A herd mentality

Exchange traded funds (ETFs) have come a long way since they were first launched in the U.S. in 1993. Investors are bombarded with information on ETFs and business news networks discuss ETFs on a daily basis. There are also endless commercials on the Robo-Advisor and the do-it-yourself programs that are all centered on building you a portfolio of ETFs.

Since their debut, there are fewer than $100 billion in ETF assets. “The global ETF market hit a record high of $4.7 trillion under management (AUM) at the end of 2018. There were 6,483 ETFs globally, which was up close to 12% from the previous year.” 1

According to BMO Global Asset Management’s (BMOGAM) annual research report entitled ETF Outlook Report, they anticipate that the global ETF industry will more than double to $10 trillion over the next five years. “The Canadian industry is expected to grow at a faster rate to $400 billion CDN by 2024.”2 “Investors worldwide plowed $516.1 billion into ETFs in 2018. This was down 21% on the $653.6 billion record set in 2017.”3 As of January 31, 2019, there were 679 ETFs with $164.1 billion in assets under administration in Canada according to the statistics from the Canadian ETF Association. “There was an increase of 110 funds from the end of January 2018 to the end of January 2019.”4

Canadian ETFs attracted over $20 billion in new assets in 2018, outselling mutual funds for the first time since 2009.5

In January of this year, the Canadian ETF industry experienced a dramatic shift when the world’s biggest ETF manager, BlackRock Inc., and Canada’s largest asset manager, Royal Bank of Canada, announced they were teaming up to sell ETFs under a single $60 billion brand, entitled RBC iShares.6 CIBC and National Bank of Canada also just recently announced their own ETFs – now all of Canada’s largest banks have entered the ETF market.

The iShares S&P/TSX 60 Index ETF (XIU), which is the oldest ETF in the world and the largest in Canada, has seen selling pressure as investors move to cheaper alternatives and foreign investors turning away from the Canada ETF marketplace. Assets under administration for XIU are down about 30% over the past five years shrinking the ETF to $9.1 billion. Still Canada’s largest ETF, its share of the market is now approximately 5%, down from 25% of all assets in Canadian listed ETFs.7

One of the reasons is that the expense ratio on XIU is 0.18% and the new norm for ETFs is a management expense ratio (MER) of just 0.06%.

BlackRock Inc. forecasts assets to more than double to $12 trillion by the end of 2023 and potentially reach $25 trillion by the end of 2027. There are currently four trends that are likely to continue propelling the growth of ETFs.

Investors globally have become increasingly sensitive to investment costs and are demanding higher quality for lower fees.ETF investors are increasingly becoming active investors rather than passive investors. We will address this issue later on in the article. ETFs are increasingly being used in portfolios to seek outcomes that are different from the broader market. Investors are increasing their use of ETFs as a way of diversifying their portfolios more efficiently.Buying individual bonds for the retail investor has largely become obsolete. Bond liquidity that many institutions once took for granted is evaporating. To facilitate large transactions, investing in a bond ETF is substantially easier and more efficient.Over the last decade, there has been a transformation in the business model for financial advice. Fee-based advisory models are replacing transactional commission rates for individual securities. Companies like Wealth Simple and Questrade are inundating investors with the new trend of robo-advisors.8

The benefits of ETF investing

Lower costs – ETFs usually charge lower management fees and expenses than many other diversified investment options. By purchasing an ETF, an investor avoids the commission costs that would be normally associated with purchasing individual securities.Investment flexibility – Most open-end mutual fund shares are traded only once per day after the market is closed. An ETF can be bought or sold at any time during the course of a regular trading day.Liquidity – Unlike other investments, ETFs allow an investor to buy and sell whenever they choose when the markets are open.Diversification – An ETF can replicate a specific index or any given market sector such as financial, energy, or cannabis. An investor can replicate the S&P 500 by buying SPDR S&P 500 ETF (SPY), which replicates all 504 stocks in one single transaction.9

Active versus passive

Active management is a fund that has an investment management team that is actively investing based on their process and beliefs in an attempt to beat the market or their underlying benchmark. Passive investing is implemented with an ETF, like SPDR S&P 500 ETF (SPY), that tracks an index. Active ETF investing has become popular over the last few years. The debate over active and passive investing has been a subject of controversy for years. 10

Recent television commercials that start with proactive statements about how much of your retirement saves are being lost to fees are on the rise. The reality is that advice has a price. How will your retirement look in the absence of good advice, or in the presence of poor investment management? Lower management fees are of no benefit if the net results to the investor is less than the price of good advice.

There are abundant examples of illustrations and a mountain of charts showing the impact of lower fees. However, it is often the case that investment performance is ignored. It can be easier to understand that paying little or no fee is preferable, but what is harder to illustrate is the value of professional advice that guides clients not only to choose the right investment vehicle, but also to make the tough strategic decisions, especially in times of crisis and opportunity.

At the end of the day, human intellect can add value

When purchasing an ETF, you are basically investing in an underlying index or sector and your performance is going to be closely aligned to that of the underlying market or sector. We are bombarded by the stats of how many active managers don’t outperform the market or their underlying benchmark. The North American market place is inundated with active managers that have failed to beat the market or their benchmarks.

For the ninth consecutive year, ending December 31, 2018, 64.49% of large-cap funds lagged the S&P 500 in 2018.

