If you’re investing outside of tax-sheltered accounts like RRSPs and TFSAs, you need to choose your investments carefully—otherwise you risk giving a big slice of your returns to the good people at the Canada Revenue Agency. Today we’ll look at ways to create a tax-efficient index portfolio using some innovative ETFs.

Swapping dividends for capital gains

In Monday’s post, I explained that Canadian dividends are not always as tax-advantaged as people believe. Capital gains are not only taxed at a lower rate in the highest tax brackets, but investors can also control when to take them—dividends, on the other hand, are taxable in the year they’re paid, even if you reinvest them.

Horizons’ swap-based ETFs—which I wrote about here—were designed to address this issue. They use a type of derivative that allows investors to earn the same return as the index, without collecting any distributions. Dividends paid by the companies in the index are reflected in the fund’s return, but all of the growth is characterized as capital gains and deferred until the fund is sold. There are currently just two funds in the family: the Horizons S&P/TSX 60 (HXT) for Canadian large-cap stocks, and the Horizons S&P 500 (HXS) for US large-caps.

The tax advantage is especially large for HXS, because dividends from US companies are fully taxable, while capital gains are taxed at half that rate. Consider this: if you held the iShares S&P 500 Index Fund (XSP) in 2011, you received $0.24 per share in cash dividends, a yield of about 1.6%. At the highest tax bracket, you would have lost almost half of that to taxes, reducing your return by about 80 basis points. If you held HXS instead, you would have received a similar 1.6% price appreciation instead, and you would have paid no tax. If you eventually sell the fund at a profit, you’ll pay tax on only half the gain.

Forward thinking

Claymore’s Advantaged ETFs—read a detailed description here—use forward contracts that “recharacterize” bond interest or foreign dividends as capital gains or return of capital (ROC). Unlike swap-based ETFs, which pay no distributions, the Advantaged ETFs are design for investors who want current income.

Return of capital is the most tax-efficient of all distributions, though it’s not a free lunch. ROC is not taxed in the year it’s received: instead, it lowers your adjusted cost base, and if you sell your shares at a profit in the future, you’ll incur a capital gain. So you’re not getting truly tax-free income—you’re really just getting your own money back—but you are generating tax-deferred cash flow. This document from Claymore explains the idea.

You can see why ROC is preferable to bond interest, which is fully taxable. In 2011, the Claymore Advantaged Canadian Bond (CAB) returned 6.8%. Roughly half of that came from price appreciation, while the other half came from distributions. However, unlike every other bond ETF, those distributions were return of capital, not interest. So you would have collected that entire 6.8% return without a tax bill.

Before you get too excited, there are downsides. All of the 2011 distributions from Claymore’s Advantaged ETFs were return of capital, but that won’t always be the case. In 2010, for example, CAB’s distributions were all capital gains. These would have been taxable—albeit at only half the rate of bond interest.

More important, the Advantaged ETFs have considerably higher costs than plain-vanilla index funds, which will lower their pre-tax returns. Those added costs offset some of the tax savings, and may even wipe out the advantage altogether. For example, both the iShares DEX Universe Bond (XBB) and BMO Aggregate Bond (ZAG) returned well over 9% last year—dramatically outperforming CAB. Even if you lost half your interest income to taxes, you might still have been better off with XBB or ZAG.

If you’re out of RRSP and TFSA room, you could use these ETFs to build a reasonably well diversified and tax-efficient portfolio of Canadian stocks (HXT), US stocks (HXS) and bonds (CAB). In some years—including 2011—you’ll have no tax payable at all. Just spend some time researching these complex products first, and don’t invest in anything you don’t understand simply because you think you’ll save some tax.

H&R Block software giveaway

Speaking of tax, the folks at H&R Block have offered to give away copies of their DIY tax software to five lucky Canadian Couch Potato readers. To enter the draw, leave a comment below or tweet this post to your followers before midnight EST on Sunday, January 29. I’ll announce the winner next Monday.

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.

Announcements in the ETF world are mostly tedious these days—usually they involve the launch of another exotic and increasingly narrow new product. That’s why yesterday’s announcement that BlackRock is buying Claymore Investments was a shocker. I’m not the only one who didn’t see that coming.

BlackRock, of course, is the parent company of iShares, the largest ETF provider in Canada, with about $29 billion in assets—about 75% of the market. Claymore’s family of ETFs and closed-end funds currently have about $7 billion under management. Together, the two families will be a powerhouse in the ETF space in this country.

