Should you invest in an ETF?

"Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees. Those following this path are sure to beat the net results [after fees and expenses] delivered by the great majority of investment professionals."

– Warren Buffet, 1996 Chairman’s Letter to Shareholders of Berkshire Hathaway

Written by Steve Nyvik, BBA, MBA ,CIM, CFP, R.F.P.

Financial Planner and Senior Portfolio Manager, Lycos Asset Management Inc.

Originally Published January 2016 on "You and Your Money" at Money.ca

The quote above from Warren Buffet illustrates how market index ETFs have become a highly regarded way to invest. In this article we'll learn about ETFs, their advantages and disadvantages, the market-cap index ETFs versus Fundamental ETFs, and how ETF investing can make sense.

What is an ETF?

An Exchange-Traded Fund (ETF) is an investment fund listed on a stock exchange, which is designed to track the yield and return of a stock market index or sub-index, a bond index or a commodity (we call this the “benchmark index”). The ETF trades like a stock where you can buy or sell units throughout the day while the exchange is open.

An ETF can be based on a broad market index, such as the Dow Jones Industrial Average, the S&P 500 Index, or the S&P / TSX 60 Index, or based on a sub-index such as an industry sector (like consumer staples, consumer discretionary, energy, financials, healthcare, industrials, information technology, mining and metals, telecom, utilities), market capitalization (micro-cap, small-cap, mid-cap, large-cap and mega-cap), investment style (value versus growth), geography (eg. Canada, United States, Europe, Asia, Emerging Markets), and combined (small-cap U.S. growth, large-cap Canadian value), and commodities (like gold).

The ETF fund attempts to replicate its benchmark index by owning assets (which can include stocks, bonds, commodities, foreign currency, futures contracts) which might be in similar proportions to the benchmark index. Depending on the liquidity of the index underlying investments, the ETF may not necessarily own exactly all of the constituent investments of the benchmark index.

The main difference between ETFs and other types of investment funds is that ETFs don't try to outperform their benchmark index (like most mutual funds); they just try to replicate the benchmark index performance.

By mimicking an index or commodity, the management fees tend to be low compared to actively managed investment funds – like mutual funds where the manager attempts to outperform his or her benchmark index. The ETF manager makes only minor periodic adjustments to keep the fund in line with their benchmark index.

The appeal of an ETF is that most active managers tend to underperform the market, so by buying an ETF, you’re eliminating "managerial risk". Your returns are tied to the market where your return will equal the benchmark index less ETF management fees and expenses and the tracking error.

To keep the ETF Fund market price close to its Net Asset Value and to ensure liquidity for the ETF units, many ETFs act as, or employ, a market maker.

ETF Advantages and Disadvantages

The key advantages of ETF investing over an actively managed fund are:

• Elimination of manager risk. The risk of an active fund manager underperforming compared to the benchmark index is eliminated. Instead, the ETF fund return is tied to the market.
• Lower costs. The management cost of an ETF is significantly lower than an actively managed fund.
• Tax efficiency. ETFs tend to have lower turnover of investments than an actively managed fund. As such, there is less accrued gains that are being realized resulting in a greater amount of tax deferral. In addition, open market trading of ETF units has no direct effect on the underlying portfolio and no tax consequences on other unitholders. This is unlike mutual funds, where trading of fund units might trigger capital gains if enough investors redeem their shares all at once and force the manager to sell off securities to raise cash. ETFs are similar to owning individual securities in that the trading activities of short-term holders will not have a tax impact on the long-term investors. ETF redemptions are typically placed by institutional holders and ETFs have a process to allocate capital gains from those redemptions directly to the redeeming counterparty, instead of affecting all unitholders.
• Transparency and Intuitiveness. With most ETFs, all of the holdings are disclosed on a daily basis for investors and portfolio managers to see. This disclosure provides the composition of the ETF and helps assess the attributes it offers when adding the respective ETF to a portfolio. So you know at any time what the ETF fund holds. Market indexes are also widely reported so you know how you're doing. With an actively managed fund, you don’t know from one day to the next what changes are being made in the fund and if the fund manager is sticking with their discipline and style of investing.

The key negatives of ETF investing are:

• Transaction Commissions. The purchase and sale of ETF units is a commissionable transaction over the market. The commission paid can erode the low expense advantages of ETFs. This can have a great impact when regularly buying or selling a small amount of units. Further, if the ETF has a wide bid-ask spread, this additional acquisition cost may make market index mutual funds more attractive;
• Underperformance. Buying a basket of all items for sale (like a broad stock market exchange traded fund) doesn’t carry any guarantee that you’ll do better than those experienced buyers that are selective in what they buy and the price they pay. In a market index, you end up getting: (i) a lot of crappy investments (poor quality businesses), (ii) investments that are over-priced (poor value businesses), (iii) big positions in a small number of investments (poor diversification in managing company risk; this occurs as most market indexes are market capitalization based), and (iv) too much industry concentration (as many country economies are not well diversified).

