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By Larry MacDonald
MoneySense
Thursday, April 28, 2005
April 27 was Fee Freedom Day for Canadian mutual fund investors. That was the date, according to Barclays Canada, when the return on deposits in Canadian mutual funds stopped going into the coffers of the fund managers and went into the pockets of investors.
Adrian Mastracci, investment counsel at Vancouver’s
‘fee-only’ KCM Wealth Management, says, "Many mutual fund investors who come in for the first time do not seem to understand the costs.”
Fee Freedom Day for the exchange traded funds (ETFs) offered by Barclays Canada was in January, three months ahead of mutual funds. Looking at the cost comparison in a more conventional manner, the annual management expense ratio (MER) of the median equity mutual fund in Canada was 2.29% versus an MER of 0.17% on Barclay Canada's equity-based ETF, the iUnits S&P/TSX 60 Index Fund.
Yet, Canadians still have billions of dollars invested in mutual funds. Adrian Mastracci, an investment advisor with KCM Wealth Management Inc., reports that many mutual-fund investors who come to see him for the first time do not seem to understand the costs.
This is a reflection that they "do not receive invoices" with their financial statements issued by fund companies. Fees are paid directly from the mutual fund to the fund company. They remain out of sight and out of mind.
In the economics profession, this situation could arguably be classified as a case of market failure: the market failing to provide the optimal allocation of resources due to asymmetries or hindrances in the flow of information. There may be a theoretical rational for government intervention in the form of regulation that requires costs to be rendered more explicit.
What is more likely to happen in Canada is that markets will eventually provide the solution as awareness spreads of the high costs of mutual funds and the cheaper alternative of ETFs. Over time, more investors will switch to ETFs and fewer will go into mutual funds.
The main problem with this process is the length of time it takes. In the absence of facilitating government measures, it could be years before the allocation of savings within Canada come close to the optimal setting.
But one can see the market at work in the increasing number of ETF-based portfolios making appearances in the media (see the MoneySense.ca portfolios) and put forward by financial planners. To date, most are based on rather straightforward buy-and-hold strategies where an amount of money is spread, often in equal portions, over a number of equity- and bond-based ETFs (often with periodic rebalancing to maintain original weights).
Take one of the simplest of these, the One-Minute Portfolio and the One-Minute RRSP Portfolio. A fully diversified portfolio across equities and bonds was created with just two simple transactions: the purchase in prescribed proportions of the iUnits S&P/TSX 60 Index Fund and the iUnits Canadian Bond Broad Market Index Fund (converted in 2004 from the ten-year treasury fund).
The emphasis has been on setting up low-maintenance ETF portfolios requiring as little as an hour or so a year to review and adjust (yet perform just as well as or better than a mutual fund). The amusing names given to these portfolios aptly convey the message that they don't require a lot of time or work (a plus for the average Canadian typically busy with job, family and other priorities):
- Couch Potato (designed by Dallas-based financial journalist Scott Burns)
- Lazy Man's (designed by U.S. money manager Ted Aronson)
- Easy Chair (designed by University of Toronto professor Eric Kirzner)
- No Brainer (designed by SmartMoney columnist William Bernstein)
- Coffee House (designed by personal finance writer Bill Schultheis).
To build more sophisticated ETF-portfolios, investors can tap into other unique features of ETFs, such as the ability to sell ETFs short or trade options on ETFs. Specifically, hedge fund style strategies can be developed to boost overall returns and/or set up market-neutral portfolios capable of delivering absolute returns regardless of the market's direction (unlike the relative returns of the Couch Potato and other lazy portfolios).
One hedge fund ETF portfolio was outlined by option expert Richard Croft. It uses the technique of covered call writing to boost returns on an ETF holding. Croft suggests this arrangement may actually be better than covered call writing on individual stocks because company-specific risks are eliminated.
To set one version up, buy the iUnits S&P/TSX 60 Fund and sell an appropriate number of iUnits 60 call options against the holding (a broker should be able to help you with this). The investor collects income from the sale of the options and the gain in the underlying iUnits fund up to the point where the call options would be exercised.
To set up a market-neutral ETF portfolio, establish long and short positions on various sector ETFs in a roughly balanced fashion. If an investor is successful in going long on the strong sectors and short on the weak ones, they will make a profit regardless of the general direction of the market.
The use of ETFs here may actually be better than the customary approach of using individual stocks to set up a market-neutral position. As in the Croft portfolio, ETFs eliminate company-specific risks and let the investor focus on broader, sector-level trends (which have fewer variables to analyze).
No one, as far as I know, has publicly set out such an ETF portfolio, so let's develop an example here. Let's go long and short in equal proportions on the following iUnit funds:
- Long on the iUnits S&P/TSX Capped Energy Index Fund because the International Energy Agency keeps raising its estimate of world demand for crude oil, indicating prices should remain high and support projections of a 30% to 40% surge in energy sector earnings this year
- Long on the iUnits S&P/TSX Capped REIT Index Fund because the U.S. economy should eventually cool off as the Federal Reserve jacks up interest rates, thus allowing U.S. bond yields to fall — which removes downward pressure on prices for income trusts
- Long on iUnits S&P/TSX Capped Financials Index Fund because the Canadian chartered banks are oligarchic and expanding into new markets, reducing dependence on its interest-sensitive lending business
- Short on iUnits S&P/TSX Capped Information Technology Index Fund because the IT sector is trading at thirty times projected earnings, close to valuations at the peak of the 1990s tech mania
- Short on iUnits S&P/TSX Capped Gold Index Fund because the Canadian gold stocks have a group price-earning ratio near 300 and gold prices tend to falter in an environment of rising real interest rates and a firming U.S. dollar (stemming from recent Federal Reserve monetary policies).
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