It’s way too early to tell what this will mean for Canadian investors, but overall I expect it will be a positive development. I’ve always liked Claymore’s entrepreneurial spirit and its desire to innovate. For example, the company was the first to create preauthorized contribution plans that allow investors to add money to their holdings each month without incurring trading commissions. Their recent partnership with Scotia iTrade—which makes all Claymore ETFs available with no brokerage commissions—was also a game changer that prompted Qtrade to follow suit. (Claymore’s DRIP program, in my opinion, was not as innovative or as significant as often believed.)

But as refreshing a presence as Claymore has been, I think BlackRock will take them to the next level. The iShares products are probably the most prudently managed ETFs in the country, with consistently low tracking errors, even when the funds are small. I’ve also found them to be among the most transparent and straightforward firms to deal with as a journalist. The Claymore ETFs are now in good hands.

Opposites attract

In some ways, the two ETF families are unlikely allies. iShares was among the pioneers in the industry more than a decade ago, and they’ve remained steadfast in their position that traditional indexing—plain vanilla, cap-weighted funds that track third-party benchmarks—is still the best solution for investors. Claymore, on the other hand, has been a vocal critic of cap-weighting and the leading Canadian proponent of RAFI fundamental indexes.

But the ETF industry is changing, and both companies recognize that. Investors already have access to plenty of low-cost traditional index ETFs, so there’s little room for growth in that area. The only way a new player could compete in the traditional ETF space would be to lower fees even more. That’s what Vangaurd has done with its Canadian launch, but they are the only company with the size and influence to pull that off. No one else is going to be able to compete on price.

BMO is competing with superior distribution: they have an army of advisors (most of whom have little or no interest in passive portfolio strategies, by the way) selling their products—and they’re doing that extremely well. RBC looks poised to do the same. Meanwhile, other ETF providers will have to compete with each other by offering more and different product choices.

With that in mind, Claymore and iShares are actually a perfect fit. Although they have 82 ETFs between them, there is almost no overlap. I can’t think of a single ETF that is an obvious candidate to be closed or merged with another as a result of this merger. While many asset classes are covered by both Claymore and iShares products, the funds usually track use very different indexes and strategies.

Index investors will be watching with interest as this one unfolds over the next few months.

The Couch Potato strategy thrives on simplicity, but advanced index investors (geeks) should understand what goes on under the hood of ETFs. One of the most important concepts is how ETF shares are created and redeemed. I’ll warn you that this gets a bit technical. But it turns out that this process is the single most important difference between ETFs and index mutual funds.

Let’s begin by looking at how a mutual fund creates new shares (or units). When you make a $2,000 contribution, your money goes directly to the mutual fund’s manager, who uses it to buy more securities. If the fund’s net asset value (NAV) per share is $20, the manager then creates 100 new shares ($2,000 ÷ $20) just for you. This is what’s meant by the term open-end fund: the number of units changes every time money moves in or out.

Closed-end funds, by contrast, do not create or redeem new units. They are launched with a finite number of shares, and if you want to invest in the fund you have to buy your shares from another investor who is willing to sell.

An open-ended discussion

ETFs trade on an exchange like closed-end funds, but they are open-ended: new shares are created to meet investor demand. Unlike mutual funds, however, ETFs do not create new units every time money flows in.

Instead, whenever necessary, ETF providers issue a large block of shares called a Prescribed Number of Units (PNU), typically in multiples of 50,000. The providers then work in partnership with third-party “designated brokers,” or DBs, who distribute these units to the public. A new ETF might be launched with 200,000 units, for example, and several DBs would  divide these up and sell them on the secondary market. Going forward, when invetsors want to sell their units, the DBs are obliged to buy them back at a price very close to their net asset value.

(Geeky footnote: ETF providers south of the border use different terminology. If you’re reading American books or websites, PNUs are called creation units, and designated brokers are called authorized participants. Feel free to share this fun fact with your friends and coworkers.)

When you purchase $2,000 worth of an ETF trading at $20, the DB will simply fill your order with 100 shares from its inventory. However, if an institutional investor wants to buy $2 million worth of shares, the DB will not have enough inventory. So it will credit the investor’s account for 100,000 shares and simultaneously purchase $2 million worth of the fund’s underlying holdings. Then the broker will deliver that basket of stocks or bonds to the ETF provider, who will create 100,000 new shares and send them to the DB as payment.

