Are ETFs Growing for the Wrong Reasons?

On the day his company announced it was acquiring Claymore, BlackRock’s CEO Bill Chinery called ETFs “electric cars in a world of internal combustion engines.”

What he meant was that ETFs, despite the attention poured on them by the media and DIY investors, are still only a small part of the fund industry. ETFs in Canada now manage about $43.1 billion in assets. By comparison, Canadians have $778.5 billion invested in mutual funds—about 18 times more.

That’s a big gap, but it’s been closing for a few years now. According to a recent report, ETFs in this country saw more than $7.6 billion in new sales in 2011, increasing their total assets by nearly 13%. Compare that with another report from the Investment Funds Institute of Canada. Canadian mutual funds, it says, now manage $8.8 billion less than they did at the beginning of 2011. Of course, part of that decline is a result of negative equity returns and not investor withdrawals. But the stats do make it clear that the mutual fund industry is moving in the opposite direction of ETFs:

  • Balanced mutual funds saw inflows of $27.7 billion in 2011—a hefty sum, but almost $1 billion less than the previous year.
  • Bond mutual funds accepted $8.87 billion in new money last year, compared with $11.1 billion in 2010, about a 20% decrease.
  • Equity mutual funds saw net redemptions of $10.8 billion during 2011.

ETFs may still be electric cars, but the mutual fund industry is looking more and more like a tractor trailer with a hole in the fuel tank.

Every silver lining has a black cloud

Not everyone agrees that ETF growth is encouraging. “To me, the ETF sales numbers are both underwhelming and disappointing,” wrote Tom Bradley of Steadyhand Investments this week. “In the context of a wealth management industry with over $1 trillion in client assets, $7 billion doesn’t represent much of a market share swing.”

I also share Bradley’s other concern: “I have to wonder what portion is being used by individual investors to implement low-cost, long-term strategies.” Indeed, while it’s tempting to see the growth of ETFs as a triumph for Canadian index investors—who are finally waking up to the fact that they’ve been paying too much, for too little, for too long—the numbers don’t support that:

  • About $900 million of the new money that went into ETFs in 2011 (12% of the total) went into the iShares S&P/TSX 60 (XIU), which is mostly a tool for institutional investors. It’s unlikely that much of that $900 million came from newly sprouted Couch Potatoes.
  • Another 16% of ETF inflows ($1.2 billion) went into covered call ETFs. While these ETFs may have a role in some portfolios, such widespread enthusiasm for covered calls probably has more to do with chasing yield than prudent investing. The enticing distributions paid by these ETFs (often 7% to 9%) are not likely to be sustainable.
  • As Bradley points out, there’s “some serious performance chasing going on.” Fixed-income ETF assets were up 44% in 2011, a year that saw excellent bond returns. But other than XIU, equity ETFs saw very little new money—just $400 million, or barely 5% of the total inflows. In a year where emerging markets performed poorly, investors pulled $45 million out of the Claymore BRIC ETF.

I’m encouraged that Canadian investors are putting pressure on the mutual fund industry, and pleased to see that more are embracing ETFs. But part of me thinks they’re doing the right thing for the wrong reasons.

26 Responses to Are ETFs Growing for the Wrong Reasons?

  1. Chad Tennant January 19, 2012 at 9:20 am #

    I like the title of this piece which to some degree reminds me of the Apple story. Apple’s slow rise was due to “growing for the wrong reasons” in that it took a while for the mainstream to pay attention compared to those early adopters who purchased their products for creative, functional and design purposes. The mainstream is still sitting in overpriced and nonperforming mutual funds, but I’m confident that ETFs are moving well toward its tipping point.

  2. Canadian Couch Potato January 19, 2012 at 9:43 am #

    @Chad: I would be more optimistic if I thought people were moving toward long-term passive strategies. But if you drill down into the numbers, it looks more like the growth of ETF assets in 2011 was driven by people who are chasing performance and buying income-oriented products they probably don’t understand. Only 5% growth in equity ETFs other than XIU is not an encouraging sign.

    This is one area where I hope Vanguard will have some influence. They have been very good at raising awareness and education in the US. They seem more interested in getting across the important distinction between strategies and products. Moving from active mutual funds to active strategies with ETFs is great for the ETF industry, but it doesn’t suggest that Canadians are making better investment choices.

  3. SterlingF January 19, 2012 at 10:51 am #

    @CCP: I agree that it doesn’t do anything to help with the education of Canadian investors (which is what I think you mean) but does it not potentially help the passive CP investors with lower MER fees because of more $ assets under management. I suppose if all the money is being put into XIU I may not see an MER descrease in XIC.

