ETFs can be simple, flexible replacements for mutual funds, thanks to their ease of trading. However, they may not always be appropriate for mining particular sectors.
For one thing, says Pat Chiefalo, director of derivatives and structured products at National Bank Financial Markets, “I think the market is split. There are certainly advisors that have over the years built their books on mutual funds or whatever types of products that they use. Once you have a book of certain size and it’s been working for you for a number of years, why would you all sudden switch because someone tells you, hey there’s a hot product or there’s an interesting way of doing things?”
He was speaking earlier this moth at 2011 Exchange Traded Forum sponsored by Radius Financial Education in Toronto.
Call it stodginess or call it sticking with what works. It extends beyond the adoption of of ETFs. Canadians still exhibit an extreme home bias to Canadian investments, notes Tyler Mordy, research director at Horizons HAHN Investment Stewards.
“Let’s be adults here. We work in a business where investments are sold not bought,” he says. “If we look at portfolios right now, what’s missing? I personally think there’s a lot of global ETFs that are not in most investors’ portfolios. If you look at the average U.S. pension fund as an example, they’ve got about 4% to 6% in emerging market asset classes. When you look at the MSCI All-Country World Index, the market cap there is about 15%. So, there’s a huge mismatch between what investors should be doing and what they are doing.”
In Canada, he estimates “90% of mutual funds are in Canadian-domiciled assets. So Canadians too, we do have a pretty good economic situation right now, but by and large we are overexposed to Canadian assets.”
Although it may be harder to get access to foreign assets through ETFs listed on the Toronto Stock Exchange, acknowledges David Munro, an analyst at DundeeWealth. “We can buy things on other exchanges. The U.S. has a historically been a great market for different ETFs, I know that Tyler deals with markets all around the world for different ETFs. There are certainly ETFs that you can get access to to get exposure to those other markets and just the fact that it doesn’t trade on the TSX is not really an excuse to not to look for the exposure.”
Still, not every asset class is suitable for an ETF. Convertible bonds are an example, explains Alfred Lee, vice-president and investment strategist at BMO ETFs. “At certain times you may not have a sufficient universe. So I think in areas like that, active management really makes sense, where the active manager has the ability to slowly work in the trade and has the decision to buy other issues and not be measured against tracking area.” Convertibles may not be a liquid market; and if the index is buying, then a passive manager “has to put in his trades at certain times, otherwise he’s going to cause tracking errors. At times like that he could push up the price of the underlying, and he has to buy a certain issue that may not be available.”
Another area where ETFs may not provide the best exposure is in the Canadian resources arena. That’s because small-cap managers have access to IPOs that index trackers do not – until they become public. As a result, a resource fund manager needs only one issue to hit a four-bagger to buoy returns above the index – something that happens so much so that Chiefalo considers resources indexes less than efficient.
Another issue is liquidity. It’s not so much the liquidity of the ETF – they trade as stocks and can be bought and sold immediately, depending on whether the individual investors accepts the bid-ask spreads on offer – it’s the liquidity of the underlying.
To some extent, that was a factor in last May’s flash crash, where bids on highly liquid stocks dried up. But, Yves Rebetez, a specialist in ETFs, wonders about fixed income ETFs. Such ETFs depend not on publicly quote markets, as stocks do, but on over the counter markets – on an interbank market that could seize up if there are counterparty worries, where one bank refuses to trade with another.
And that speaks to another danger in Canadian ETF markets: Not only are investors piling into Canadian products, but they are piling into income products. Says Lee: “There is a lot of yield products that have been popular, such as U.S. high yield, to a lesser degree emerging market bonds. On the equity side, I think it’s been a little bit more conservative, areas such as low-beta products, higher yield products such as Canadian REITs have been popular. I think that’s just a reflection of where we are in the market cycle.”
Those are likely to get left behind if momentum returns to the equity markets.
Yield, momentum or both? Munro argues for caution. “I think sometimes the trap that we can get caught in as retail advisors is having clients come to us and say…How can I get exposure to this? Just because something is popping doesn’t mean it’s right for a client portfolio – as the recent meltdown in silver illustrates. Just because we can get access to silver through an ETF or oil or anything like that doesn’t necessarily mean it’s the right move for our clients at any given time. It might be, but you really have to nail down what that strategy is and what’s best for that client.”