That wasn’t so hard, was it?

Redeeming qualities

This creation-redemption process may be complicated, but it has a couple of important benefits.

First, if the ETF is selling at a premium, a designated broker can buy the fund’s underlying securities and simultaneously sell shares of the ETF, thus making a risk-free profit. (If it is selling at a discount, the DB can do the opposite.) This presents an arbitrage opportunity, and when multiple DBs compete with each other to profit from it, the result is that the ETF’s price stays close to the NAV. That, of course, is exactly what investors want.

Second, the process prevents buy-and-hold ETF investors from being penalized by active traders. An inherent problem with mutual funds is they must always keep cash on hand to pay investors who redeem their shares, and this uninvested money is a drag on the fund’s returns. Worse, when investors sell in droves (such as during a market decline), the mutual fund has to liquidate holdings to pay them, which can mean forced sales and tax consequences for the fund’s other investors. ETFs never have to do this: if investors flee, the designated broker can just return blocks of shares to the ETF provider and receive the underlying securities in exchange. Because this is an “in-kind redemption” and not a sale, there is no taxable event.

For more information about the nuts and bolts of ETF construction, I recommend All About Exchange-Traded Funds, a new book by Scott Paul Frush (McGraw-Hill, 2011).

Here’s another excerpt from my recent interview with Atul Tiwari, Dennis Duffy and Joel Dickson of Vanguard. These questions focus on the types of products we might see from Vanguard in the future. You can read also read Part 1 of the interview here.

Your first family of ETFs have all been plain vanilla funds that track major third-party indexes. What new products are on the horizon?

AT: We’re in the development and design stage for the next suite of ETF products that we’ll launch next year. Before we make any decisions about what those will be, we want to be in the market, talking to clients, talking to advisors, and then we will try to reach a conclusion about the next tranche.

The interesting thing that we have come across in terms of how to bring passive investing to Canada is that the index mutual fund market in Canada is pretty small. It’s concentrated in a few issuers and products that really don’t get much prominence. So we have seen indexing growing in Canada, but clearly the vehicle of choice is ETFs. The growth in the ETF market has been 30% or 35% per year, and predictions are $105 billion by 2016.

The main reason index mutual funds are not popular in Canada is that they’re way too expensive. So it seems to me there is a huge opportunity for someone to come in and grab that space.

AT: We have to start somewhere. You alluded to this idea when you asked about what we are bringing other than passive ETFs that already exist elsewhere, and we obviously think that it is not just low-cost. Our ETFs are the low-cost leaders in the market now, and we all know that low costs are important. But we also are bringing the thought leadership and the education.

The other big difference is our ownership structure: we are a client-owned organization, and we really do put clients first. We are all about continuously finding ways to lower our own costs so we can lower the costs of our investments for clients, and that’s unique. It’s not just unique in Canada, it is unique globally.

Can you explain how Vanguard’s ownership structure works, because there is a lot of confusion around that. I have heard Vanguard described as a nonprofit company, for example, which is clearly not accurate.

AT: The way it works is that in the US, the clients of Vanguard own the funds and ETFs,  and in turn the funds and ETFs own the management company. So we are not a public company, but we’re not a private company either in the classic sense of being owned by a family of shareholders. It’s more like a mutual. We are a for-profit company, but we give all the earnings back to clients in the form of lower expenses.

JD: The management company derives profits from its activities, and those profits are paid to the owners, who happen to be the investors in the US funds. Instead of being paid as a dividend, it is paid in the form of lower expense ratios.

Many investors have asked whether Vanguard will offer US and international equity ETFs without currency hedging.

DD: We have thought about it and I can tell you it is definitely something we are considering when we look at what we will be rolling out in the second tranche. We have done that in other jurisdictions, where we have offered both hedged and unhedged versions. So that’s definitely something we have looked at and will give it some consideration.

Vanguard offers a family of target retirement funds in the US. There seems to be few of these available in Canada, and I have a theory about why. If an advisor says to a client, “I’m going to put you in this target date and we won’t need to switch for 25 years,” the first thing the client is going to say is, “Then why the heck am I hiring you?”

