Final Score: ETFs 1: Leafs 0

Too much success can be a bad thing.

The Toronto Maple Leafs don’t need to put a competitive team on the ice. Season ticket holders already compete for 90% of all seats, broadcasting revenues are maxed and virtually every game is sold out.

The Leafs represent a clear distortion in the marketplace. There is little incentive to win because fans act irrationally.

The popularity and institutional success of passive investing in general (replicating the performance of an index), and exchange-traded funds (ETFs) in particular, have led some to believe that distortions result because investors act rationally.

“ETFs are radically changing the markets to the point where they, and not the trading of underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future,” write Harold Bradley and Robert R. Litan in a 2010 paper for the Kauffman Foundation.

The authors are concerned about ETFs and other influences they feel discourage new issues and impede the efficiency of capital markets. They believe the popularity of ETFs has led to trading volumes that overwhelm the liquidity of underlying securities, thus distorting valuations.

Fundamental to the authors’ argument is the dominance of passive over active investing. Dominance that overrides the arbitrage of individual stocks gives their argument credibility.

The case for indexing

In an analysis for Vanguard research, “The Case for Indexing in Canada,” authors Philips, Walker and Kinniry restate in a Canadian context what others have observed elsewhere: that costs are difficult for active managers to overcome. The asset-weighted expense ratio for actively managed Canadian equities funds was 2.29% (May 31, 2010) versus 0.87% for Index funds, a difference of 1.42%. Cap-weighted Canadian equity ETFs have expense ratios between 0.07% (HXT) and 0.25% (XIC) for a difference of 2.04-2.22%.

Active management can occasionally overcome this disadvantage in the short term but has difficulty over the long term. The sidebar (see “Relative performance of Canadian actively managed funds”) from the Vanguard study shows the consistency with which actively managed funds underperform their benchmarks, and somewhat alarming median annual return shortfalls.

The (weak) case for active management

1. The most popular argument for active management is a desire to beat the market. Advisors say the only way to guarantee you won’t beat the market is to index. It is possible to pick an outperforming stock but difficult to do so consistently, and really difficult to pick a portfolio of winners. If investors selected only a few stocks, watched them closely and kept trading costs low, they would have more success because high turnover costs kill returns. Picking active, outperforming mutual funds is a low-probability activity. Nevertheless, investors try to pick winners because they think it is possible.

2. Fun. Indexing isn’t. There is no question that passive investing is the intelligent choice. Lower costs boost returns, but talking about stock picks is more fun. People do it even if they aren’t quite sure what they are doing. There is higher entertainment value to active management.

3. Special knowledge. In most professional endeavours, specialized education is a barrier to entry. With no apology to my portfolio manager colleagues, picking stocks is not neurosurgery. Anybody can do it. Results may not be consistent and the methodology may at times resemble picking horses at the track, but anybody can open an online account and get some kind of return. In bull markets they are likely to be successful. Less so in bear markets. Investing is egalitarian.

Current SEC investigations aside, material non-public information is difficult to obtain and illegal to use, so potential access to inside information is no longer an advantage for Street veterans. Twenty-four-hour business news media has given the public access to the same information as the professionals, on as timely a basis. The poor record of investment professionals—reflected in the mutual fund numbers—suggests that educated and experienced pros find outperforming difficult. Despite what should be a discouraging record, mutual funds have 20 times the assets of ETFs in Canada. This is hardly the overwhelming dominance to which the Kauffman paper alludes.

4. The superstar. Western society has a fascination with the superior individual. The U.S. Naval Academy graduate with a Harvard MBA and PhD in Quantitative Finance from Wharton must be a superior human being and should be able to build portfolios that outperform on any basis. If such a person exists, she is working at a hedge fund and couldn’t care less about your money or mine!

5. Not-so-smart people do it. Hubris is a huge motivator. The annoying neighbour, the chatty dentist, and Uncle Fred the blowhard all talk about how they picked the stock of the decade. Maybe they did, but you will also notice that only lottery winners are interviewed, not the hundreds of thousands of losers. Ask Uncle Fred about his portfolio’s total return over five years for a reality check.

There’s not much of a case for active management. In Canada, however, a $12 billion-a-year gorilla of an investment industry stands between the retail investor and the door containing common sense. Greed will always create the motivation to arbitrage the valuation of underlying securities in an index. This may not happen as instantly as the Kauffman authors would like, but if there is an opportunity to squeeze a penny from the market, it will be done.

