Tuesday, January 26, 2010

Lower costs, better portfolios (sometimes)

Exchange-traded funds (ETFs) are less expensive than mutual funds by a wide margin. Embedded mutual fund distribution costs, paid to financial advisors for selling them, are most of the difference. Claymore is the only ETF sponsor in Canada paying advisors from a separate ETF series that is 0.50-0.75% more expensive. While brokerage costs must also be considered when acquiring ETFs, improving transparency is helping investors make more informed choices.
Canadian Median Mutual Fund MER vs. ETF MER

Canadian Equities Mutual Fund Median 2.45%
0.16% BMO Dow Jones Canadian Titans 60 (ZCN)
0.17% iShares Large Cap 60 (XIU)
0.25% iShares CDN Composite (XIC)
0.65% Claymore Canadian Fundamental (CRQ)
1.15% HBP S&P TSX 60 Bull Plus (HXU)

Canadian Bonds Mutual Fund Median 1.96%
0.15% Claymore 1-5 yr Laddered Gov’t Bond (CLF)
0.325% BMO Canadian Gov’t Bond Index (ZGB)
0.35% iShares CDN Government Bond (XGB)

Int’l Equities Mutual Fund Median 2.69%
0.455% BMO International Equity Hedged (ZDM)
0.49% iShares MSCI EAFE Hedged (XIN)
0.65% Claymore International Fundamental (CIE)

Emerging Markets Mutual Fund Median 2.93%
0.535% BMO Emerging Mkts Equity Index (ZEM)
0.65% Claymore BRIC (CBQ)
0.82% iShares CDN MSCI Emerging Markets (XEM)
1.15% HBP MSCI Emerging Mkt Bull Plus (HJU)

Commodities Mutual Fund Median 2.60%
0.40% iShares COMEX Gold Trust (IGT)
0.75% HBP COMEX Gold (HUG)
1.15% HBP COMEX Gold Bullion Bull Plus (HBU)

Among the Canadian Equity ETFs shown, newcomer Bank of Montreal (BMO) undercut comparable and more established iShares LargeCap 60 by 0.01%. and similarly positioned themselves in bonds, U.S. and international equities, and emerging markets.

Sometimes costs reflect structural differences. Higher-priced iShares CDN Composite at 0.25%, includes a broader holdings base (S&P/TSX Composite’s 204 issues). Claymore’s Canadian Fundamental (0.65%) would appear to be out of step with the group, but includes an “embedded strategy” namely a value bias in the construction of its index. Claymore is actually offering an actively-managed ETF in passive clothing.

Distinguishing passive ETFs from those with embedded strategies is a good starting point for portfolio building. One is not better than the other, but those with embedded strategies are usually more expensive. Director of Quantitative Strategies at PŮR Investing, Ioulia Tretiakova, maintains: “You never know what the future return of an ETF is going to be, but you do know its cost.”
Embedded strategies try to offer something in return for their higher cost. In Claymore’s RAFI Fundamental series, it is a tilt towards value stocks. If this is what you want, ETFs can give you effective access. The Horizon BetaPro (HBP) Plus ETF series offers two times the DAILY return for the “Bull” version and two times the inverse DAILY return for the “Bear” series. This powerful leveraging capability comes at a cost of 1.15% but considering the “double exposure” makes the effective MER 0.575%. This appears expensive in the Canadian equity category with offerings at 0.16-0.17%, but in emerging markets, where iShares cost 0.82%, HBP appears more competitive.

While lower cost is a key ETF benefit, management expense ratios tell only part of the story. Studies of U.S. mutual funds showed that annual trading costs were 1.44% per year (Edelin/Evans/Kadlec, 2007). Canadian mutual fund trading costs are not available, but exchange traded fund trading costs are certainly lower than mutual fund costs for two reasons:

1. the index nature of ETFs means little trading is required for rebalancing;

2. market-makers for Canadian ETFs assume the cost and risk of rebalancing including index composition changes. Elsewhere in the world, the cost of an index change is borne by the ETF unit-holder. If the annual trading cost for an active Canadian mutual fund is 1.0%, and the comparable ETF cost is 0.0%, it is little wonder that active funds have so much difficulty beating index and ETF performance.

Canadian investors, like counterparts around the world, focus most investments in their domestic currency. This makes sense because liabilities and expenses are Loonie-centric. Some international ETFs are offered “hedged”. This comes at a cost. Is it better to buy the hedged or unhedged ETF? The answer is related to your expected holding period. Here’s a guideline:

1. The longer the holding period (over 4 years) you may be better off unhedged. The cost of hedging is fixed and compounds over time.
2. If you have a view about the direction of currencies, hedging for protection or unhedging for exposure can become part of your strategy.

ETFs offer an increasing palette of risk shapes and colours giving investors broad scope to construct portfolios that reflect their views and address their needs. Cost is a rare certainty in a financial world filled with unknowns. Consequently, it is one of the most important considerations in building any portfolio.

PŮR Investing Inc. is a registered portfolio manager specializing in risk management using exchange traded funds. PŮR’s free ETF screener is available at: http://purinvesting.com/demo/Screen.htm .

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