  4. Canadian Couch Potato January 19, 2012 at 11:00 am #

    @Sterling: In theory, you’re right that ETFs could afford to lower fees if they attract more assets. But in practice, I am not aware of any Canadian ETF that has ever lowered its fee in the last 12 years. I don’t mean to be too negative, but I think investors who are expecting significant fee decreases in the near future are going to be disappointed. ETFs are already the cheapest investing option available in Canada and there is little incentive for them to shrink their already small margins. It makes more sense for them to go after a lager share of that $780 billion in mutual funds first.

  5. GeoEng51 January 19, 2012 at 11:20 am #

    Well, you can count me as one new Couch Potato. Not only have I moved significant $ into a Complete Couch Potato portfolio (at Questrade), I also bought a copy of “Guide to the Perfect Portfolio” for Christmas and gave it to each of my (5) kids and several co-workers. I’ve been reading financing books for 5 years now, trying to educate myself, dabbling with some direct investment in stocks, and watching my mutual funds perform very poorly. I’m very happy to finally find an investment strategy that makes sense :>) Thanks for all the good information on the web site and in your book!!!

  6. ACMZ January 19, 2012 at 12:26 pm #

    I would have to agree that people are maybe using a new tool but not necessarily a new approach to investing. This all comes down to education again. Like GeoEng51 my christmas reading included Dan’s book (Building the Perfect Portfolio), Andrew Hallam’s book (the millionaire teacher), David Chilton’s (The Wealthy Barber Returns), and then to finish of Burton G. Malkiel’s (A Random Walk Down Wall Street). With this new knowledge, I now really enjoy discussing money matters. My kids are just starting with summer jobs and they both have e-series accounts (one is even to young so I have it in trust). I even have siblings taking charge of their finances (the index way) after a good christmas family chat. Education is the key and this site is doing exactly that. Keep up the great work Dan.

  7. Canadian Couch Potato January 19, 2012 at 12:34 pm #

    @GeoEng51 and ACMZ: Many thanks for the kind words about the book. Very happy to hear you found it helpful!

  8. SterlingF January 19, 2012 at 12:38 pm #

    @ACMZ & GeoEng51 : My Christmas was spent much of the same, reading and informing family members. I borrowed “Millionaire Teacher” from my brother-in-law. He got it for Christmas and I read it before he even cracked the cover. I don’t think he minded though. 🙂 Thanks JD! The next books on my list are “The Little Book of Common Sense Investing” (Mr. Bogle), “Think and Grow Rich” (Napolean Hill), and “A Random Walk Down Wall Street” (Burton Malkiel).

  9. Raman January 19, 2012 at 2:08 pm #

    Have you considered the possibility that Canadians may be buying US ETFs (i.e., ones traded on the NYSE) instead of those domiciled in Canada? If we were to add the portion of those assets held by Canadians into the comparison above, it may paint a different picture of the war between mutual funds and ETFs.

  10. Canadian Couch Potato January 19, 2012 at 2:53 pm #

    @Raman: Fair point. I don’t think anyone knows how much money Canadians have invested in US-listed ETFs. I would guess, however, that it would not change the picture at all.

    I just came across this article saying that in the US, ETF inlows were double those of mutual funds in 2011. It also says that mutual fund assets are only seven times higher than ETF assets, compared with 18 times higher in Canada:
    http://www.indexuniverse.com/hot-topics/10771-2011-etf-inflows-twice-that-of-mutual-funds.html

  11. The Dividend Ninja January 19, 2012 at 3:57 pm #

    Hi Dan, very nice post 🙂

    You bring up a good point. The problem is investors are just switching ETFs for mutual funds, to save on commissions and fees, but still making the same investing mistakes. You’ve clearly illustrated this point. It doesn’t matter what an investor puts there money into or takes their money out of, whether its an e-series fund, an AGF mutual fund, or an iShares ETF. If you buy high and sell low, then what difference does a 2.5% MER make?

    If you pull equities out of a down or declining market, out of fear, and top up when markets are rising then you’ve obviously dimished any savings and future returns. I bet a lot of people withdrew from European and foreign mutual and index funds, this last month, when they should have been adding money. In Millionaire Teacher, Andrew Hallam calls that “nutty behaviour” and shaves 4% off annual returns for that…

    Cheers
    The Dividend Ninja

  12. Maxwell C. January 19, 2012 at 8:38 pm #

    Random question here….