In the face of all this illogical behaviour, investors can still efficiently participate in the long-term growth of an economy, sector or industry using ETFs at low cost and with full transparency. Unlike the long-suffering, irrational Maple Leafs fan, an ETF investor may appear to perform in mediocre fashion throughout the season but in the long run will beat 90% of the competition.

Stanley Cup? Who cares, because someone other than the owners will be laughing their way to the bank: you.

ETFs and the Egg Management Fee

I met a broker from Rochester at breakfast on the second day of an ETF conference in Albany New York. I was a speaker on the first day and a moderator on the second and was curious about the audience’s knowledge level and how the message was getting through. “Do you use ETFs in your practice?” I asked. He admitted that he had purchased some SPDRs (Standard & Poor’s Depositary Receipts, SPY) for his largest client. “I went to a meeting with her auditor and all he said was ‘I see that your broker bought an ETF for your portfolio, he must be doing a good job for you!’. I am here to find out what I bought and why they are so good!”
There is a halo effect over ETF use that transcends their undeniably beneficial use in portfolios. But we, in the industry, should not rest on our laurels. There is a directness that has accompanied the electronic revolution and social media that can bite, so making ETFs just another offering on the investment product buffet could be dangerous.
Take for example the Ally Bank ads that portray conventional bankers as insensitive to clients. Clients are portrayed as kids in the commercials. Fine print, exclusionary offers, undisclosed information, run-arounds, and the now ubiquitous “egg management fee” are offered as proof of big bank practices that “even kids know” aren’t fair. It could be argued that banks deserve this treatment. But mutual funds could be tarred with the same brush and with them, the entire investment profession. In Canada, the major banks, through branches and wholly-owned brokerage firms, account for two thirds of all mutual fund sales. And yes, mutual fund fees seem inexplicably large in relationship to what they deliver particularly when compared with ETF fees. But mutual funds still provide retail investors with professional management and diversification while sharing expenses. That their structure is out-dated is not entirely their fault: lack of transparency in an era of full disclosure, once-a-day pricing in a 24-hour-a-day global market, bundled fees when everything is being unbundled (except cell phone packages, strangely enough). The traditional mutual fund format struggles to keep up.
The same fate may await practitioners if they treat ETFs like just a bunch of mutual funds and stuff them into client portfolios like “last year’s hot performer”. ETFs should be used to provide the kinds of solutions, continuous client value and vehicles for managing risk for which they are so well suited with costs justified and construction communicated simply and effectively.


Managing an expanding ETF universe
There are lots of ETFs and more each week. While there are many ways to sort them, keeping things simple has great appeal because it is easier to explain to clients. Ioulia Tretiakova, Director of Quantitative Strategies at PŮR Investing, classifies the ETF universe into two basic categories: those that are passive and those with embedded strategies.
“Passive ETFs follow a simple index or an unleveraged commodity. They are characterized by low fees. Those with embedded strategies are everything else. ETFs with embedded strategies often have higher fees. Leveraged and inverse ETFs and those that follow a manipulated index like revenue or fundamentally weighted, are examples. Actively managed ETFs are the most obvious examples of an embedded strategy.”
Explaining to clients that a low cost core of passive ETFs is an effective way to capture beta, or exposure to market returns will help. You could build a core of actively managed mutual funds or ETFs with embedded strategies that try to outperform your benchmark, but it is difficult to identify successful ones in advance, extremely difficult to pick them consistently year after year, and you risk the inefficiency from fund overlap (see AER Sept 2010 “How Many?). You do, however, know their cost in advance. Go with what you know, it’s logical and clients understand it.
With your passive core established, consider the manageable characteristics of ETFs (or other assets) that make the most impact on portfolios, cost and diversification are the most important followed by liquidity, tax efficiency and tracking error. This column has examined each of these in the past.
What about returns? They can’t be predicted in advance, but by capturing the market return inexpensively with a core of passive products, you can select other “satellite” assets around the core that position the portfolio to perform. Diversified exposure to areas you feel will do well like small capitalization stocks, emerging markets, or commodities, can be added as individual securities, passive ETFs, mutual funds or ETFs with embedded strategies. If the satellite investments chronically underperform the core, you will know and so will your clients. But what to do about it will be clear. In coming issues we will examine the considerations for satellite assets more closely.
Keeping portfolio construction and classification of ETFs simple will help clients understand what you are doing, help dispel the mystery of the “egg management fee” and will distinguish ETFs as a signature part of the portfolio menu.
Mark Yamada is the President and CEO of PŮR Investing Inc. www.purinvesting.com

Taxes, like hemorrhoids, are annoying ETFs can provide relief

People don’t like to talk about them and they are decidedly a pain . . . but taxes are the bane of an investor’s existence.

