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ETFs are a cost-effective alternative to mutual funds in an RRSP

by Wayne Cheveldayoff, 2007-02-08

Exchange traded funds (ETFs) linked to stock indices are a viable, cost-effective, well-diversified alternative to mutual funds in an RRSP.

ETFs are similar to mutual funds in many respects except for the fact that ETFs are listed on stock exchanges and are priced and traded through out the day. In contrast, mutual funds are priced and traded once a day after market close.

All things considered, ETFs appear to have the edge on investment performance.

Mutual fund managers have a hard time beating the broad stock-market indices to which many ETFs are linked.

For example, in the first half of 2006, only 18.8 per cent of actively managed Canadian equity mutual funds outperformed the S&P/TSX Composite Index, according to Standard and Poorís Indices Versus Active Funds Scorecard (SPIVA) for Canada.

Looking at it the other way around, 81.2 per cent of actively managed mutual funds fell short. This is part of a consistent pattern of underperformance and it obviously raises questions about the value of traditional, actively managed equity mutual funds.

An active manager can beat the index in any given year but few can do it for longer. Over the past five years, only 13.9 per cent of Canadian equity mutual funds outperformed the index.

An important advantage for ETFs is cost. The average annual management expense ratio (MER) for ETFs is usually under 0.5 per cent, whereas the typical actively managed mutual fund MER is around 2.5 per cent (with about two-fifths of that going to pay investment advisors). This 2-per-cent difference is a sizeable drag contributing to mutual fund underperformance.

An RRSP portfolio exclusively of ETFs would not be disadvantaged in terms of diversification. ETFs linked to broad market indices like the S&P 500, Dow Jones or S&PTSX Composite are available.

Nor would investors be limited from playing different sectors or regions of the world. Barclays Global, the leader in ETFs in Canada, offers broad i-shares index ETFs covering almost the entire world, with specific country funds such as for China, Spain, Sweden, Mexico, Brazil, Singapore, Hong Kong, Taiwan, South Africa and so on.

Sector ETFs exist for information technology, biotechs, housing constructors, financials, energy, gold mining, and so on.

Specialized ETFs exist for value, growth and dividend-paying stocks, and bonds and oil sands companies, among others.

Claymore has sponsored the BRIC ETF, which holds shares of companies from four fast-growing economies Ė Brazil, Russia, India and China.

For those interested in clean energy investing, there are several ETFs tracking the stocks of companies involved in solar photovoltaic, biofuels, wind energy and fuel cells. Among these are the NASDAQ Clean Edge US Index, Wilderhill Clean Energy Index, CleanTech Index, and Powershares Clean Energy.

Of course, with almost as many ETFs as mutual funds to choose from, investors need to do extensive research and may need the help of an investment advisor.

Investors can find ETFs listed with commentary at such standard financial websites as Globeinvestor.com, Yahoo Finance, MarketWatch.com, Morningstar and Street.com.

Specialized sites have sprung up, such as www.etf.seekingalpha.com and www.etfguide.com. Investors can go straight to the source for Canadian issuers at Barclayís www.ishares.ca, Horizonís (BetaPro) www.hbpfunds.com and Claymoreís claymoreinvestments.ca.

BetaPro Management recently launched bull and bear ETFs linked to the S&P/TSX 60 Index and set up to produce movements to the upside and downside amounting to double what the index does.

A few ETFs arenít allowed in RRSPs. Canada Revenue Agency rules require ETFs to be linked to stock indices to be eligible. This excludes some that contain gold and silver bullion.

An interest question is why some investment advisors have fully embraced ETFs while others havenít. The answer probably lies with how the advisors want to be compensated.

In the case of traditional mutual funds, the advisor gets a commission for selling the fund and a trailer fee of between 0.5 and 1 per cent a year. This trailer fee is paid directly from the mutual fund company to the advisor.

But while advisors get commissions for buying and selling ETFs, they donít get trailer fees. If the advisor wants to be compensated beyond the buy/sell commissions, the advisor must ask for an annual fee, which leads to a level of disclosure and transparency that some donít feel comfortable with.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.

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©2007 Wayne Cheveldayoff