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.