuing company.  If a PPN is doing well, the company may have the right to call the note.  Some PPNs are not callable and investors researching PPNs should find the non-callable types more appealing.
  3. Liquidity:  PPNs generally have a one or two year holding period.   If an investor sells the investment during the holding period a redemption fee may apply.  Prior to purchasing a PPN you should also determine how many years the investment must be held to obtain the principal protection.  The time period generally ranges from three to ten years.  Interest rates, the cost of protection, and the type of protection are all factors that impact the time period of the structure.  Investors should obtain an understanding of both the holding period (to sell without DSC) and the principal protection period.  These periods should be consistent with your investment time horizon.
  4. FundServe:  Many PPNs are beginning to trade on FundServe which is the same order entry system used by mutual funds.  This provides greater transparency and liquidity.
  5. Income:  Care should be taken to understand the type of income distribution and whether the payments are guaranteed or not.  Many of these structures enable the income stream to be treated in a more tax-efficient manner, which is important if the investment is held in a non-registered account.  Some PPN structures have a guaranteed distribution while others do not.  Many investors may find the guaranteed distribution attractive but there may be disadvantages to such a structure.
  6. Viability:  A key item for individuals considering PPNs is the viability of the firm.  Who is guaranteeing the PPN?  How much exposure does the company have to this type of structure?  Will they be able to follow through with the guarantee if there is a significant market correction?
  7. Leverage:  Investors should ask if the structure they are considering uses leverage.  Understanding leverage and its potential use may be required to obtain an understanding of the associated risks and rewards.
  8. Volatility:  The underlying investments and the use of leverage will impact the level of volatility of a PPN structure.  Volatility may also be caused by limited liquidity although many issuers are now providing an active secondary market
  9. Limited Upside:  Several PPN structures have limits on the upside potential of the investment.  Investors should be aware if the PPN has any capping features.  Prior to investing, people should ask what component of any positive performance would they participate in.
  10. The Structure:  A good rule of thumb is to avoid investments that you do not understand and that seem overly complicated.  If you do not understand the investment structure prior to purchase then it is unlikely that you will be able to appropriately monitor the position.

Informed decisions are necessary in the world of structured products

Investment bankers and financial institutions have become very creative in the structured products they design.

Essentially, these products are designed to meet investor demand.  Special features are often added that may relate to risk and return, such as principal protection, while some are arranged to distribute tax efficient income.

Nearly all of them have a targeted investment objective.

Structured products are generally a pre-packaged investment strategy that may include a combination of investments and derivatives.  The structure is generally linked to the performance of an underlying security or basket of securities.  The structure is generally linked to the performance of an underlying security or basket of securities.

Every structure is different and some may hold domestic investments while others are linked to foreign investments.  Some structures may be linked to direct holdings, other funds and indices.  Often, the linked investments may be combined with derivatives making structures more complicated to understand.  Typical types of derivatives include options, forwards, and swaps.

Rather than explain the mechanics of derivatives we will explain the main reason why they exist.  Derivatives exist to enable the transfer of risk from those who do not want to bear the risk to those who do.  In other words, some investors may use derivatives to reduce risk (for a fee), while others may use them to increase risk and the potential for return.

So, how are they used?  Structured products are generally an alternative to a direct investment.  When people get excited about an asset class or a specific type of investment then financial companies are likely to respond by creating a structured product to meet the investment demand.  Structured products may be added to a portfolio for a number of reasons, to provide diversification, exposure to different asset classes and geographies.  Investors may find them appealing because they provide lower correlation to other investments within a portfolio.  Simply put, they react and perform differently to various market conditions.  The products that offer some form of protection may provide a method of managing downside risk.  As noted above, many structured products provide tax-efficient income.

During the technology boom of the late 1990’s many people were following financial news and seeing incredible gains in this sector.  Sophisticated and unsophisticated investors wanted to buy technology.  Financial firms responded by setting up technology mutual funds and other structures linked to technology.

Many investors want to preserve their capital, but even more so after the tech bubble and 9/11.  Around this same time, fixed income investments, such as bonds, were barely staying ahead of inflation and taxes.   Financial firms responded quickly by offering financial products with equity exposure and principal protection.

Trust Example

Prior to the federal government’s “tax fairness plan” announcement on October 31st, many investors were excited about income trusts.  Several structured products were created to hold a basket of income trusts and provided investors an easy way to obtain diversification within this type of equity investment.

Retirement Example

Some companies have developed income and segregated funds that are more complicated than previous series.  Some of these funds are focused on creating retirement income and have different features that individuals should fully understand prior to making an investment.

Infrastructure Example

Some structured products are very interesting to read about.  Take the recent “infrastructure funds” as an example.  The average investor cannot simply go out and buy a road or bridge.  Some of these structures allow individual investors access to these types of asset classes that have primarily been reserved for private equity and pension plans.

