The Globe and Mail, Report on Business
Published April 17, 2010

Four years ago my business partner Neil Jensen and I were sitting on Kits Beach contemplating a new mutual fund company. As we looked out at the competitive horizon, we could see a wave coming at us. It was called ETFs (exchange-traded funds), and we knew it would be a tough, low-cost competitor to Steadyhand.

What we didn't anticipate was that the wave would turn into a tsunami. In no time, Canadian investors were flooded with new ETF offerings. By our count, there are now 145 funds traded on the stock exchange and a steady flow of new ones coming out from Blackrock (iShares), Claymore, Horizons BetaPro, Bank of Montreal and PowerShares. During the past year in particular, the marketing machines have kicked into high gear.

As a consequence of the swelling numbers, the ETF sector has profoundly changed how it's positioning itself with investors, and how it competes against other investment firms like ours.

Not So Simple. For starters, when investors are looking for “simple and transparent”, ETFs are no longer the default. There still are many clean, easy-to-understand ETFs to be had, but they're harder to find among the proliferation of new products.

Indeed, ETFs no longer take a back seat to closed-end funds or mutual funds when it comes to complexity, opaqueness and fine print. Investors need to ask the same questions they would of any packaged investment product. Will I own stocks, commodities or derivatives? Is there any leverage? What index is the fund replicating? Is it currency hedged? How well does it trade? Are there other fees or costs?

In the rush to catch the wave, the ETF providers have cluttered what was a pristine landscape just a few years ago.

Not so Predictable. It used to be that investors knew what to expect from an ETF. If the market went up X per cent, that would be the fund return, minus a small fee. The emergence of BetaPro's leveraged ETFs blew that notion out of the water. If an investor held their ‘Plus’ funds (two times market exposure) for more than one day (yes, one day), the returns were totally unpredictable relative to the index or commodity they were tracking.

But the unreliability of returns is not limited to the high-octane funds. The returns from some currency-hedged equity funds diverged widely from their expected targets in 2008 and 2009. And in general, the tracking error of ETFs (the amount a fund's return diverges from that of the target index) have widened over the past few years. According to the Wall Street Journal, U.S. ETFs on average missed their targets by 1.25 per cent in 2009, more than double the 2008 gap.

The Fee Halo Over all, ETF fees are lower, but the scene has changed here too. From a rock-bottom start with the original iShares funds, fees have steadily crept up. If an investor uses some specialty funds and trades a few times a year, the cost of an ETF portfolio can easily push into the range of low-priced mutual funds.

In another disturbing innovation, some ETFs are being launched as closed-end funds and then converting to open-end at a later date. These funds are prohibitively expensive for the initial buyer.

Despite the trend to higher fees, there is still a halo around ETFs. This was particularly noticeable recently when some actively managed ETF's were rolled out and the 20-per-cent performance fee was hardly mentioned in the commentaries.

Trading at a Price. One of the advantages of ETFs is that investors can buy or sell at any time. For day traders and institutional investors, including hedge fund managers, this is what makes them so attractive.

However, many of the new funds are extremely illiquid and require trading experience to ensure that the price paid is at or near the value of the fund. For long-term investors who are looking for cheap, broad-based market exposure, negotiating a trade in the open market and paying a brokerage commission is not always so great a deal. For some, buying a mutual fund after the market closes at net asset value (calculated to four decimal points) may be more appealing and practical.

The 90/10 Rule. The marketing of ETFs has gone from being all about cheap, broad-based and passive to being focused on specialization and active trading. Most new products are designed to allow investors who “have a view” to implement their strategy with surgical precision. An investor can now get exposure to virtually any commodity, country or industry sub-sector, and as of this week, can speculate on spread trades between like commodities (i.e. long oil and short gas).

It's all about market timing, sector rotation and trading. In other words, we have arrived at a point when 90 per cent of new offerings are suitable for only 10 per cent of investors.

Stop Generalizing. When we drew up our business plan, we made lots of mistakes, including underestimating how big a competitor ETFs would be. Going forward, the biggest error we could make would be to oversimplify the differences between ETFs and mutual funds. Other than the way they are transacted, the lines between them have almost disappeared.

We can no longer naively say that ETFs are simple, low cost, index-based, tax efficient and have a trading advantage. Or conversely, that mutual funds are none of those things. It's time to stop generalizing and go back to the beach in search of the next wave.