    Speaking of the E-series funds…
    If I own these in my regular TD Investments account (with the bank, not with TD Waterhouse), I can easily swap one e-series fund for another to rebalance as necessary.

    Can I also do this if I hold the e-series funds in a TD Waterhouse SDRSP? Has anyone any experience with this? Am I still able to swap the funds, no problem, or is it not possible as they are from differing “Fund families”? (Not that it would really be a problem as IIRC after 3 months’ holding I could just sell one e-series fund for cash, then buy new units of the other one using that cash, riiiiight?). This wouldn’t screw me tax-wise or anything, I don’t think.

  13. The Dividend Ninja January 19, 2012 at 9:06 pm #

    Maxwell C
    I have e-series funds in both a TD MFSA (Mutual Fund Savings Account) and with a TD Waterhouse TFSA, and my TD Waterhouse RRSP. It doesn’t matter what the account is, unless you withdraw out fo your RRSP of course. There is no charge to buy, sell, or switch e-series funds. But you will be dinged with a 2.5% fee if you switch or redeem within 90 days (e-series).

    If you withdraw money from your TD MFSA there is no cost, but if you withdraw from your TD Waterhouse TFSA, you will pay $25 per withdrawal. RRSP as well, plus withholding taxes. Hope that helps 😉 Dan, apologies for hi-jacking the post…

    Cheers
    The Dividend Ninja

  14. Canadian Couch Potato January 19, 2012 at 9:08 pm #

    @Ninja: Hey, thanks for answering Maxwell’s question!

  15. Joe S January 19, 2012 at 9:33 pm #

    Interesting to see net mutual fund sales of $25.77 billion, according to your numbers, versus net ETF sales of $8.7 billion. I suspect Canada is still missing critical mass with respect to fees, but it’s only a matter of time. The difference in MERs between mutual funds and ETFs is just too large.

  16. Chad Tennant January 20, 2012 at 9:58 am #

    Increasing assets. Check.
    Providers doubled last year. Check.
    Media coverage increasing. Check.
    MER scrutiny increasing. Check.
    Vanguard in the mix. Check.
    Awesome ETF/index bloggers such as yourself. Check.

    Even if people were driven by chasing performance, ETFs are generating interest. The cream always rises to the top, but I agree that the fundamental picture has to change from a ‘core active’ to ‘core passive’ approach to see mass adoption.

  17. Monevator January 21, 2012 at 3:50 am #

    I do see plenty of active traders using ETFs where they would have used individual stock names to bet on market niches. Beyond being a bit more diverse for anyone who wants to gamble on a sector, here in the UK, ETFs are even free of our traded 0.5% stamp duty tax on share purchases (not a nice hit for Couch Potatoes, either!)

    I’ve no idea how much of the market is active like that versus passive, however.

    The more worrying trend is another you’ve covered before – ‘exotic’ ETFs, leveraged ETFs and so on.

    I don’t like those because they make a simple idea complicated, and could suck in people on the passive path for no reason…

  18. Dale January 21, 2012 at 7:35 am #

    The etf industry has done a very poor job of marketing their products. Because they marketed their producst. Or the companies tried to create their own brand. They did not sell the benefits. There’s nothing wrong with selling the category. The human and simple financial benefits of etf’s over mutual funds.

    As a marketer it is my opionion that they have missed the boat. I worked on ING Direct Canada and US, and they get it. They re- introduced a very simple premise, Save Your Money.

    The etf players should also band together and sell etf’s and etf strategies as a group. The big banks have the CBA (Canadian Bankers Association). There needs to be an ETFA. I think I will approach ‘them’.

    It’s time to educate the masses.

  19. Doug January 21, 2012 at 9:41 pm #

    I think I can understand why the ETF numbers are so low in Canada and why the Mutual fund numbers are so high.
    First, most of my mutual funds were ‘redone’ in Oct 07 by my ‘financial adviser. Most of those funds still carry a 4% ‘early’ redemption penalty four years later. Man, was I stupid back then letting my ‘financial adviser’ do that to me. That ridiculously gross penalty and the self serving business practices of the mutual fund industry is definitely slowing the transition to ETFs. I am slowly getting out of servitude, 10% a year.

    2) Raman was ‘right on the money’. All of my NON Canadian holdings (about 75% eventually targeted) are indeed held in US sourced ETFs. They are cheaper, more liquid and taxed less. If I bought a Canadian sourced US equity ETF, the distributions would be hit with a 15% withholding tax even if it is held in my registered accounts (that has to be fixed for the Canadian industry to advance). The foreign tax credit helps with the withholding tax in non registered accounts.

