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February 20, 2007

ETFs Giving Mutual Funds a Run for their Money
by Tyler Mordy

Certainly the most disruptive development in the investment industry over the last few years has been the emergence of a serious competitor to the conventional mutual fund vehicle. The rapid pace of new listings and the degree of innovation in the exchange-traded fund industry has side-swiped mutual fund providers, leaving many clinging to an investment tool that is more expensive, less tax efficient and increasingly less suitable for many investor portfolios.

In earlier years, with the backdrop of several mutual fund scandals, ETFs' combination of low cost and transparency provided a significant impetus for growth of the ETF market. But from simple beginnings of supplying investors with exposure to only a few major equity indices, ETF offerings have expanded to achieve a broad range of exposure to different types of underlying asset classes. These developments advanced largely below most investors' radar -- until recently.

Today, established ETF manufacturing firms are rapidly expanding their product lines, with new players regularly announcing forays into the ETF business. Providers are scrambling to offer niche ETFs or to secure firstmover advantage in a variety of asset classes. (Consider State Street Global Advisor's, manager of the "spider" brand, well-timed launch of the first gold bullion-backed ETF (NYSE:GLD) which gathered over USD $1.4 billion of assets in the first trading week and now has over USD $9 billion in assets. By comparison, the second gold bullion offering by industry leader, Barclays Global Investors, still lags at around USD $900 million).

Fund Manager Performance Underwhelming. The core attributes of ETFs versus the traditional mutual fund vehicle are hard to deny - transparency, trading flexibility, diversification, tax-efficiency and cost-effectiveness. But the fundamental case for ETFs rests on horrific performance track records established by most active fund managers.

It is well documented that over the long-term and after fees, most mutual funds do not consistently outperform their benchmarks. The facts speak for themselves. The table below shows the percentage of US equity fund managers that underperformed the index over the past fifteen years. A similar dismal experience applies to bond mutual funds.

Fund manager performance may be even worse in Canada due to higher management fees. In a February 2006 study entitled "Mutual Fund Fees Around the World," three professors reviewed fees charged by 46,799 mutual funds in the world (representing 86% of the world fund industry). By a wide margin, Canadians are charged the highest mutual fund fees in the world. According to the survey, the average bond fund in Canada charges a hefty 2.25% total expense ratio (before loads). The typical bond ETF charges a mere 0.15% MER.

The main drawback to ETFs is the transaction costs incurred when buying and selling. Opponents point out these frictional charges render ETF investing inappropriate for active traders. While excessive trading with ETFs may significantly dampen returns, high turnover mutual funds share the same disadvantage. With many custodial firms offering much lower fees, the chasm between the more competitive institutional pricing and higher retail charges is narrowing, making the transaction cost disadvantage less important.

ETF Expansion Accelerating. Many industry followers believe we are only in the first innings of a lengthy expansion which will initiate an epic battle for market share between mutual funds and ETFs. Recent evidence supports those claims. There are now over 300 ETFs in registration with the US Securities and Exchange Commission, many providing access to previously expensive or illiquid asset classes unavailable through mutual funds. Innovation is proliferating. The traditional market capitalization approach has been challenged by competitors, providing indexing techniques based on enhanced, fundamental, rules-based, and even some qualitative methodologies. Different structures are also emerging, namely exchange-traded commodities (ETCs) and exchange-traded notes (ETNs). ETNs offer returns to published indices in the form of senior unsecured debt, as opposed to the typical ETF collateralized by underlying securities. (Essentially tracking risk of the benchmark is swapped for credit risk of the debt issuer).

Cautionary Approach Still Recommended. Many second generation ETF developments will miss their mark proving to be not much more than marketing noise for investors, similar to some of the flaws seen in the mutual fund industry's evolution. As discussed in last month's inaugural issue of ETFocus, investors should become more cautious to the underlying indexing process and security holdings.

As with all budding developments, there are positive and negative aspects. One feature of the ETF industry remains certain: investors will be left with more investment options in a more economical format than traditionally available through mutual funds.

But it also calls attention to the long-term viability of the mutual fund product vis-à-vis the ETF. What reactions or dislocations will take place in the mutual fund industry as a result? To date, the response from fund players in general has been surprisingly muted.

Funds Still Dominate - But for how long? To be sure, the asset management landscape continues to be dominated by the colossal mutual fund market, although ETFs are hogging current headlines. According to the Investment Company Institute, at the end of 2006 US mutual fund assets exceeded USD $19 trillion. By comparison, Morgan Stanley reports only USD $445 billion in US ETF assets. Going into 2007, mutual funds now number more than 77 000 globally, with only approximately 750 ETFs worldwide.

Clearly, ETF investments still represent a drop in the pond. But looking at growth figures, the perspective changes radically. During 2006, US mutual funds saw only a 16.9% increase (during a time when overall investment markets were quite robust), while US ETF assets increased a whopping 45.9%.

Mutual Fund Relevance. Are mutual funds still appropriate for most investors? Certainly. Investors with smaller investable balances practicing dollar cost averaging may be better off in a fund in the early stages of building a larger asset base. Also, pooled instruments are still one of the only vehicles available for active stock selection managers. (However, ETF manufacturers are racing to be the first to offer a truly actively managed exchange-traded fund. David Haywood, director of alternative investments at Financial Research in Boston, calls the active ETF the "Holy Grail of the industry" and sees the floodgates opening once it comes to market).

ETF Potential Remains Untapped. Ultimately, successful long-term investment management is about holding the right assets - those with suitable liquidity, value, income and growth potential - in the most costeffective vehicle. ETFs are a refreshing step in that direction, providing an alternative to mutual funds while challenging traditional money management practices.

Tyler Mordy
Hahn Investment Stewards & Company Inc.

Hahn Investment Stewards & Company Inc.
Global Fund Management & Investment Counsel
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Phone: (888)-957-0602 e-mail: information@hahninvest.com

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