JD: Even among advisors who buy into our philosophy, target date funds are not a huge seller, because advisors do view their job as asset allocation. Even if it is long-term strategic allocation, they want to build that for you rather than having it pre-packaged like a candy bar you buy in the store. So that is a hurdle. We get a lot of questions about how we might create target date funds out of our ETFs, but it’s just not clear what the distribution would be for a product like that.

DD: Much of the appeal of our target date funds has been in the retirement segment, for defined contribution investors. We just launched a series of target date funds in the UK, and that is also something we are looking at as we consider future opportunities in the Canadian market, where there is a huge number group RRSPs and defined contribution plans.

One of the alarming trends in Europe is the move towards synthetic ETFs. Is there any plan to move away from the physically backed ETF model that Vanguard has made its bread and butter?

DD: If we look at what we have launched in the US, the UK, Australia and Canada, having full-replication, asset-backed securities, as opposed to swaps, makes a lot more sense. I would never say never, but it is definitely not the direction that we are planning to go in.

JD: We have 35 years of experience managing physical, full-replication index funds, and that works great in large, liquid, diversified markets. There could be a role for synthetics in hard-to-access markets, where there might be some liquidity issues—where there might be restrictions on your ability to access those markets. Synthetic by itself is not the issue: it is how you negotiate the swap contracts.

When Vanguard announced its arrival in Canada this summer, investors welcomed the company with open arms: perhaps no country would benefit more from Vanguard’s devotion to low-cost investing. The company’s first Canadian ETFs started trading on the TSX on December 6.

On the day of the launch, I had the pleasure of sitting down with Atul Tiwari, managing director at Vanguard Investments Canada; Dennis Duffy, Vanguard’s director of business development for non-US markets; and Joel Dickson, a principal in Vanguard’s Investment Strategy Group.

Here are some highlights from the interview dealing with Vanguard’s overall strategy in Canada. Later this week I’ll run another excerpt that focuses specifically on the new ETFs and Vanguard Canada’s plans for the future.

Why did you decide to enter the Canadian market with ETFs rather than mutual funds? And why did you target advisors rather than retail investors?

AT: Having looked at the Canadian market for at least 14 or 15 years, Vanguard considered a number of different entry strategies. The reason we executed now is that the Canadian marketplace is changing. We are seeing a lot more advisors moving from a commission-based approach to a fee-based approach, and that fits in squarely with the Vanguard model. We don’t pay for distribution anywhere in the world, so to enter the Canadian market with mutual funds would be kind of tough, because it is a very commission-oriented business.

About 20% of advisors’ overall business in Canada uses a fee-based model, whereas in the US it is about 65%. Canada is probably where the US was about eight years ago. The other thing is, there are a lot of regulatory changes going on globally. By the end of next year, commissions will essentially be banned in the UK. Same thing in Australia. In the US, they are discussing the fiduciary standard for brokers, and even the OSC [Ontario Securities Commission] has said recently that they are going to consider a fiduciary standard. So with a little help from the regulatory changes, we think we will be well-positioned.

What were some of the uniquely Canadian challenges that you faced? For example, low-cost, direct-sold mutual funds are extremely popular in the US, but investors in Canada haven’t really embraced them.

AT: You’re absolutely right: a number of companies have tried, but direct-sold funds just haven’t caught on in Canada. And a lot of that is because mutual funds are sold and not bought. We haven’t got any plans to launch mutual funds at this stage, but that is not to say that in the future we won’t. We entered the market with the product that we thought would be the best entry point for Canada, and that is ETFs.

One of our other challenges—and certainly one of the key components of our Canadian strategy—is investor education. We will be doing a lot of thought leadership, a lot of seminars—we will do whatever we can to get the message across to investors and advisors about the effects that costs have on your returns over the long run.                                  

Index investors are well aware of the benefits of low costs. But how do you make that case to advisors?

DD: This has been a challenge for us in every market. Even before ETFs, we had a pretty significant advisor business in the US, but the fee-based business was a relatively small percentage of the overall market back in the early 2000s. We went into the UK prior to the legislation banning commissions: we felt there was enough fee-based business there, and we were willing to make the commitment. We are very patient company: look at how long it took us to get into Canada! But there is a lot of education that is going to be needed.