    As an example, there is no advantage to holding VEE instead of VWO . Half the yield and over twice the cost for the same index. Other than hedging, I don’t (yet) see the value in Canadian sourced ETFs other than true Canadian equities and bonds or am I missing something here?

    Great site Dan. Discussion and education is the answer.

  20. Greg January 22, 2012 at 12:18 am #

    ETF uptake is likely slow for the same reason that fully 50% of the people are buying mutual funds that are on the bottom half of the performance curve and the top half of the fee curve — they simply don’t know any better, or don’t think they have the time or the “financial savvy” to figure it out.

    Every time I see the table of mutual fund performance and see the worst 10 performers over the past 10 years I wonder how those funds continue to do business.

  21. Jon Evan January 22, 2012 at 12:17 pm #

    Canadian investors need to seriously awaken and take the mutual fund industry to task! I’m glad you are doing it Dan and your new book should be on every news stand :). Take this mutual fund company for example that makes this bold statement: “Indexers seek to match the market’s returns by copying its composition. Our goal is to beat the market over the long run.” But that is deceptive as it doesn’t define the “long run”! It isn’t even a honest contract with the investor because there are no consequences for the mutual fund company if they don’t meet that tempting goal! If they truly believe that beating the market is a realistic goal they should then refund their higher fees if they then don’t beat the market or do worse! Why not? Why the higher fees then? There should be truth and substance in advertising not used car salesman talk!

  22. Mac January 22, 2012 at 1:31 pm #

    Why is XIU a tool primarily for institutional investors? Is it not a good tool for passive personal investors?

  23. Canadian Couch Potato January 23, 2012 at 8:09 am #

    @Mac: XIU is an excellent choice for retail investors, too. It’s just that in practice it is widely traded by institutional investors, which explains why it has about $11 billion in assets (about 25% of the entire ETF asset base in Canada).

    @Doug: Thanks for the comment. I tend to agree with you regarding US-listed ETFs. Just a couple of clarifications: VEE is not hedged. In fact, no emerging markets ETF in Canada uses hedging, as it is too expensive to hedge these currencies. It’s also worth noting that the currency conversion costs associated with trading US-listed ETFs can be appalling. There are ways around this, but unless you take steps top reduce these fees, Canadian-listed ETFs are sometimes preferable.

  24. Bluehorshoe January 25, 2012 at 11:34 am #

    The entire CDN mutual fund industry is based on commission selling. I work for a manufacturer of both active and passive funds and there is an old industry saying “Mutual Funds are sold not bought” The distribution network of financial advisors and bank branches have no financial incentive to recommend or sell ETFs unless they have been repackaged into a mutual fund form or the ETFs are used within a ‘fee for service’ account. These distribution channels have been marketing active managers for so long that the turn to passive investments will take time. As someone that deals in the advisor community everyday I can tell you that passive investments are gaining steam. Fee for service accounts are growing ( slowly ) and the advisor friendly mutual fund ETFs are expanding daily.

  25. Canadian Couch Potato January 25, 2012 at 11:38 am #

    @Bluehorshoe: Thanks for the inside story—this is encouraging. I expect that Vanguard will be a leader in the move toward fee-based accounts in Canada, which is where we need to go.

  26. Carole September 2, 2013 at 7:18 pm #

    To the Dividend Ninja:
    I checked the index investing page at TD Waterhouse today. Here’s good news.

    “Exclusively for TD clients investing online, TD e-Series Index Funds offers MERs as low as 0.33%. In addition, there are no commission fees to buy or sell.
    2% Early Redemption Fee (ERF) for units sold within 30 days of purchase.”

    Now the bad news:

    “Short-Term Redemption Fee Policy

    Funds held for less than 30 days are subject to a short-term redemption fee of 1% of redemption value or $45 (whichever is greater). This policy applies to all mutual funds offered by TD Direct Investing, with the exception of all Money Market funds and those purchased on a rear load basis.

    The majority of mutual fund investors rely on a long term, buy and hold investment approach. Frequent trading of mutual funds can result in adverse effects on mutual funds and their shareholders due to increased costs in managing the fund. In addition, short term trading has an administrative cost to TD Direct Investing, which is not covered in our standard fee structure. Short term redemption fees are designed to discourage frequent trading in mutual funds and to offset the costs associated with those trades.”

    I can think of one possible explanation for the different policies; index funds may be offered by the TD Bank, while some other funds are only offered by TD Direct Investing (TD Waterhouse).

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