I Thought I Wanted An ETF?
"You've heard the story before, and no doubt some assertions seem compelling. Before you get on board with ETFs, explore the facts." - Mackenzie Investments, "I thought I wanted an ETF", September 2009 (http://www.mackenziefinancial.com/eprise/main/MF/DocLib/Public/MF3928.pdf)
"With Charles Schwab's recent announcement that it plans to create its own line of ETFs, inquiring minds will wonder if actively managed mutual funds, like the rotary-dial telephone, are not one of the great ideas of yesteryear." - James Grant, Grant's Interest Rate Observer, September 2009
It's official. One of Canada's largest mutual fund families has finally taken a public swipe at ETFs. In a recent article entitled "I thought I wanted an ETF", Mackenzie Investments compares the traditional mutual fund vehicle to the exchange-traded fund ... clearly siding with the former. Mackenzie has not been the first to throw a punch. Indeed, there have been several other clashes between mutual fund and ETF proponents in recent months.
Here at ETFocus, we've had ringside seats to these competitive pugilistic disputes for some time. As for this most recent jab, however, we can't resist jumping in the ring and taking a few swings of our own. To date, it's been like watching David confront Goliath. Consider that Mackenzie Financial represents more than CAD 50 billion of the CAD 470 billion Canadian mutual fund industry, while total Canadian ETF assets are still under CAD 30 billion. Although ETFs are experiencing rapid growth, global mutual funds still trump ETF assets by a factor of 20 (over USD 20 trillion in mutual funds, compared to approximately USD 900 billion in ETFs).
At ETFocus, we try to make unbiased research our beat. As such, we strive to remain objective (impossible, but we try)... separating facts from opinion. After all, facts are the survivors and opinions will invariably change. So, let's all take a deep breath, consult the data and let the conclusions follow:
Mackenzie Assertion: "The reported cost of ETFs does not include transaction fees or the cost of advice." (The source for all Mackenzie's statements is their own publication, the link to which is provided in the quote section.)
ETFocus Response: Valid points on both counts. We agree with Mackenzie's "cost of advice" estimates, ranging from 67 to 100 basis points. But let's examine the hypothetical example used to arrive at a total annual cost of 2.30%. For one, the management expense ratio for a "bundled" ETF is listed at 0.70%. Really? According to Barclays Global Investors, the average ETF total expense ratio is significantly less at 0.31% (data as of third quarter, 2009 for the US and Europe).
Secondly, they assume monthly contributions of $1500 and transaction costs of $24 (does anyone still pay that?). For reasons of consistency, let's use the same figures and assume that investors do live in a world where they really do pay $24 per trade. But, let's alter the frequency of trading, batching the trades into quarterly implementations (instead of monthly) ... a completely rational move. Immediately, execution costs drop to 0.53% per year ... significantly less than Mackenzie's 1.60%.
Mackenzie Assertion: "Short-time periods do not reflect the actual experience of long-term investors, where mutual funds have outperformed the index."
ETFocus Response: We agree that short time periods are incomplete measurements of manager skill (better to analyze performance over a full market cycle). But Mackenzie's statement is simply inaccurate based on the evidence. Yes, comparative indices do not include transaction costs and the cost of advice. But the large majority of mutual funds over the long term under-perform their bogeys by a significant margin. And, for outperforming funds, investors have the incredibly difficult task of selecting the right ones! Why should private investors have to outperform in order to find outperforming managers? It defeats the very notion of professional active management.
Again, let's turn to the facts. Standard & Poors regularly releases an "Index Vs Active Fund Score Card". Q4 2008's report showed a 5-year annualized return of 2.44% on an asset-weighted basis, and 0.87% on an equalweighted basis for Canadian equity funds. The comparable index's return? 4.16%. Other fund categories similarly show a consistent underperformance (see chart below).
Mackenzie Assertion: "The returns posted by ETFs are usually not the same as those achieved by ETF investors. Besides transaction fees, there's a bigger reason why investors lag ETF returns: trading. Particularly in volatile categories and markets, investors typically buy and sell at the wrong time."
ETFocus Response: This is a general statement and is true for all investment vehicles ... including mutual funds. Dalbar Inc., a financial services market research firm, releases its annual Quantitative Analysis of Investor Behaviour that reaches the same conclusion every year. The average investor continuously earns only a fraction of market returns.
According to Dalbar's 2008 report, from 1988 to 2008 the average US mutual fund investor in a balanced fund achieved a 1.67% annualized return while the passive benchmark achieved a return of 7.89% and inflation averaged 2.89%. The study determined -- as it does every year -- that the primary reason for the average investor's low return was that investors tended to buy "high" and sell "low." Investors are inclined to flee markets when they have already fallen, buying them only when optimism has returned. That's true for both mutual fund and ETF investors.
Mackenzie Assertion: "An active strategy gives you the opportunity to outperform - and many successful portfolio managers do - whereas a passive strategy guarantees you will never do as well as the index (due to MERs and transaction costs)."
ETFocus Response: Mackenzie assumes that ETFs are only for indexing purists, "Bogleheads" and other passiveonly enthusiasts. Our view continues to be that active and passive are not mutually exclusive approaches. True, the active versus passive discussion has never been black and white. Market efficiency debates continue to rage throughout the halls of academia, as well as the wealth management industry. Our own view has been well documented in previous issues of ETFocus. However, when discussing ETFs, it is no longer accurate to simply equate them with passive investing and market efficiency.
For one, the introduction of alternative index-weighting methodologies (e.g. fundamental and other quasi-active tracking strategies) and, indeed, even actively-managed ETFs has blurred the line between pure active and passive approaches. Secondarily, and perhaps most importantly, an active strategy can be pursued utilizing passive investments. Indeed, many actively-managed mutual funds are now buying ETFs for their own portfolio ... incorporating a mixture of both approaches.
Therefore, an active approach no longer has the singular goal of outperforming an individual index (i.e. stock-picking). Rather, active strategies can be pursued through shifting asset mix. For example, ETFs are investment tools that lend themselves well to a big picture, "global macro" style of investing ... hardly a passive approach. Consider that ETFs have granted access to a multitude of global investment classes in a single security ... the perfect macro tool for this top-down approach to investing. Only five years ago, this macro toolbox was not available to investors (see August 2009 ETFocus for more comments on this style of investing).
ETFs - Disruptive Development or New Paradigm? ETFs simply "wrap" a variety of targeted global assets classes in a transparent, low cost, tax efficient investment vehicle. That's an indisputably beneficial step forward in the wealth management industry, positively re-shaping investor economics and global portfolio construction.
A recent study published by Deloitte titled, "Exchange Traded Funds: Challenging the Dominance of Mutual Funds?", concludes that growth in ETFs will continue with "greater intensity": "Mutual funds have a 69-year headstart and are much larger than ETFs. Therefore, ETFs are unlikely to beat mutual funds in terms of net assets in the near future. However, retail and institutional investors and advisors are ensuring that ETFs will be one of the fastest-growing investment products of the future."
It's important to note that ETFs are just investor tools. A disciplined, unemotional investment process and prudent risk management framework will always be critical ingredients of a successful investment program. Rather than fighting the ETF trend, Mackenzie and other large mutual fund megaliths who have prospered by the past mutual fund phenomenon would be better off embracing the future. The times are changing.