JD: It’s important to recognize that the advisor’s compensation doesn’t need to change at all [if they start using Vanguard ETFs]. Even if they are getting 1% or 1.5% or whatever for their services, we would hope that there is an opportunity to lower fund costs: if you can show 24 basis points with your ETF holdings as opposed to another 1.5% on underlying mutual funds, that’s a huge benefit.

Yet many advisors—and their clients, for that matter—continue to insist that active management is part of their value-added, despite overwhelming evidence to the contrary.

JD: That is a key issue: the value-added model has been disrupted. We talk about a concept we call advisor’s alpha, which is to say, how do you as an advisor position your value to clients in a world where it is not about picking the best funds, or the best managers? It’s about focusing on things you can control, like costs, and risk, and taxes and behaviour.

The problem is, these things are sometimes hard to measure. Some of the best “performance” an advisor could have provided came when the client called them up in the depths of the market in 2009 saying, “Get me out now!” and the advisor said, “Remember our overall asset allocation for the long run?” That doesn’t show up on your statement as the performance of your portfolio versus some benchmark. But if the investor would have sold out on their own, there is huge value added.

No new models yet

Many readers have emailed to ask me whether I will be updating my model portfolios with the new Vanguard ETFs. I’m not planning to do that just yet—for a couple of reasons.

First, the funds have been trading for only a couple of weeks, and while I have little doubt that Vanguard will do a good job keeping tracking errors and bid-ask spreads low, I would like to wait and see.

Second, Vanguard Canada’s US and international equity ETFs use currency hedging, which I have avoided in my model portfolios. It is possible that Vanguard will eventually launch unhedged versions of these ETFs, at which point I would be more likely to incorporate them.

I am resisting the urge to tinker with the model portfolios every time new ETFs are launched. However, this time next year I will re-evaluate the marketplace, and it’s likely that I’ll make some changes to the portfolios to reduce their cost.

Quicken winner

Thanks to everyone who entered the draw for the copy of Quicken Home & Business 2012 money management software. The lucky winner is Chris, who contributes some of the wisest comments on this blog. Congratulations!

The BMO Canadian Dividend ETF (ZDV), launched last month, is unusual among dividend ETFs in that it does not track an index. Instead, it follows a “rules-based methodology” to screen stocks according to yield, dividend growth and payout ratio.

Last week, I asked whether ETFs really need an index in order to play a role in a passively managed, low-cost and low-turnover portfolio. Instead of tracking a traditional third-party index, can an ETF’s fund manager simply draw up its own set of quantitative rules and accomplish the same thing? If I had to make that argument in court, I’d build my case this way:

Many indexes are not transparent. Let’s all agree that transparency is paramount in a passively managed fund. But we should acknowledge that many well-known indexes are not particularly transparent.

Few people question whether funds tracking the S&P 500 or the Dow Jones Industrial Average are passive. And yet, although the major criteria are public knowledge, the companies in the S&P 500 are selected by a committee. The DJIA is even more of a black box—there’s nothing at all transparent about how this granddaddy of indexes is built. Just because your ETF tracks a third-party index doesn’t mean that you can understand exactly how the holdings are determined.

The fund provider may be determining the strategy. In the olden days, index funds all tracked well-known third-party benchmarks, many of which had been around for decades. But many new ETFs track indexes that were commissioned by ETF providers themselves.

Claymore’s bond ETFs are a good example, as are several of BMO’s equity funds, including the BMO Dow Jones Canada Titans 60 (ZCN). Dow Jones has long managed a family of Titans indexes that track the large-cap market in various countries, but I don’t think it’s a coincidence that the index for Canada has 60 stocks (the same number as the S&P/TSX 60), nor that it was launched in May 2009, three weeks before ZCN started trading.

The point is that even if a third party creates the index, the ETF provider may still be the one making the decisions about the overall strategy.

Index licensing is expensive. Any time an ETF or index fund uses a third-party benchmark, it pays a licensing fee. Fund companies are tight-lipped about how large this fee is, but according to a recent Reuters article, it is typically one-tenth to one-third of the overall management fee. In most cases, that would be somewhere between three and 18 basis points.

When the ETF’s investing strategy is straightforward, you have to wonder whether it really makes sense to pay an index licensing fee. The BMO S&P/TSX Equal Weight Banks (ZEB) is the most glaring example: it holds equal amounts of the big Canadian banks, and that’s it. Does one really need to hire Standard & Poor’s to divide by six? Couldn’t the fund save its investors several basis points by getting rid of the index?