Investment professionals know that three key characteristics make exchange–traded funds (ETFs) tax efficient:

1. Index-based ETFs have extremely low turnover. Transactions trigger gains taxable in the hands of unit holders.

2. The redemption of ETFs allows for in-kind transfers, allowing sponsors to transfer out the lowest cost shares without incurring tax. This maintains the adjusted-cost base closer to the market value. Unit holders pay most taxes when they sell the ETF, effectively deferring taxes until realized.

3. The creation method and exchange-traded nature of ETFs means that supply and demand are balanced in the marketplace and units do not have to be sold (incurring a possible tax liability) to meet redemption requirements as mutual funds do. As a consequence, ETFs hold less cash to earn taxable income. (albeit not much lately given low interest rates).

These tax minimizing characteristics are a big relief for taxable investors. Had they owned mutual funds, they could be subjected to big taxes unrelated to their actual investment results. Paying for the capital gains or income received by others is just silly.

Tax losses

ETFs are ideally suited for capturing tax losses. The conventional way is to replace a losing stock position with an ETF. Example: sell Research in Motion (RIM) at a loss to buy iShares Canadian Tech Sector ETF (XIT). The loss in the stock position is captured, to be used to offset capital gains in the current year, back three years or carried forward indefinitely. The portfolio exposure, to the technology sector in this case, is maintained.

Another effective tactic is to swap between ETFs with similar underlying risk. An example is iShares S&P 500(IVV) and SPDR 500(SPY). Both have the S&P 500 as their underlying index but because the ETFs have different sponsors, BlackRock and State Street Global Advisors respectively, they are considered different securities for tax purposes. Therefore, they may be traded simultaneously to capture a loss. The 30 day waiting period to avoid a superficial loss is not required.

Holding a core portfolio of ETFs and owning a satellite portfolio of individual stocks is a good way to protect capital gains generated by the stock portfolio by applying tax losses generated from the core. Some firms may offer a tax-loss-capture module, like PŮR Investing’s, that does this automatically.

Caution

Ms. Ioulia Tretiakova, Director of Quantitative Strategies for PŮR Investing, says that while ETFs have tax efficient characteristics, some have shocked investors at tax time.

The 2008 experience with some leveraged Rydex Inverse sector series ETFs is shown here.

ETF	Gain
Rydex Inverse 2x Sector Energy	86.61%
Rydex Inverse 2x Sector Technology	59.46%
Rydex Inverse 2x Sector Financial	42.35%

Ms Tretiakova explains that inverse, leveraged long and leveraged inverse ETFs use swaps and derivative instruments rather than securities that can be transferred in-kind. This creates potential tax liability when the contracts are closed out. Capital gains, influenced by volatility and the expiration of futures contracts related to the underlying sectors on January 1, 2009, were huge for several Rydex ETFs. In Canada, a similar situation is not expected although in 2012 the Horizons Beta Pro’s leveraged ETF products listed below have OTC derivative contracts maturing. A different Canadian structure, unavailable in the U.S., allows sponsors to better minimize taxes. At any rate, leveraged ETFs should always be watched carefully.

ETF	Date	Symbol
HBP S&P/TSX Financials Bull Plus ETF HBP S&P/TSX Financials Bear Plus ETF	June 11, 2012 June 11, 2012	HFU HFD
HBP S&P/TSX Energy Bull Plus ETF HBP S&P/TSX Energy Bear Plus ETF	June 18, 2012 June 18, 2012	HEU HED
HBP S&P/TSX Global Gold Bull Plus ETF HBP S&P/TSX Global Gold Bear Plus ETF	June 25, 2012 June 25, 2012	HGU HGD

Screening ETFs for tax efficiency

While it should be clear by now that taxable investors should always use ETFs rather than mutual funds, differences in the tax efficiency of ETFs bears some attention. Like other forms of investing, “tax” should never be the prime reason to make an investment, however, it is common sense to be mindful of an instrument’s tax impact.

Screening ETFs by the proportional size of their historical distributions is a fair way to assess their tax efficiency. It is these distributions that incur the tax that investors seek to avoid. To be fair, indexes that change their components or are in start-up mode, may incur more transactions and more taxable activity. This should diminish over time.

When choosing between similar ETFs, picking the one with better tax efficiency may improve your after tax return. To see the tax efficiency of ETFs trading in Canada, check the free screener at: http://purinvesting.com/demo/Screen.htm