Some Bad Advice on ETFs and Mutual Funds

Just read an extremely shoddy article in a financial management company publication called “Understanding protected products and index funds.” (see page 7-8). It’s about ETFs, and here’s how it goes:

“Exchange-traded funds (ETFs) are mutual funds traded on a major stock exchange, such as the TSX. The investment strategy for each ETF is to align with a particular stock or sector index, such as the S&P/TSX Composite or one of its sub-sectors. Investments in each fund mirror the same proportions as the index that the particular fund tracks. This strategy is known as passive management or indexing.”

Well this introduction to ETFs is not stellar to say the least, but if directed at a very introductory audience, could be considered satisfactory. It is not true that all ETFs are passive, nor is it true that all ETFs “align” with an index (by market cap), but most are, so close enough. Here’s where it gets kind of crazy:

ETFs are perceived to offer three main advantages. First, since the funds are traded on exchanges, trading is done in real-time.

You stated a fact, but why is that an advantage? Actually it isn’t. How many people (by people I mean investors not speculators) out there are day-trading with ETFs? How many people should be concerned about the weekly, let alone daily activity of the market? How many people should be concerned about whether the security they buy has its price updated in real-time, or every night? The answer to all the questions is ZERO.

Second, ETF values rise (or fall) as the index rises (or falls).

Another fact but why is it an advantage? Was this article written by a 12-year old blogger? The fact that an ETF tracks an index is not an advantage IN ITSELF. So I guess having something that tracks an index is advantageous over something that doesn’t track an index… if what you want to do is track an index? I’m not even going to try to understand what is meant here.

Third, management expense ratios (MERs) are usually lower than the MERs for actively managed mutual funds.

Yes, ETFs can have lower MERs than actively managed mutual funds; however, is that really an apples-to-apples comparison? Sure actively managed mutual fund MERs are high (>2 or 3%). What about passively-managed mutual funds, like an index mutual fund? The Altamira index funds have MERs of 0.54%, at least for the Canadian Index Fund. Last time I checked iShares’ XIC ETF had an MER of 0.25% which is close and don’t forget that you have to pay your trading costs every time you buy and sell it. Anyways, what they were trying to do with advantage #3 was say that MERs are lower for ETFs, which in general, they are, which is the main advantage of ETFs (but don’t forget the commissions) over their competitors. Here’s where it gets really crazy (I mean wacko):

The primary disadvantage of ETFs is their inability to outperform the index.

This seems to conflict with the above advantage that the ETF value “rises (or falls) as the index rises (or falls)”? If it is a primary disadvantage that it can’t outperform an index shouldn’t it also be a disadvantage that is tracks the index? He/she does add that “on rare occasions, an ETF may slightly outperform its benchmark level–a phenomenon known as ‘tracking error'” which again is incorrect. Tracking error is defined as the total error between the index and the index-tracking ETF. Due to MERs it would be almost impossible for your tracking error to be positive except by some crazy fluke of timing. But let’s get back to the statement that “The primary disadvantage of ETFs is their inability to outperform the index.” Well this isn’t really a disadvantage as an ETFs goal is to track an index (modulo those tracking errors) not outperform it. So they must be referring to this as a disadvantage compared to some other financial instrument, which CAN outperform the index. With more risk though right? Nah, with less, because “in fact, investors assume additional risk [with ETFs] because passive managers are unable to take action to outperform the index or to protect the fund during a market decline.” What are these magical investments that can outperform index with less risk than an ETF. Fund managers to the rescue!

On the other hand, a mutual fund manager has the ability to surpass benchmarks – thereby strengthening a portfolio in the event of a market downturn. In other words, while investors can ride the index up, they will also ride it down with no protection from the fall-out.

A mutual fund manager has the theoretical ability to surpass benchmarks, but this ability is rarely manifested in the real world. We have been told countless times about the inability of the majority of mutual funds to beat their corresponding index benchmarks. It is difficult for fund managers to protect their investors from the “fall-out” anymore than a passive index. If it were easy, well, everyone would be in mutual funds. No one is inherently more “protected from the fall-out” with either a passive index ETF or an actively managed mutual fund. Finally,

Also, the low MER on ETFs may be deceiving. Most ETFs are bought through fee-based advisors who will add an annual asset allocation fee to their client portfolio, which in turn can significantly reduce the performance of these passive investments. Fund performance reporting services . . . do not take these fees into account when reporting the performance of these products. When these costs are factored in, ETFs are as expensive as some of the more actively managed funds.

This paragraph sounds like complete rubbish to me. I have an ETF in my portfolio as well as mutual funds. I pay nothing extra on top of the MER, just the commission to buy the ETF. I don’t think the situation would be much different if I had a fee-based portfolio.

Not surprisingly, the author of this embarrassment’s name is not given. Page 3 of the magazine reads “the material in Strategy, while obtained from sources believed to be reliable, is for information purposes only.” If only it were 2-ply, it could serve a more useful purpose.

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