For what it’s worth, the index-free BMO Canadian Dividend ETF (ZDV) is currently the cheapest dividend fund in Canada, with an MER of 0.40%, including HST.

Indexes still have value

I’ve laid out these arguments because I want investors to make sure they understand the subtleties. I do think it’s possible for a fund to be transparent, passively managed and maybe even cheaper without a third-party index. But I also believe that an investor considering an ETF with no index needs to ask some pointed questions:

Is the methodology fully explained? Indexes don’t guarantee full transparency, but they certainly help: many providers do publish thorough explanations of how their indexes are built. The description of the stock-picking criteria used by the BMO Canadian Dividend ETF (ZDV), by contrast, is extremely vague. All we’re told is that stocks are chosen based on “the three-year dividend growth rate, yield, and payout ratio” and that “securities will also be subject to a liquidity screen process.”

By comparison, the index-tracking Claymore and iShares dividend ETFs use methodologies that are explained in much greater detail by S&P and Dow Jones, respectively. If BMO were to provide a more meaningful description of its strategy, and they could ensure that the manager is not at liberty to stray from these rules, then I would consider ZDV a passive fund. But we’re not there yet.

Who’s benchmarking the fund’s performance? The most useful measure of an index fund’s performance is its tracking error, or the difference between the returns of the index and the actual return achieved by the fund. The iShares Dow Jones Canada Select Dividend (XDV) returned 12.82% in 2010, compared with the index’s return of 13.32%. As an investor, I know that the tracking error of –0.50% is identical to the ETF’s fee, which means the fund was managed almost perfectly.

How will investors measure the performance of ZDV? Even if the fund is transparent about its methodology, it will be impossible to know how well the managers executed that strategy. An index provider does more than just draw up a methodology: companies such as S&P and Dow Jones also compute and publish the returns of their indexes monthly and annually, which holds ETFs accountable. There’s a lot of value there—certainly it’s worth paying a few basis points for that benchmarking.

I’m not ready to jettison the idea of passively managed funds that don’t track an index. But it’s too early to accept them uncritically. For now, at least, I believe there’s just too much potential for things to go wrong when no one is looking.

This post is the second of three that will look at the potential risks that ETFs may pose to the stability of financial markets. Last week I discussed synthetic ETFs, which use derivatives called swaps to get exposure to their underlying indexes. Now we’ll examine leveraged ETFs.

Leveraged ETFs are designed to provide double or triple the daily return of their underlying index. The Horizons BetaPro S&P/TSX 60 Bull+ ETF (HXU), for example, promises twice the daily return of the popular large-cap Canadian equity index. If the index goes up 2% during the day, HBP will return 4%, and if the index loses 2%, the ETF’s return will be –4%. In the US, some providers even offer triple-leveraged ETFs, such as the Direxion Daily Large Cap Bull 3x Shares (BGU), which delivers three times the daily return of the Russell 1000 index.

A related family of products, called inverse ETFs, move in an opposite direction to the market. If Canadian large caps lose 2% in one day, the Horizons BetaPro S&P/TSX 60 Inverse ETF (HIX) will gain 2%, and vice versa. Many inverse ETFs also use leverage: they may rise 4% when the their index declines 2%, for example.

The problem

Since leveraged and inverse ETFs appeared in 2006, critics (myself included) have argued that these products are potentially harmful for individual investors who may not understand their risks. For an even-handed discussion of these risks, see Dan Hallett’s comprehensive report.

But the recent concerns about leveraged ETFs do not centre around poorly informed individuals. Rather, the US Securities and Exchange Commission is investigating whether these products have played a role in creating extreme market volatility, especially the huge swings we saw in early August.

Although these concerns have been around for a while, they got a boost from an influential October 10 article by New York Times writer Andrew Ross Sorkin. The piece included an interview with hedge fund manager Douglas Kass, who argued that “at the end of every day, leveraged ETFs have to rebalance themselves by buying and selling millions of shares within minutes to remain properly weighted.” This flurry of trading, the article suggests, causes huge swings in the market during the final minutes of each trading day.

