Exchange Traded Funds: A once efficient investment tool Jumps the Shark-Part 2

A couple of months or so ago, I commented on one of Canadian Couch Potato's blogs that discussed an article in the Globe and Mail by Fabrice Taylor claiming that ETF's are more costly than a managed portfolio. I took the position that if I had a choice of building a portfolio of well managed businesses that generated strong returns on capital, combined with clean balance sheets or a "managed" ETF that I would take the former. I forgot that I was taking this position on a forum that was pro-ETF and so I got slammed by the community. My claim is that traditional, vanilla ETF's aside (I prefer those and they make wonderful investments for long-term investors who are not interested in following the day-to-day neuroticism of the market), the latest generation of ETF's are becoming nothing more than slickly marketed closet mutual funds which charge higher fees and yield sub-par returns.

I tried to illustrate this through an example, but network hiccups prevented me, so I thought I'd post them as a blog. In my example, I looked at investing in an ETF that covers the Canadian equities.

For arguments sake let's say I'm looking at the Horizons Betapro suite of ETF's. Here are my options for investing in the S&P/TSX60 index:

HXT Horizons BetaPro S&P/TSX 60™ Index ETF
MER 0.07

There's also an US$ equivalent. HXT.U (Same MER 0.07) (Prospectus states Trading Expense Ratio of 0%)

Appears to be the traditional/vanilla/passive ETF

HEW Horizons S&P/TSX 60 Equal Weight Index ETF
MER 0.50

Both these ETF's seem to be passive in nature, but the MER is noticeably different. This is the "morphing" I speak about. It doesn't have to be an ETF changing its investing style. More often and from my experience, it's easier to just crank out another product.

Then there are the active ETF's that you can still go long the index

HXU Horizons BetaPro S&P/TSX 60™ Bull Plus ETF


MER 1.15% (Prospectus states 1.36%, Trading Expense Ratio 0.60%)

 

From the prospectuses, it appears all 3 ETF's employ a combination of direct investing in the index components and through derivatives (swaps etc).

 

So there you have 3 ETF's from the same company, essentially doing the same thing which is mirror the performance of S&P/TSX60 index. The "morphing" is from the traditional HXT security to now HEW and HXU. 10 years ago the choice was clear and simple.

 

For people in this (forum I was commenting on), I'm sure you all can filter out the noise, but do you expect an average person who isn't as street smart to see this difference? This is what concerns me about ETF's now and how anyone could get skewed to something that may not be their interest. Forget about risk tolerance, investment objectives, time horizon, and tracking error right now. I just want to have Canadian equity exposure in my portfolio. The options are just not as clear-cut as they used to be.

I'm just using Horizon in this example. I'm sure if you go to other vendors there's a similar type of offering. We haven't even got into currency hedging and all that other wonderful stuff.

This is just Canada. Imagine what it's like when you venture out into the US or international!

I'm not trying to bash the whole ETF concept. I like them. I use them. The reality is that the game has changed and there's more marketing and spin around them now. They are not as simple as they used to be and so investors need to be aware of this and ask questions and dig into the details. This site (Canadian Couch Potato) is doing a great job of looking under the hood and calling the vendors out. I guess I'm just more old school in that the best value for money for me is the traditional vanilla brand ETF. Simplicity always wins with me.

Now if you get into the active managed ETF's and ask me to choose one of the 2 options below with a goal of NOT beating or outsmarting the market (because you can't do that consistently over a long period) but simply "trying" to earn a consistent long-term rate of return for equities

Option 1: Pick an actively managed mutual fund/ETF

Option 2: Building my own portfolio of high quality companies that I've researched and analyzed according to the fundamentals of business, quality of earnings and balance sheet and are selling at a discount.

I would take Option 2. That's just me. I don't expect everyone to go along with this for the reasons I've stated previously. Neither option is a slam dunk but I like my chances.

Of course there is another completely valid Option 3 which this group supports which is to build a portfolio of passive, low MER ETF's. I support this approach whole heartedly.

Whatever option you choose depends on how confident you are in your analytical abilities, how disciplined you are in staying true to your strategy, your financial literacy, the time you have to research, and your tolerance for risk. Everyone is different.