After 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92% are trailing the index.11

More than 75% of active Canadian large-cap funds failed to beat the S&P/TSX Composite in 2018. Over a three year period, 95% of active Canadian funds failed to beat the index.12

A good Wealth Advisor has the ability to seek out talented investment managers that consistently deliver superior risk-adjusted returns. Here are two examples:

Polen Capital is a third-party equity manager for Verus Financial at National Bank Financial. They are the number one U.S. manager in the world. 30 years ago, if you invested $100,000 with them it would be worth over $6.2 million today. If you bought the S&P 500, your $100,000 investment would be worth slightly over $1.8 million. This chart clearly depicts that human intellect can add enormous value.

Verus U.S. Focus Growth 13

Here is another example:

Verus High Income portfolio 14

Regardless of one’s opinion about the merits of passive investing, we believe there should be little debate that they are essentially “momentum” strategies, systematically buying when money flows in and selling when money flows out. The concern we have as active managers is that, in the next bear market, this passive capital will not discriminate between the high-quality businesses that comprise our portfolios and the lower quantity businesses that we believe populate many of the largest index funds.

“J.P. Morgan also estimates that 90% of current equity trading volume comes from what we view as “trend-following” traders (quantitative trading, index, ETFs, futures and options-related strategies) whose trading decisions are often driven by algorithmic or programmatic reasons rather than fundamentals ones. The remaining 10% is comprised of active traders, i.e. active managers, who act as a natural floor for equity prices because they often buy into share price weakness.”15

Our final concern is one of capitulation when trading decisions are driven by algorithmic or computer trading programs. The next bear market will offer very little protection in our view. One has to look no further than the chart below to see what the new trading reality looks like.

Average stock holding period for NYSE traded securities 16

ETF investing may be popular today however, the next bear market could quite easily impact the current herd mentality.

Ken Gordon PFP, CDFA Director, Wealth Management Senior Wealth Advisor

Sources 1. “Global ETF Industry Set to Double in Next Five Years; Canadian Industry to See Even Faster Growth.” News Releases, newsroom.bmo.com/2019-01-31-Global-ETF-Industry-Set-to-Double-in-Next-Five-Years-Canadian-Industry-to-See-Even-Faster-Growth. 2. “Global ETF Industry Set to Double in Next Five Years; Canadian Industry to See Even Faster Growth.” News Releases, newsroom.bmo.com/2019-01-31-Global-ETF-Industry-Set-to-Double-in-Next-Five-Years-Canadian-Industry-to-See-Even-Faster-Growth. 3. . Flood, Chris. “ETF Growth Sputters after Markets’ ‘Rocky Ride’ in 2018.” Financial Times, Financial Times, 11 Jan. 2019, www.ft.com/content/f536decc-3c8e-3ca5-9ccd-450785e99fa6 4. Zochodne, Geoff. “As Canada’s Big Banks Pile into the ETF Game, Barrage of Options Is Only Growing.” Financial Post, 1 Mar. 2019, business.financialpost.com/investing/etfs/as-canadas-big-banks-pile-into-the-etf-game-barrage-of-options-is-only-growing 5. Zochodne, Geoff. “As Canada’s Big Banks Pile into the ETF Game, Barrage of Options Is Only Growing.” Financial Post, 1 Mar. 2019, business.financialpost.com/investing/etfs/as-canadas-big-banks-pile-into-the-etf-game-barrage-of-options-is-only-growing. 6. Zochodne, Geoff. “Financial Post ‘As Canada’s Big Banks Pile into ETF Game.’” Financial Post “As Canada’s Big Banks Pile into ETF Game”, 2 Mar. 2019. 7. Shufelt, Tim. “The World’s Oldest ETF Is Shrinking.” The World’s Oldest ETF Is Shrinking, 2 Mar. 2019. 8. “Insights – Four Big Trends Driving ETF Growth: IShares.” BlackRock, www.ishares.com/us/insights/etf-growth. 9. “Benefits of ETFs.” Fidelity, www.fidelity.com/learning-center/investment-products/etf/benefits-of-etfs. 10. Basinger, Craig, et al. Market Ethos “The Latest Market Insights from the Richardson GMP Team” “Active vs. Passive” Richardson GMP . 25 Mar. 2019. 11. BobPisani. “Active Fund Managers Trail the S&P 500 for the Ninth Year in a Row in Triumph for Indexing.” CNBC, CNBC, 15 Mar. 2019, www.cnbc.com/2019/03/15/active-fund-managers-trail-the-sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html. 12. So How Did Active Canadian Fund Managers Make out in the Plunging Markets of 2018? You’re about to Find Out.” The Globe and Mail, 3 May 2019, www.theglobeandmail.com/investing/markets/inside-the-market/article-more-than-75-per-cent-of-active-canadian-funds-failed-to-beat-equity/ 13. Polen Capital Focus U.S. Growth Fund (UNCITS.” Polen Capital, www.polencapital.com/strategies/growth-ucits/. 14. Verus High Income.” Verus Financial, www.verusfinancial.ca/verus-portfolios/verus-high-income/. 15. “Investment Commentary, Webinars, and insights.”Polen Capital, www.polencapital.com/insights/. 16. Russel Investments, The Telegraph</strong=””>