ETFs – The New Old Funds

 In The Gratifying Harvest

Today I will tackle the much talked about use of exchange trade funds or ETFs. To listen to the hype, you would think that they were brand new. Well, the first one was introduced in the US in 1993 and Canada followed in 1999. I have been recommending their use since 2001. Hardly yesterday.

Let’s understand them better first. Sometimes the best way to start is to demystify them, so, Exchange Traded Funds ARE Mutual Funds. There I said it. That’s right Mutual Funds. If you understand mutual funds then you understand ETFs. ETFs are Mutual Funds in that they are regulated just like mutual funds, they have a manager and the fund is a structured package of assets. Their main difference lay in that ETFs are listed on the Exchange like a stock and are traded intraday, whereas mutual funds are traded at the end of day only by the fund company. Certainly, the difference is NOT because ETFs track an index and mutual funds do not. Many mutual funds also track the same indices as many ETFs and many ETFs now have active managers. In fact, if you understand index mutual funds, you understand a great deal about ETFs, which until recently were almost all index funds. If you are planning to hold the index security for many years, it will not matter much whether you bought it intraday or end of day, unless it is an extremely unusual day. Traders care, you should not.

We repeatedly hear that ETFs are “cheaper” than mutual funds. This was mostly true in the past because almost all ETFs were index funds and almost all mutual funds had an active manager. It is the active manager and the sales distribution network that makes mutual funds more expensive, not their structure. In fact, we often can find index mutual funds with lower MERs than some ETFs. It is primarily indexing that makes them cheaper. We are also seeing ETFs rise in cost as the sales distributions techniques of mutual funds are applied to ETFs.

So, why do I tell you all this? Before proceeding to understand and evaluate ETFs, you must first understand the passive/active argument and gain an appreciation and understanding of index funds. Your exploration into ETFs is without a doubt taking you on a trip into index funds, so go armed with appropriate and useful knowledge. A manager (active management) costs money. It also requires a sales force to promote the different managers. If I am going to pay more, I need to expect more.

Standard and Poors (S&P) have a scorecard called ‘SPIVA’. Their report for US mid-year 2011 shows that over the past three years, which can be characterized by volatile market conditions, 63.96% of actively managed large-cap funds were outperformed by the S&P 500 index. The five-year results are similarly unfavorable for actively managed fixed income funds, where over 50% of active managers failed to beat benchmarks. In Canada the results are even worse. At 2010 year end, three- and five-year periods, only 11% and 2.5%, respectively, of actively managed Canadian equity funds have outperformed the S&P/TSX Composite Index.

Terrible, but I do not want to overstate the case. Let’s just go with the best case of 50% as a long term average result for both equities and fixed income and see where that takes us. I like to form this problem to my clients as follows: You are interviewing 20 prospective mutual fund managers, each and every one of them tells you that they have the credentials, the training, the strategy and the smarts to beat the index. You know that some are going to be proven right, since it is established fact that the index can be beaten. We do know that some managers can and will beat the market. BUT HOW TO CHOOSE? Without a clear rule or indicator to choose with, you must rely on probabilities. You have less than a 10 in 20 chance of getting the selection right. 10 managers will not beat the index, so you have a 10 in 20 chance of getting it wrong. Neither good or bad odds. What to do? First, realize that you will have to select more than one manager for a diversified portfolio. You may be selecting 6 or more. The problem is also one of making multiple choices. Mathematics tells us that if we make a 1 in 2 choice, 6 times, the odds of getting them all right is only 1.6%. Now we all want to try to outperform the market, but resist. By choosing index funds or index ETFs, you will be right 100% of the time. Those are odds you can understand and embrace. Your final result will be the index less the known imbedded fees, a small tracking error less what you pay for advice. All known costs. Remember, your odds of bettering this strategy are heavily against you.

As I write this, I am interrupted to watch the TSX fall over 500 points. This serves to remind me that when the market goes down, so will any index fund tied to that market. So, do you really want to own index funds or ETFs? The answer is yes, but you must respect them. If you are a long term investor you must pay particular attention to the market conditions at the time of purchase. Remember, your choice is going to just blindly follow its index, good or bad, and you have NO idea which way the market is going tomorrow. So, a simple rule. Do not buy above the long term trend of the fair value of the index being tracked, unless you are going to sell out again soon. In other words, wait unless you are a trader/speculator.

Well, isn’t waiting a form of “trying to time the market”, which we all know cannot be done, since future market results are random and unknowable? True, but what happened to prudence and patience? There is no disputing that the market in the future will fluctuate widely, just as it has in the past. It is its nature. The past fluctuations and the future fluctuations all define a trend line. By definition, there will be results above and below the market trend in the future as well. You are not the market. Success for you will come most easily by buying below the trend, putting most future points above you. You are not staying in forever, you will wish to harvest your wealth for the reasons you saved it in the first place. You will want to do so without worry. So, how do you know it is time to buy and you are below trend? Well, look for the opposite. If everybody is debating whether the market is high or not, it certainly is not low. If the data is fuzzy and the opinions are conflicting, it is probably neither very high or very low. You prefer low. Stop trying to determine if the market is high. If it is cheap, you will know. You might be scared but you will know and it is always coming in the future. Prudence and patience are virtues. Respect them.

Efficient Wealth Management has created a new coaching program called The Gratifying Harvest.  The program helps you enjoy your future by carefully harvesting cash flow from your lifetime of savings or preparing you to do so.  We thought a column devoted to this pleasing idea would be great.

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