Evolving Revolution in ETFs

Free at last!

Once an opaque pastime for the rich, investing has been hidden behind obscure terminology, highly paid advisors, and arcane documents, like the mutual fund prospectus. The digital age is changing all that. ETFs are weapons in the movement to emancipate individual investors.

The explosive growth of exchange traded funds (ETFs) has been both exciting and bewildering. Retail investors, excited by broad access to timely, low-cost, tax efficient and diversified exposure to capital markets are also bewildered by the scope, breadth and number of products – 224 in Canada, 3,500 globally and 500 ETFs in registration with the Securities and Exchange Commission (March 2011). Sorting, selecting and constructing portfolios are new and growing challenges for investors. Nevertheless, ETFs have provided only the second significant advance for individual investors since the popularization of the mutual fund in the 1990s (the first being the introduction of the index mutual fund).

Mutual fund companies must also be excited and bewildered. Traditionally marketers and distributors of investment products, banks and fund companies are reassessing their business models. Scale has always been important but it is critical today with compliance expanding and margins contracting. Although the mutual fund continues to dominate retail investing, better-informed investors recognize that costs matter and that in an interconnected world, transparency and access to pricing more than once a day should be fundamental.

ETFs, because they are listed directly on stock exchanges without having to be “approved” by a sales entity, provide a distribution “end run” around the established axis of bank and fund company control, and give buying choice directly to individual investors. Furthermore, the hype around “star” managers and persistent marketing of past performance has worn thin. It is not exactly breaking news that past performance is no indication of future performance.

Sophisticated investors have been using ETFs for over a decade, but the broad public is catching on, albeit slowly. Early adopters of ETFs have been CEOs, senior executives, sophisticated high net worth investors, and investment professional themselves. However, innovation is still driven by professional money managers motivated by increasingly knowledgeable institutional clients. Individual investors can exploit these trends and ETFs enable them.

Democratizing diversification

The principle of diversification is not new. Natural selection and evolution itself may have been the first practical implementation of diversification as a means for the species to survive. Harry Markowitz put form around the substance of portfolio diversification in (Modern) Portfolio Theory (1952). Retail and institutional investors already knew not to put all their eggs in one basket but it wasn’t until the 1970’s that index or passive investing became pervasive among large institutional portfolios about ten years after the introduction of the Capital Asset Pricing Model (CAPM) suggested a distinction between systematic non-diversifiable or market risk, β, and unsystematic diversifiable idiosyncratic or asset specific risk, α. The idea of combining a low cost passive core portfolio using index strategies to capture broad market (β) returns and using satellite portfolios to generate excess (α) returns has been accepted institutional practice for 30 years. Importantly, passive investing, once the domain of the largest institutions and pension funds is becoming “mainstream”.

Investment professionals were the first to embrace exchange traded funds (ETFs) when the Toronto Stock Exchange introduced Toronto Index Participation Shares (TIPS) in 1990. Replicating the TSE 35 Index (predecessor of the S&P/TSX 60 Index), institutional managers found they could rapidly deploy cash in a diversified manner using TIPS. Individual investors gained their first access to instant transparent diversification through an exchange as a result.

Diversified Canadian Equity – ranked by diversification and cost	Symbol	MER
iShares S&P/TSX Capped Composite	XIC	0.25%
BMO Dow Jones Canada Titans	ZCN	0.16%
Horizon BetaPro S&P/TSX 60	HXT	0.07%
iShares S&P/TSX 60 Index	XIU	0.17%

International diversification

Thirty years ago, international equities were considered “alternative” asset classes. Access to markets and diversification within them were barriers. Not so today. ETFs offer access to a growing array of international markets. The emerging markets are an area of particular interest to professional investors. As a consequence, more granular choices are available to all.

International or Global Equity – ranked by diversification and cost	Symbol	MER
iShares MSCI World Index	XWD	0.45%
iShares MSCI EAFE	XIN	0.50%
BMO International Equity Hedged to CAD	ZDM	0.49%
Claymore International Fundamental Index (hedged and non-hedged)	CIE	0.68%
Emerging Markets Equity – ranked by diversification and cost
iShares MSCI Emerging Markets Equity Index	XEM	0.82%
BMO International Equity Hedged to CAD	ZEM	0.54%
Claymore Broad Emerging Markets	CWO	0.65%
Specific Emerging Markets Equity - ranked by diversification and cost
Claymore China	CHI	0.70%
Claymore BRIC	CBQ	0.64%
BMO China Equity Hedged to CAD	ZCH	0.71%
iShares MSCI Brazil Index	XBZ	0.75%
iShares China Index Index	XCH	0.85%
iShares CNX Nifty India Index	XID	0.98%
iShares MSCI Latin America 40 Index	XLA	0.65%
BMO India Equity Hedged to CAD	ZID	0.71%

