Archive | August, 2013

Will Mutual Fund Advisors Soon Be Selling ETFs?

There are many reasons why relatively few Canadian investors use ETFs compared with actively managed mutual funds. There’s about $900 billion in mutual funds in this country, while ETF assets total about $60 billion—just over 6% of the total. One of the main reasons for that yawning gap is that most advisors in Canada are licensed to sell mutual funds, but not ETFs. But that may be about to change.

The Canadian ETF Association (CETFA), an industry group that represents the country’s ETF providers, is spearheading an effort to enable mutual fund advisors to offer ETFs to their clients ETFs.

Here’s the crux of the issue. Investment advisors in Canada can be licensed by either the Mutual Fund Dealers Association (MFDA) or the Investment Industry Regulatory Organization of Canada (IIROC). MFDA advisors—many of whom work at bank branches and firms such as Investors Group—can sell mutual funds and nothing else. Only those who are IIROC-licensed can recommend and sell individual stocks or ETFs. Up-to-date numbers are hard to come by, but a 2012 report from Advocis suggests MFDA advisors outnumber their IIROC counterparts by about four to one.

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ETF Choices Are Less Important Than You Think

The comments following my recent post about new ETFs from Vanguard were another reminder of just how often investors get overly focused on products. I accept part of the blame here, since I write a lot about the relative merits of specific funds. But I want to be clear that the choice between similar ETFs or index funds is not nearly as important as many people believe. In many cases, it’s trivial.

Successful investing is about saving regularly, keeping costs and taxes low, diversifying broadly, and sticking to a plan. For index investors, selecting appropriate ETFs is important, but it should only come at the end of the planning process. These important steps should come first:

1. Determine the asset allocation appropriate to your goals. This is the most important decision of all, as it will determine your portfolio’s expected risk level and expected rate of return. My model portfolios are all based on a mix of 60% equity and 40% bonds, which isn’t appropriate for everyone. The right mix of stocks and bonds for you depends on your current savings rate and your ability, willingness and need to take risk.

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Inside the New Vanguard ETFs

Vanguard Canada launched some new ETFs this week, and I spoke with managing director Atul Tiwari about the funds. Let’s take a closer look.

Cross-Canada coverage

The Vanguard FTSE Canada All Cap (VCN) expands on the older Vanguard FTSE Canada (VCE). While VCE holds 78 large-cap stocks, the new index includes 255 holdings and covers 96% of the Canadian equity market. That makes it roughly equivalent to the S&P/TSX Composite Index, which holds 234 companies and claims 95% coverage.

This is about as close as you can get to a total-market index in Canada: dig further and you run into serious liquidity problems with small, thinly traded stocks. “We started out with a very large universe and pared it back to a number we thought would be terrific,” Tiwari explains. “But once you get to the practical aspects it gets pretty tough. Our partners on the capital markets side, who are creating units and doing the market making, have to be comfortable they can find these securities. Obviously there’s a cost associated with that, and at some point it gets too unwieldy and it doesn’t make sense.”

With a management fee of just 0.12% (the MER will be a few basis points higher),

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How to Argue With a Couch Potato

Last week, published a debate under the heading “Faceoff: Index, friend or foe?” The arguments against passive investing should be helpful to mutual fund salespeople trying desperately to defend their turf in the face of overwhelming evidence that they are failing investors. Here’s a summary of the arguments in the article, along with some handy tips:

1. Imply that large funds are more likely to outperform

Example: “The best-performing mutual funds are usually the ones with the most AUM, a fact glossed over by promoters of the passive option.”

Start by implying that investors who choose funds with more assets under management (AUM) have a greater probability of outperformance. This won’t be easy, because your client might notice you’ve got it backwards. He might explain how funds grow in assets after they have performed well, because advisors chase performance. He might explain the concept of survivorship bias. Finally, he might ask you for data showing a correlation between fund size and future performance, which will be awkward, because there are none.

2. Explain that your fund manager is smarter than the market

Example: “Passive investing presupposes that markets reflect all relevant knowledge.

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Is Your Bond Fund Really Losing Money?

When the yield on 10-year federal bonds spiked earlier this year—from 1.88% on May 16 all the way to 2.55% on July 5—the value of broad-based bond ETFs plummeted sharply. But I’ll wager that many investors think their bond ETFs are performing worse than they really are.

There’s a common misunderstanding about how fixed-income ETF returns are calculated. That’s understandable, because your brokerage’s account summary is highly misleading: it indicates only an ETF’s price change while ignoring all the cash distributions. And lately, 100% of your bond ETF’s return has come from interest payments, not price appreciation. Unless you understand that, you might think your ETF has lost money when it’s actually logged a nice gain.

Why bond ETFs fall in price

Most investors understand that bond prices fall when yields rise. What’s less well known is that bond ETF prices will decline steadily even if interest rates don’t change. That’s because virtually all the bonds in a broad-based ETF today were purchased at a premium—in other words, for more than face value. As these bonds mature or get sold, the fund will incur a steady trickle of small capital losses.

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More Power in Passive Portfolios

Rick Ferri and Alex Benke recently collaborated on an interesting white paper called A Case for Index Fund Portfolios, which I introduced in my previous post. They compared index portfolios to thousands of randomly generated active portfolios to estimate the probability of outperformance. Passive came out ahead in about 80% to 90% of the trials, which is compelling enough. But there were some surprises, too. Let’s look at a few of them.

Indexing gets better with age

Ferri and Benke’s paper was novel in that it looked at portfolios rather than individual funds. They found that combining index funds led to greater outperformance than you would expect from examining the funds in isolation. In other words, the portfolios were greater than the sum of their parts. The authors called these factors Passive Portfolio Multipliers, or PPMs

One of these PPMs highlights the importance of taking a long-term view. Ferri and Benke looked at the five-year periods ending in 2002, 2007 and 2012. The first of those periods includes the dot-com bubble, while the last includes the worst market crash since the Great Depression. Not surprisingly,

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