What Canadians need to know

Leveraged and inverse ETFs are primarily speculative products that have no place in a long-term investor’s portfolio. But there is simply no compelling evidence that these products pose a systemic risk—that is, that they cause market instability that affects all investors. Sorkin’s article offers nothing but vague suspicions: “Ask any hedge fund manager what their gut says,” is all we get. Let’s consider the other side of the argument:

They’re a tiny blip in the markets. Leveraged ETFs account for a mere 3% of total ETF assets in the US, while inverse ETFs make up another 2%, a market share that a Morningstar analyst called “a grain of sand on the beach.” It is hard to imagine that their rebalancing trades could be a primary cause of daily price movements. “Rather than focusing on leveraged ETFs’ supposed role in boosting market volatility, a more relevant examination would include options, futures and other financial products that increase leverage in the system, the analyst added,” says ETF Trends. “The size and scope of these markets dwarf leveraged ETFs.”

The tail doesn’t wag the dog. At the US Senate subcommittee hearing on October 19, Eric Noll of the NASDAQ presented an analysis showing that “trading in ETFs varies roughly in proportion with overall trading in the market. When news breaks and market prices move, trading volume increases in both the ETFs and the underlying stocks.” In other words, ETFs are responding to market volatility, not causing it. A Credit Suisse report echoed this argument: “We believe it’s a case of confusing correlation with causation.”

The world economy has a few other issues. Those who blame a tiny segment of the securities market for the recent market volatility seem to have forgotten that there are some serious macro issues in the world. As Eric Noll argued in his testimony: “Restricting or eliminating the [ETF] business will not solve the sovereign debt crisis in Europe, will not balance the US budget, will not restore bank balance sheets, will not add jobs, and will not repay consumer debt and get them spending again. There are very large, very real uncertainties that are driving global financial market volatility.”

If ETFs—leveraged or otherwise—are found to be contributing to market instability after a thorough investigation, I will be the first to support increased regulation. Until then, I’m inclined to echo the words of Dave Nadig of IndexUniverse. “There’s a big difference between being a niche, complex and sometimes misused product and being a threat to modern capitalism,” he writes. “Leveraged and inverse funds aren’t for everyone. In fact, they’re not for most people. They’re expensive, complex and require constant monitoring if held for more than a day…. But these funds aren’t the progenitors of some sort of global collapse.”

Not so long ago, ETFs were simple and transparent. But with the tremendous growth in the industry, ETFs have not only become more numerous, but also more complex and opaque. A number of influential bodies—including the International Monetary Fund, the Financial Stability Board, and the US Senate—have expressed concerns about how ETFs might damage the global financial markets. As a Canadian ETF investor, should you be worried about the funds in your portfolio?

In a series of three posts, I’ll take a look at the major concerns and try to give some perspective, with a specific focus on Canadian ETFs. Let’s kick off with a look at the new breed of “synthetic ETFs.”

The problem

Synthetic ETFs use a derivative called a total return swap to get exposure to the indexes they track. The ETF provider enters into a deal with a counterparty (usually a bank) who agrees to deliver the precise return of the index, minus a fee. While the swap structure has many potential benefits—including lower cost, smaller tracking error, and tax efficiency—it also introduces counterparty risk. If the bank fails to deliver the promised returns of the index, investors in the ETF may suffer losses.

To mitigate this risk, regulators require the counterparty to post collateral. If the counterparty were to default on its obligation, the ETF provider would have a claim to the collateral, and investors who redeem their shares should receive full market value. But there are several potential problems:

• The bank’s collateral may be assets that are illiquid or of low quality. If the ETF provider has to sell this collateral in order to redeem shares during a period of financial turmoil, it may be unable to do so.

• Some of Europe’s biggest providers of swap-based ETFs are banks (such as Deutsche Bank and Société Générale), and their counterparties may be the asset-management arms of those same banks. There are potential conflicts of interest here: for example, a bank may find it convenient to use its most illiquid assets as a basket of collateral for one of its own ETFs.

• At least half of all European ETF assets are now in synthetic products, and all of that counterparty exposure may create a systemic risk. If all of the banks have derivative agreements with one another, one counterparty failure could trigger a domino effect, as it did during the mortgage meltdown.

What Canadians need to know

Despite their popularity overseas, there are only two swap-based ETFs in Canada: Horizons S&P/TSX 60 (HXT) and Horizons S&P 500 (HXS), both of which use the National Bank of Canada as the counterparty. With the above risks in mind, consider the following:

• While it is certainly possible that a major Canadian bank could become bankrupt, most people would consider that risk remote. If you would buy stock in National Bank, you should feel comfortable buying an ETF backed by the bank’s credit.

