The Evolution Of ETF

Private Wealth Canada staff writer Karen Treml recently had an opportunity to discuss exchange traded funds (ETFs) with Barry Gordon, president and CEO of First Asset Capital.

Private Wealth Canada: Perhaps you could start with a brief description of exchange traded funds (ETFs) in Canada.

Barry Gordon: Interestingly, the very first ETF was here in Canada and it was called TIPS, the Toronto Index Participation Units. That was back in 1989, I believe. Most people credit the SPDRs done by State Street as the first, but it was actually the second. The earliest ETFs were very simple and useful tools for tracking a market. They were all capitalization weighted which means the representation in the index and in the ETF was proportionate to the size of the total value of equity outstanding of a company. In other words, the bigger the company, the bigger the weighting. Then you saw a proliferation of ETFs that were tracking those broad market indices. That is what I will refer to as simple market capitalization weighted beta. Beta essentially just means tracking the risk and return of a particular index. If you have perfect beta to an index, it just means your ETF should track exactly. What you saw then was people looking to the investment universe and saying ‘okay, we have tracked these broad market indices, what about sub-indices and sub-sectors?’ Then you saw a proliferation of ETFs that were tracking, say, the energy sector and the real estate sector and so on, again on a capitalization weighted basis. Next you saw the advent of different ways to weight indices, so you saw a proliferation of equal weighting strategies. With academic research saying over time that equally weighting is a good way to mitigate the risk – with capitalization weighting you are affording too much weight to overvalued companies and too little weight to undervalued companies – you saw proliferation of equal weight strategies, again, for all the indices and the sub-indices. Laterally, what you started to see was the advent of ETFs that track single commodities or currencies, and that type of thing. When you come to the modern era, this is the advent of intelligent beta or different ways to order an index or weight an index based on more fundamental factors. Where that all springs from is just saying ‘we know that ETFs are useful tools for tracking index or strategies, so why not look at creating indices based on style?’ So, for example, you could have a value type index where you are weighting companies based on their fundamental analytics such as price-to-book or price-to-earnings. Now you are seeing a proliferation, which I think is a natural evolution, of strategies that include several different types of fundamental factors in weighting stock, in choosing stocks to include in an index and the weighting thereof. Some more popular ones might be the RAFI ones, which are fundamental indexation. They weight stocks, among other things, on the basis of dividend yield and certain other value parameters. The evolution in the market has gone from basing indices and weighting the constituents on the basis of market capitalization, to choosing constituents and weighting them on the basis of more fundamental factors – you are trying to capture certain factors or indices of value that are not imbedded in the notion of capitalization. Just because a company is big, does not mean it is necessarily good. It can be big for a whole number of reasons and just because it is big now, it does not mean it is going to get bigger. For intelligent beta, modern indices and the more modern ETFs are looking to combine the best elements of traditional indices – the rules-based approaches to take human emotion and discretion out of the equation – with the best aspects of active management, those value based screens or quantitative based screens that help you uncover stocks that are poised to outperform what is just implied by their size. So that is the equity market summary. I mentioned you have this whole evolution of ETFs which are more tools than long-term investment strategies. You have the ETFs that track individual commodities or currencies or provide levered daily returns on the up side or down side. Those are really what I call trading tools. They are tools that facilitate portfolio management.

PWC: What are the advantages of these?

BG: There are a number. ETFs democratize the investment process in many respects. Instead of having to trade futures on oil and gas and other commodities, you can buy an ETF which, in turn, does that for you. It provides access to investments where otherwise you would have to have a very specific type of expertise to invest. It simplifies the access to it. It does not necessarily mean people should always be doing it. The catch is that ETFs, because of their simplicity and ease of use, sometimes provide access to very sophisticated tools such as volatility and levered commodities, which really are not necessarily for the average investor. Those are great institutional tools. They are great hedging tools, but some people use them inappropriately. That would be a disadvantage – not even a disadvantage, but a risk that people should be aware of. As with any other investment, you have to understand what you are buying. There was a period of time where people were buying these two-times exposure to oil, but they did not realize that it was to the daily price of oil so if you hold that over a longer period of time, that volatility can actually kill you – oil could have gone up 20 per cent, but the ETF could actually be down. If you do not understand exactly what it is you are buying, then there are risks as with any investment.

PWC: What about the fixed income ETFs?

BG: Fixed income ETFs have lagged behind in their development mostly because of the opacity of the fixed income markets. Equity markets are extremely transparent. They are all exchange traded. You see the price, you see the bid/ask. It is all very, very transparent to the user. Fixed income markets are over-the-counter markets so an average person cannot see what the bid/ask and transaction prices of individual bonds are. That is the nature of the bond market. Particularly in Canada, it is a completely opaque market. Enter ETFs, which are wonderful tools to provide access to bond indices or strategies. We are just seeing the advent of different types of bond strategies beyond simple size weighted exposure to broad bond markets. That is largely because the market is, and has been, traditionally opaque. There is no transparency. It is more difficult to actually evolve ETFs in that space, but it is happening. If you think about it, fixed income ETFs are incredibly useful tools both for individuals and institutions to get access to bond markets on a liquid, relatively transparent basis.

PWC: Is there a natural trend toward sophistication?

BG: If you look at the marketplace, it is not revolutionary, it is certainly only evolutionary, and it reflects the broader marketplace. The notion that active management can actually outperform is not new. So, if you are using the tools that active managers use to sift through the universe of stocks for good value, but you do so on a low-cost basis, it really should not be a surprise to anybody that the market evolves in that direction. It just makes sense that what you are going to see is people trying to take the best things that ETFs have to offer ‒ that liquidity, transparency, rules-based, unemotional decision-making ‒ with the best things that active management has historically brought to the table – which is looking for value, looking through the universe of stocks, screening for fundamental things that imply that a stock is a good one and is poised to outperform the market. It is just the marriage of those. I think the market is going to double in size and we are going to see more intelligent indexing products. We are going to see more actively managed ETF products and when I say actively managed, I mean people actually making decisions in ETFs. I think we are going to see continued growth in the fixed income marketplace as well.