Other Examples

New structures are continually being created.  Many of these structures may provide investors access to international investments.  Other funds may have specific objectives including uranium funds, water funds, socially responsible investing, etc.  A key point to remember is that with some types of investments or asset classes, structured products may be the easiest way to gain access.

Who uses Structured Products?

Although heavily marketed to the retail investor, they extend to all individuals regardless of net worth.  Investors with small accounts may be attracted to the low minimum amounts required for most structured products.  Hedge funds are generally targeted to the high net worth individual.

Understand the Structure

Regardless of the amount people would like to invest, or their level of sophistication, it is important to understand the structure before making a purchase.  This understanding should include how the investment objectives of the structure fit into your overall plan.  Take a detailed look at the risks and rewards, fees, and liquidity.  Comparing structures issued by different companies may soon reveal the different options available.  A complete understanding of the investment is also necessary to monitor the ongoing performance.

We caution all investors to only consider purchasing structures they understand and are suitable for their plan.  We recommend avoiding investments you do not understand.  From time to time you may miss out on a good opportunity, however, successful investing also involves avoiding poor investment decisions.

Unmasking F-Class Funds

F-Class mutual funds are gaining in popularity as investors begin to understand the benefits.  Designated in 1999, they are available for fee-based clients only, and the majority of fund companies offer them.

To understand F-Class we need to understand the types of fees associated with mutual funds.  All mutual funds have annual fees and service fees.  Combined they are often referred to as the Management Expense Ratio (MER).  The annual fees include the fees to the portfolio manager and the ongoing expenses of the fund.  The service fee is the amount that is paid to the investment firm that is holding the investment, a portion of which is generally paid to the advisor.

Let’s use a fictional mutual fund called XYZ Fund.  The XYZ Fund has an annual MER of three per cent that is comprised of an investment management fee of one and a half per cent, administrative and operating expenses of a half of a per cent and a service fee (often referred to as trailer fees) of one per cent.  With regular mutual funds, the three per cent is deducted from the adjusted cost base of the fund and the mutual fund company sends the servicing firm one per cent.  With F-Class mutual funds, only two per cent would be deducted within the fund and the fund company does not compensate the servicing firm.

How is F-Class different?

The structure of the MER is different with F-Class mutual funds than with regular mutual funds.  Fee-based clients are already paying a fee to their advisor based on the assets in their account (including mutual funds) so the fund companies have eliminated the advisor commission component, thereby eliminating a duplication of fees for the client.  The F-Class version simply excludes the one per cent service fee, making the XYZ Fund available with an MER of two per cent (rather than three per cent).

Why is this important?

Five reasons why we like F-Class:  1) Fee Transparency, 2) Fee Flexibility, 3) Commission, 4) Tax Efficiency, and 5) Benefits for RRSPs and RRIFs

1.  Fee Transparency:  With regular mutual funds the fees are embedded in the unit price and are not transparent unless one is inclined to read through the prospectus and financial reports.  The unit value of the fund declines when the fees are charged.  With F-Class funds the investment management fees and administrative and operating expenses totaling two per cent are still embedded in the unit price.  The service fee is charged by the investment firm directly allowing the individual investor to clearly see the fees paid.

2.  Fee Flexibility:  With regular class mutual funds the ongoing fees paid to the investment firm are set by the mutual fund company, there is no flexibility.  With fee-based accounts, the client and advisor agree on an appropriate fee to be charged.

3.  Commission:  The majority of mutual funds have been purchased on either a front-end (initial service charge) or back-end (deferred sales charge) basis.  Front-end means that the investor paid a commission to the investment firm when the fund was first purchased.  With back-end purchases, the fund company paid the investment firm the commission at the beginning and the investor paid no commission.  If the investor sells the position, the fund company will charge the investor a redemption fee that declines with time; however, this is generally zero if the fund was held for seven years or more.  F-Class is considered no-load as it has no commissions to purchase or sell, resulting in greater flexibility.

4.  Tax Efficiency:  For non-registered accounts the quarterly fees charged for F-Class are fully deductible on schedule four of your tax return when paid, even though you may still hold the underlying security.  With regular mutual funds the fees are deducted automatically and have the effect of lowering the current market value of the fund.  When you ultimately sell the regular mutual fund then the difference between the adjusted cost base and the current market value is a capital gain (loss).  As only one half of capital gains are taxable, investors are essentially only getting a deduction for half of the embedded fees.

5.  Benefits for RRSPs and RRIFs:  Although investors are not able to deduct the fees associated with F-Class mutual funds held within a registered accounts they are able to pay the fees by contributing outside money.  Contributions into the account to pay fees are not deductible; however, this does allow the investments within the account to compound even more.

F-class is one of the benefits available to investors that have a fee-based account.  You may want to talk to your advisor to see if a fee-based account is right for you.