The Electronically Traded Fund (or ETF), was first introduced to Canada in the 1990s. Since then, especially within the last few years, the market has seen a dramatic increase in the number of ETFs and correspondingly heightened interest in them from investors.
In 2006 there were about 700 ETFs in the world. By the middle of 2017 there were over 5,000. This article will look at what this investment vehicle is meant to do, the pros and cons of what they have to offer, and how they compare with actively traded mutual funds.
How they work
Traditionally an ETF is a security that trades like a stock and is designed to use a passive investment strategy that tracks, as closely as possible, a market index. These indices can range from the very large (like the S&P500, or the Global Bond Index), to ones focused on a specific sector within the market (technology, real estate, energy, or small market capitalization stocks). Still, others will track a geographic market such as Japan, the UK, or Canada. As a passive investment, ETFs will do as well, or as poorly, as the underlying index because it purchases securities included in the index proportionately to reflect the index. For example, if a stock represents 5% of the total within an index, you will find 5% of the ETF invested in that stock.
Pros and Cons of ETFs
One of the advantages of an ETF is it allows investors to create a more diversified portfolio without having to purchase a large number of individual securities. A single ETF, much like a mutual fund, can hold within its portfolio dozens, hundreds, or even thousands of individual securities. The first challenge with this method is that the ETF is required to buy the good securities with the bad. This makes ETFs prone to market fads. For example, by 2000 Nortel was worth over 30% of the entire Canadian stock market. An ETF that tracked the Canadian market at that time would be required to own 30% of Nortel and when the stock eventually crashed, the ETF suffered accordingly.
The second major advantage is often relatively low costs. Since the ETF employs a passive investment strategy (in other words, the ETF is not expected to do better than an index) it does not require a management team. The fees will therefore usually be lower than those of mutual funds. The assumption is that over time active investment managers cannot outperform the market. This brings us to the second challenge faced by ETFs: even the lowest cost ETF cannot outperform an index. By design it is meant to mirror the index, not beat it. This means ETF owners will always underperform that index due to imbedded fees and trading costs.
So, the questions we must consider are: can human management add value to the process of selecting good quality stocks? If they can, then how do we find those managers that have demonstrated that they can outperform? These are the questions we will consider below.
Actively Managed Mutual Funds
Like ETFs, mutual funds are an investment vehicle that allows an individual investor to own a diversified portfolio of securities that will help them achieve their investment goals. For us at CHF, we consider a mutual fund to be actively managed if it does not mimic an index. That being said, we will compare the performance of the manager against an appropriate index to determine if that manager is producing either a higher rate of return, net of the funds fees, or a lower level of risk (ideally both at the same time!). Put simply, it is a core conviction of our firm that management matters. Just as successful companies and organizations cannot successfully operate for very long in an “auto-pilot” mode, neither can well constructed investment portfolios. The risk of following the herd or getting caught in market fads and bubbles presents too great a danger. We rely upon the tools, processes, experience, patience and emotional calm of our managers to both protect our clients’ wealth and to generate better returns than could be achieved through passive buy and hold strategies.
As we noted with ETFs, the process to determine which securities to hold is built to replicating the composition and performance of an index. The fund is not expected to deviate from that index, nor should it.
By contrast active managers use their training, experience and beliefs to add value by creating tools and processes that will separate the better stocks or bonds from the weaker ones. As one example, in an index the biggest players will typically have the highest weighting within an index. RBC is much larger than Canadian Western Bank (CWB), so would have greater weight in a stock index. The question of RBC being a better value than CWB is much different and requires careful evaluation and comparison. Mutual fund managers conduct this evaluation and decide how much of each of these companies to include in their portfolio, not based solely on size but also on which stock is offered at a better price compared to its underlying value.
The same is true in a bond fund. For example, Italy is the fourth largest government borrower in the world but their bonds may not be as good a value as those of another country. In an index Italy would have a large weighting simply because it has borrowed a lot of money. By contrast, in a mutual fund the manager may decide that Italy presents more risk than he wants to have within his portfolio and it may be absent from his fund completely.
Just as we at CHF seek to help our clients stay calm during highly emotional times, our investment managers do the same when looking at which securities to buy. It is always tempting to go along with what everyone else is doing and buy the latest “hot” stock idea or investment theme. History is filled with all sorts of bubbles that ended up costing investors large portions of their wealth (think of the Tech Bubble of the 1990s, or the US real estate bubble in the mid-2000s). Indexes will, by definition, follow these trends as each new bubble grows. Our managers help protect our clients by minimizing their exposure to these fads.
No less importantly, a manager can have the courage to look for value where other investors fear to go. Stocks don’t necessarily decrease in value because the company has performed badly. Good stocks can, and do, fall out of favor for all sorts of reasons. Exceptional fund managers are able to find undervalued stocks to add to their portfolio, helping our clients keep and grow their wealth.
Whether ETFs or mutual funds are right for a specific client will depend on a number of factors, but most importantly, the investor needs to decide if they believe it is possible for good managers to do better than the market as a whole. For us at CHF, we remain convinced that the “human” element still matters. Managers, using their experience, discipline and processes can add real value both to companies and to portfolio construction. Therefore, we at CHF will continue to seek out those mutual fund managers that demonstrate a proven track record of outperforming indexes.