PWC: Do you see ETFs having appeal to Canadian institutional investors?

BG: Canadian institutions are big users of ETFs already. They are huge users of ETFs that are traditional broad capitalization weighted because if you think about it, the performance of pension funds and institutional investors is often measured against a benchmark. So their benchmark is often the index. If nothing else, they will invest free cash balances in indexed ETFs in order to minimize their tracking error. That is natural. They also use these ETFS to get core exposure to different markets. Where we are going to see the most growth in ETF use is actually in the advice channel in Canada. Historically, advisors in Canada and elsewhere, but in Canada in particular, have not really known how to implement ETFs into the portfolio management and portfolio construction process because they fear that implied in buying the index is a lack of advice. Advisors have historically been concerned with that as well – ‘if I am just buying the index, then my client is going to ask why are they paying me for advice if you are just buying the index.’ That is where intelligent index ETFs are particularly powerful tools.

PWC: For someone who is very new and has not dealt with ETFs, where would you recommend they start?

BG: First of all, they have to start by understanding how ETFs work. At base, they are very simple investment vehicles. For the most part, they invest directly in the underlying investments that are the constituents of an index and they trade on the stock exchange. Their value at any given time is a reflection of the actual value of the underlying investments. The more liquid the underlying investments are, the tighter the spread will be. If the bid/ask spread on an ETF is $10 to $10.03, the underlying investments ‒ let us say there are 30 stocks in the underlying index ‒ the aggregate average of their bid and ask will be, let us say, $10.01 to $10.02. That difference between the two is the market maker who tries to make a penny on the trade. That is the difference between ETFs and, say, mutual funds or other types of equity investments. You have a market maker who is there constantly making a bid and offer on the ETF. Make sure you understand how they work and then, in terms of suitability of individual ETFs, every investor is different. They have different risk profiles. If someone is using an advisor, then talk to the advisors about the use of ETFs and the advisor should be able to help them in formulating and constructing a portfolio of ETFs that fits their needs. As with any other investment, you need to understand exactly what it is you are investing in and you need to match up the investments with your risk profile and your needs.

PWC: Would an ETF be considered more of a short-term or long-term investment?

BG: There are two types of ETFs. There are ones that are more trading tools and then there are the ones that are investments. I do not view the commodity space and the levered up and levered down ETFs as long-term investments. Those are trades. However, the broad index ETFs, the style based intelligent index ETFs are long-term investments. You buy those because you believe in the methodology. You want exposure to that marketplace and they are either core holdings or they are part of the explore portion of your portfolio, but they serve very specific long-term functions.

PWC: So if somebody had a TFSA within mutual funds, would you recommend switching to ETFs?

BG: Not necessarily. There are people who say mutual funds bad, ETFs good. That is not my view. My view is that different investments are right for different people. Some people want and need mutual funds with the comfort of knowing that somebody is overlooking their investments and that it is not subject to trading on the exchange where you could get price swings. They are very simple and they are very good for some people. ETFs on the other hand, are good for a lot of people as well. As a firm, our view is that it is our job to put together the best investment products for all investors. So, we have mutual funds, ETFs, and closed-end funds.

PWC: Does it fluctuate at all with age?

BG: It really just depends on who you are, what your needs are, and what your investment profile is. ETFs are for a person who is looking to get exposure to the markets on a low cost transparent, rules-based basis. What you see is what you get. It is predictable. If you are somebody who wants the manager who is using leverage or is making very concentrated bets on stocks in an effort to generate significant outperformance on the up side and outperformance when markets go down, maybe you are better suited for active management and mutual funds.

PWC: What would be the profile of the individual that fits into being a perfect ETF investor?

BG: The perfect ETF investor is not dictated by size of investment portfolio because you could have an investor with a lot of money or a little bit of money. It is one who wants low-cost, transparent access to equity or bond markets, equity or bond strategies, or specific commodities on a rules-based basis. It is somebody who is not looking for discretion, for somebody that is looking at the portfolio and making judgments and investment decisions on a day-to-day basis.

PWC: Going forward really long-term, what do you see as the future of ETFs?

BG: I would see the ETFs being long-term. Let us start with the mutual funds. Mutual funds are not going away. Let us say there is approximately $800 billion in mutual funds in Canada. That is going to grow significantly because they are very good tools. What we are going to see though is mutual funds becoming what they are supposed to be which is actively-managed funds where people are expressing views on stocks and markets and bonds as opposed to getting paid to be closet indexers. You are going to see ETFs fill that more passive space. Over time, we should expect to see very fast growth of the ETF market, to the point where long-term you have almost the same type of investment in mutual funds as you have in ETFs.

PWC: In a timeline prediction …

BG: It is hard to look beyond 10 years. It is not going to happen overnight. It is a gradual process, but I would say somewhere between 10 and 20 years.

PWC: Do you see ETFs changing over that time?

BG: You are going to see more participants in the ETF marketplace as it grows and matures, like any industry. There are natural barriers to entry in terms of cost because you actually have to make a real investment in an ETF platform. It is not something that you do without significant financial resources. And the marketplace will continue to expand and evolve. I kind of chuckle when people say is pretty crowded. Well, there are five or six of us. It is not that crowded. It looks crowded because there has been a lot of very good press about ETFs, but the opportunities are huge.