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Individual investors show little interest in exchange-traded funds

by Wayne Cheveldayoff, 2004-03-04

Exchange-traded funds are a rapidly growing segment of the investment market. But while they have caught on with institutions and active traders, there hasnít been widespread interest on the part of individual investors.

A key reason for this is that most investors want their funds managed by a professional money manager Ė not put on an index auto pilot as would be the case with exchange traded funds (ETFs).

This was made clear in a recent survey by the Investment Funds Institute of Canada. When investors were asked for the top reasons why they put their savings in mutual funds, 90% said they wanted their money managed by a professional.

The other reasons were diversification, ability to invest small amounts regularly, receiving advice from an investment advisor, ability to get the money out quickly and knowledge of what the investment is worth everyday.

This may also explain why in the United States, where ETF acceptance is more advanced, ETFs account for only 2 per cent of the entire mutual fund industry.

ETFs have characteristics that are similar to equity mutual funds Ė both types are a diversified basket of stocks.

Most ETFs have been set up to mimic the performance of a stock exchange index. The ETF holds all the stocks of the index and it is traded on an exchange just like a company stock.

The first U.S. ETF, the SPDR 500 Trust, tracking the S&P 500 index, was introduced on the American Stock Exchange in 1993 as a way to allow investors to buy one security that covered the entire S&P 500.

There are now 120 EFTs with more than US$130 billion in assets trading on U.S. exchanges. They cover various U.S. indices, including the Dow Jones Industrial, and various sectors and international equity markets.

In Canada, there are 16 ETFs. Barclays Global Investors Canada offers a series of 12 iUnits covering the broad S&P/TSX Composite index, the large-cap S&P/TSX 60, a variety of component indexes for energy, financials, golds and real estate, an international index, and 5 and 10-year Canada bonds. TD Bank has four, also covering the main TSX index and growth and value styles.

A key advantage of ETFs is the low administration cost to investors. There is a cost to purchasing ETFs just like there is with any company stock. That could amount to as low as $30 for discount trading customers to a minimum of $100 or $125 for those dealing with full-service brokers.

But ETFs have annual management expense ratios (MERs) that are a fraction of those of equity mutual funds, mainly because they donít pay for active managers and trailer fees to advisors and have lower promotion costs.

MERs in Canada range between 0.25 and 0.5 per cent a year for ETFs versus 0.75 to 1 per cent for no-load index mutual funds offered by the chartered banks and an average 2.75 per cent for actively managed equity mutual funds.

Another advantage of ETFs is liquidity. Since they trade on a stock exchange like any stock, investors can buy and sell ETFs anytime throughout the day. You can even short them. By contrast, equity mutual funds can only be purchased on the basis of the dayís closing price.

Tax considerations also come into play. ETF holders are very seldom hit with capital gains while equity mutual fund managers can trigger significant capital gains through active trading.

One drawback for retail investors is that since ETFs are purchased through a broker, investors must pay commissions every time they buy and sell. For those holding for the long-term, this is not really a big factor, although for those wanting to do dollar-cost averaging by contributing small amounts like $100 to $500 on a regular basis, mutual funds would be more cost-effective.

While ETF investing has primarily appealed so far to institutions and active traders, some fee-based advisors (who charge a fee directly to clients) have also made use of them. If you know what you are doing, it is possible to build a diversified portfolio with ETFs.

Some investment strategists have argued that ETFs should be given serious consideration by individual investors, especially as a low-cost way of achieving diversification and as an alternative to a broad-brush equity mutual fund where the manager tends to choose stocks that make up the index anyway.

They note that the majority of actively managed equity mutual funds underperform the broad index in any given year and, especially over the longer term, the high MERs of actively managed funds can exert a drag on performance. With ETFs that mimic the broad index, investors can at least be assured of getting very close to the same return as the index.

However, in the case of sector investing, the arguments for ETFs are somewhat less convincing. In the case of gold and energy, for example, an active manager can make a major difference in performance by being very successful in picking stocks. There are many examples of actively managed portfolios beating sector indices by a wide margin.

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©2004 Wayne Cheveldayoff