The three factor model and the style box

Institutional managers have found CAPM a useful but imprecise tool. The Fama-French three factor model added style (value/growth) and size (small cap/large cap) to market risk finding that, for U.S. equity markets over time, value outperformed growth and small capitalization stocks outperformed large capitalization stocks. These simple ideas provided the basis for the Morningstar Style Box™ of money management categorization (1992) and contributed to the popularization of mutual funds over the past two decades. ETFs are available that address all three factor approaches.

Value Canadian Equity – ranked by diversification and cost	Symbol	MER
Claymore Canadian Fundamental Index	CRQ	0.69%
iShares Dow Jones Canada Select Value	XIC	0.25%
Horizon AlphaPro North American Value	HAV	0.70%
Growth Canadian Equity – ranked by diversification and cost	Symbol	MER
iShares Dow Jones Canada Select Growth	XCG	0.50%

Small Cap Canadian Equity – ranked by diversification and cost	Symbol	MER
iShares S&P/TSX SmallCap	XCS	0.55%
iShares S&P/TSX Completion Index	XMD	0.55%

Sectors and countries

If three factors are good, more must be better. Breaking market risk into more component factors can be a comprehensive way to control components of risk. The simplest example is the aready-pervasive practice of isolating sectors and industries domestically and globally. Canadian sector ETFs are available for energy, financials, information technology, materials and REITs from iShares with choice in most offered collectively by Bank of Montreal (BMO), Claymore and Horizon BetaPro. Global sectors include agriculture, real estate, and water offered by Claymore with choice in metals and infrastructure offered by BMO.

For U.S. markets, BMO offers banks, healthcare and NASDAQ ETFs. Investors with access to U.S. markets get an even broader palette of ETFs in every sector imaginable. On the fixed income side, there is a growing list of sector, quality, and term choices with international and inflation protection included. Commodities and income choices are also pervasive.

What’s next and why

Investors who experienced the financial crisis and market meltdown in 2009 know that there were few places to hide from the twin forces of volatility and a liquidity vacuum. At one end of the spectrum, broad diversification did not save portfolios nor did stock picking at the other.

Expect more creative approaches towards diversification. Income generation is a popular one at the moment.

Income – ranked by diversification and cost	Symbol	MER
iShares Diversified Monthly Income	XMI	0.55%
BMO Monthly Income	ZMI	0.55%
Claymore Canadian Financial Monthly Income	FIE	0.65%
Claymore S&P/TSX CDN Preferred Share	CPD	0.45%
iShares S&P/TSX Preferred Stock Index Hedged to CAD	XPF	0.45%

Alternative approaches will also start to appear in Canada that replicate hedge fund strategies. BMO’s Covered Call Canadian Banks (ZWB 0.65%) and Horizons AlphaPro S&P/TSX 60 130/30 Index (HAH 0.95%) are examples. In the U.S. merger arbitrage and managed futures ETFs are several active global macro choices are also available.

Most intriguing are ETFs that reflect what professionals are trying to accomplish using risk and leverage. There is a clear relationship between volatility, as measured by the standard deviation of a market like the S&P 500, and market direction. Stable or falling volatility appears to accompany rising markets while increasing volatility accompanies falling markets. The reason is that volatility is persistent over the short term (autocorrelation = 0.75) and return is not (0.05). This has led to the tracking of VIX, a measure of volatility based upon option premiums. These strategies are not for the retail investor ...yet.

Volatility Indices	Symbol	MER
HBP S&P 500 VIX Short-Term Futures™	HUV	0.85%
HBP S&P 500 VIX Short-Term Futures™ Bull Plus	HVU	1.15%

As other professionals study the relationship between groups of securities we expect that their experience will be the same as PŮR’s. There are relationships that have always existed but have not yet been exploited. The application of various statistical techniques will lead to new ways to bend and shape risk and ETFs will be the testing ground for these new ideas. The retail investor will benefit in the end because the vehicles will be transparent and available on public exchanges.

The educated consumer is the ETF’s best customer today and the product stream of the future will affirm this. In a single digit return environment with pension plans shifting liability to individual and social welfare programmes under challenge, investors must take more responsibility for their financial futures. Advisors need to improve their skills and mutual funds will have to find a new value proposition.