In addition, market cap-weighted indexes automatically increase their exposure to securities whose prices have gone up and reduce their exposure to securities whose prices have gone down. As a result, they overweight overvalued securities and underweight undervalued securities.

What About Fundamental Indexing (or Smart ETFs)?

Fundamental indexing is the creation of an index that’s not based on buying an entire market of market segment, industry or sub-industry. Instead the investments are chosen based on fundamental criteria such as high dividend yield, low price to earnings, low market price to cashflow, or low price to sales.

You would need to look to the specifics of the construction of the ETF to understand how investments are selected and their weights.

Some potential negatives of Smart ETFs include:

• greater volatility than buying a market index ETF like the S&P 500 Index Fund;
• there can be more transactions with the re-balancing and more tax cost;
• there can be a material bid-ask spread to buy or to sell such an ETF. In times of market stress, the spreads can be extremely wide resulting in an inability to exit a position;
• they tend to be more expensive than a market index ETF.

However, if the ETF is well-designed, then the added cost of the attention of a person to manage the ETF is justified. Such key factors include:

• the selection factors have a logical relationship to improving earnings or other factors that lead to an increase in a company’s value,
• that the selection factors are statistically meaningful, and
• better returns and/or lower risk is found over several business cycles in backtesting.

My Own Preference – Disciplined Value Investing

My personal preference is instead to sift through stocks looking for statistically significant characteristics with a cause and effect relationship with market price – like a high dividend yield. I’d then take the surviving list of companies and screen out stocks that are over-represented in one industry, screen out poor quality businesses, screen out those that don’t generate enough earnings to pay the dividend, and screen out those businesses that use too much debt. From the surviving list of companies, I would prefer to invest an equal dollar amount in each. In essence, I prefer to manage investment risk beyond what many fundamental indexes do.

The advantages of creating your own smart ETF include:

• you save the management expense ratio;
• you control the timing of the realization of gains and losses;
• you decide which investments you feel comfortable with (like to avoid certain companies that invest in arms, cigarettes, etc. or to avoid a company you work for),
• you decide what are the most relevant factors in selecting companies;
• you can stick to the largest and most dominant companies to lower downside risk;
• you can stick to the best dividend yield payors to build a pension to meet your living needs without touching capital; and
• a much narrower bid-ask spread if you look to buy or sell individual stocks versus an ETF that is not managed by a market maker to ensure liquidity; and
• an ability to buy or sell at better prices than the fund/ETF using limit orders over time at good prices;

When an ETF Makes Sense

If you have less than $100,000 to invest in equities (so you can buy at least 20 stocks at $5,000 each to make the cost of establishing a portfolio reasonable), then ETF investing can make good sense in order to achieve appropriate diversification.

ETF investing may also make sense where you are seeking specific exposure to a bond or stock market exposure or a segment of such market. For example, you might seek exposure to: preferred shares, high yield bonds, a country like the German stock market, a core equity in a broad market index like the S&P 500 Index or MSCI World Index, exposure to real estate, infrastructure, hedge funds, etc.

Lastly, ETF investing makes sense for unsophisticated investors where one doesn't feel comfortable to build your own portfolio or where you are not sure that a manager can either outperform the market and/or reduce market risk.

If you are making periodic savings or periodic withdrawals, then a no-load mutual fund might fit better than an ETF to save on transaction commissions. (I use a no-load fixed income mutual fund to deposit interest and dividend payments and for making periodic monthly withdrawals).

I also recommend a no-load mutual fund for receiving monthly savings over an ETF. There are now some mutual funds that have a low-MER comparable to ETFs which invest in an index and thus are superior to an ETF for monthly savings. Such index mutual funds avoid the market commissions that one would otherwise pay for regular buying of ETFs.

ABOUT THE AUTHOR  Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P. is a Senior Portfolio Manager with Lycos Asset Management Inc. – an independent investment management firm located in downtown Vancouver, BC, Canada. Steve focuses on building income portfolios to meet family retirement needs and provides financial planning so that if ‘life happens to you’, your goals aren’t derailed in the process. He has been in the investing and financial planning profession since 1992. Steve can be reached at 604-288-2083 Ext 2 or toll-free at 1-855-855-9267, or by email at steve@lycosasset.com.