• Horizons and National Bank are not unaffiliated: National Bank Financial owns 20% of AlphaPro Management, a division of Jovian Capital, Horizons’ parent company. Clearly all the parties have an incentive to monitor each other’s financial health to protect their interests, but investors should be aware of the relationship. Ideally an ETF provider should use more than one counterparty to spread out the risk, and Horizons has said it plans to do this when the ETFs grow large enough.

• Under Canadian mutual fund regulations, counterparty exposure cannot exceed 10% of a fund’s assets. This means that even if the counterparty did fail, the worst-case scenario is that an investor would recover 90% of the index’s current value.

• The collateral provided to Horizons consists of high-quality, liquid money market instruments. In the unlikely event of a counterparty default, there should be no difficulty in selling this collateral to redeem the shares of the ETF.

• Horizons’ two swap-based ETFs have a total of just $325 million in assets, less than 1% of the Canadian ETF market share. If there is any concern about the overall counterparty risk in the Canadian financial markets, ETFs are a drop in the ocean.

If you’re interested in learning more about how synthetic ETFs works, Horizons has produced a clearly written educational report. But if you’re intimidated by the whole idea, or if you think they’re too risky, then don’t use HXT or HXS in your portfolio. Stick to traditional ETFs that hold the stocks in the index directly, such as the iShares S&P/TSX 60 (XIU) and the iShares S&P 500  (XSP). It’s as simple as that.

The concerns about synthetic ETFs are legitimate, but they are mostly problems for European regulators to sort out. Unfortunately, if there is a financial crisis triggered by synthetic ETFs overseas, you will be affected no matter what you hold in your portfolio. Let’s hope the regulators do their jobs effectively.

ETFs are on the hot seat these days. On Wednesday, a US Senate subcommittee held a hearing to consider the idea that ETFs are contributing to volatility and instability in the financial markets. This is pretty serious stuff. How did the humble ETF, once hailed as the most investor-friendly innovation in decades, become the target of such suspicion?

The brouhaha can be traced back to September 2010, when a little-known investment firm called Bogan Associates wrote a white paper called Can An ETF Collapse?, which got enormous media attention. One CNBC stock-picking guru reviewed the report and referred to ETFs as “a monster that will wreak havoc.” But almost immediately, the Bogan report was criticized as “wildly off the mark and highly irresponsible.” Credit Suisse exposed the report as specious.

Two months later came another alarmist report from the Kauffman Foundation, which argued that ETFs are distorting financial markets and presenting dire systemic risks. Within a day of its release the report was called out for its conflicts of interest and its “serious misunderstanding of how ETFs work.” Media outlets such as IndexUniverse and Forbes wrote scathing rebuttals, and a couple of weeks later the foundation released a revised version with most of the inflammatory claims watered down.

Yet despite their shoddy arguments, both the Bogan and Kauffman reports were highly influential. I received several emails from readers who wondered if they should be worried. Earlier this year, iShares Canada told me they were still getting phone calls every day from investors who were concerned that ETFs were going to trigger the next financial crisis.

Should you be concerned?

Although these two reports were thoroughly debunked, some of the concerns about the growing ETF industry do have merit. Several other reports released this year have raised the possibility that certain complex ETFs might potentially contribute to instability in the financial markets. Unlike the sloppy Bogan and Kauffman documents, these were prepared by people who actually understand how ETFs work:

• Global Financial Stability Report: April 2011, International Monetary Fund (see page 68)

• Market structures and systemic risks of ETFs, Bank for International Settlements

• Potential financial stability issues arising from recent trends in ETFs, Financial Stability Board

• ESMA’s policy orientations on guidelines for UCITS Exchange-Traded Funds and Structured UCITS, European Securities and Markets Authority

The concerns raised in these reports—and in the heated discussions that have followed them—can be boiled down to three important issues:

• the growing complexity of synthetic ETFs (which use derivatives called swaps rather than holding assets directly) and the risk that the swap counterparty could default

• increased volatility and market instability caused by ETFs that use leverage

• the potential dangers of excessive securities lending, whereby ETF providers earn additional revenue by lending the portfolio’s stocks to investors who sell them short

Next week, I’ll look at each of these concerns one by one, and I’ll do my best to explain how relevant they are for Canadian ETF investors.