Thursday, October 13, 2011

ETFs Reach Adolescence

The Canadian exchange-traded fund (ETF) market has reached adolescence, and hair is starting to grow in funny their chins.

What’s that smell?

The Canadian ETF market has matured with sufficient size ($45 billion) and momentum (30% annual growth) to get the attention of the major banks. According to BNY Mellon, the U.S. ETF market will double through 2015 - and Canada’s could match it. Banks and investment companies smell profit potential, and a chance to protect and grow their retail base despite massive books of profitable mutual funds.

They may also fear others will crowd them out of a lucrative market that is, apparently, here to stay. Heavy hitters RBC and Vanguard have declared their intention to enjoin iShares, Bank of Montreal, Horizon Beta/AlphaPro, Claymore, a newcomer to Canada, Invesco, and rookie XTF Capital Corp. in the battle of sponsoring ETFs here. A major Korean fund manager’s interest in BetaPro Management confirms the stakes are changing. Deep pockets and sophisticated distribution are changing the landscape.

Where did those come from?

Unlike early plain-vanilla indexes that got simple ETF wrappers, competing sponsors now race to represent different asset classes, occasionally using derivatives to replicate them. Regulators are concerned these structures may lead to another subprime crisis, or a “flash crash” like in May 2010. The Financial Services Authority (FSA) in the UK is considering banning swap-based ETFs from retail use altogether. The FSA is the UK’s version of Canada’s cluster of securities commissions. These products offer an exciting array of tools to enhance and enable new methods of portfolio construction, but registered representatives need to understand the underlying composition of all ETFs not only to use them effectively, but to manage the liability if a structure goes bad.

Why voices need to deepen

Blindsided by collateralized mortgage products, regulators are determined to prevent similar problems with ETFs. Although prospectus disclosure has been the regulatory focus for retail products, veteran fund executive Paul McKenna of One Financial reminded me that ETFs trade in the secondary market where prospectuses are available but issuance to buyers is not mandatory. Most registered reps know that prospectuses are a legal crutch few people read. Regulators need to rethink the principles and practicality of disclosure in a digital age and speak to consumers with a new voice. Perhaps making all advisors fiduciaries is part of the answer.

Will the ETF market grow up to look like the mutual fund market?

Duplication is costly and confusing, yet every mutual fund family feels it needs at least an equity, fixed income, and money market fund. ETFs compete for market share based upon a different and more useful set of metrics. Sponsors market ETFs based upon index construction, liquidity, diversification and other risk characteristics rather than how a manager happened to outperform his or her benchmark last year. While the conversation has been elevated to issues that really impact portfolios, it’s not as much fun as talking about whether RIM’s quarter will beat analyst expectations. However, getting money into investors’ pockets through lower costs is a powerfully persuasive pitch.

Each bank may want a complete stable of asset classes for their clients, but there may not be enough room for a seventh or eighth ETF based on the S&P/TSX 60. Watching RBC and Vanguard position their Canadian equity offerings will be interesting.

BMO’s ETF launch in 2009 signaled the return of banks to a space vacated by TD in 2006. Critically, taken with RBC’s filing of eight target maturity fixed-income ETFs this summer, the product category has been validated. Vanguard, the dominant index fund player in the U.S., will launch a series of funds in Canada by year-end. This is important and intriguing because Vanguard’s reputation for delivering straightforward passive products at low cost will challenge everyone. Will there be a refocusing on passive low-cost ETFs, or will active strategies finally gain traction?

Waiting for the swelling to go down

ETFs represent only 6% of Canadian mutual fund assets - a rounding error. Unquestionably, ETFs offer investors more effective, low-cost delivery of capital market exposure than mutual funds. Only two things stand between the consumer and a superior product: smarter investors and the entrenched investment advisor. Because information is ubiquitous, investors are getting smarter. Savvy RRs are already using ETFs and as clients get better informed, other advisors will follow. Peer pressure works in trading rooms as well as high school lunchrooms. Advisors sitting at the end of the bed waiting for the ETF swelling to go down are being left behind.