ETFs running off in all directions

Most 20-year-olds scare me just a little bit. They are clever, tech-savvy and often worldly, with opinions on almost everything. They can even be intimidating, in that you think they must know something you don't.

Many seem to believe they know an awful lot, and we old fuddy-duddies are either scared or lazy in our unwillingness to jump off any metaphorical cliff they think looks attractive.

ETFs just turned 20. Like many human "youngsters," they were pretty well behaved till about 16, then seemed to turn a little wild, using their new knowledge and tools to run off in all sorts of untested directions.

Exchange traded funds are a great tool. We use them all the time in our investment-management practice, and have for a number of years. For many uses, I prefer them to conventional retail mutual funds.

They became popular for a number of good reasons. An ETF allowed you convenient access to a basket of stocks (or other investments) with one purchase. That single stock or unit could be bought and sold on the stock market at any time during the trading day.

The basket of investments was picked on preset and transparent criteria (like the TSX 60 index, for example), so you could always know what you owned. I contrast this with an actively managed mutual fund, where the manager delays the release of his exact portfolio to keep competitors from stealing ideas.

Another contrast with mutual funds is the fees. Traditionally, ETFs have charged between 0.3 per cent and 0.5 per cent per year for access to a passive index, while the average actively managed fund costs more like two per cent to 2.5 per cent per year, including adviser compensation (or about one per cent less without adviser compensation). Some cost more, a few cost less.

Index-based ETFs are usually low turnover vehicles, and tax-efficient.

So, why does this 20-year-old now scare me so much?

My main concerns centre on the explosion of ETF varieties, the use of misunderstood leverage in some ETFs, access to increasingly quirky and risky investments and the rabid introduction of flavour-of-the-month options, with no apparent raison d'être other than being saleable.

This recent movement by innovative product developers uses the popularity of ETFs to sell access to things like water and agriculture investments, commodities, two and even three-times leverage returns (which provide unexpected results if not actually sold daily), hedge fund types of active management with performance fees in the fine print and a batch of modified index ETFs that sell based on selective time-period track records. As well, fees on some of these can approach mutual fund fees, and even exceed those of direct sale manufacturers like Steadyhand, and large account options like Standard Life Legend Series.

Many of these products are poorly understood by both investors and advisers (not to mention personal finance writers).

An ETF investor now needs to ask a whole bunch of new questions, like:

-- Is this ETF currency hedged?

-- Does it use leverage?

-- Does it own derivatives?

-- Will there be liquidity when I want to sell?

These new products stand in contrast to the traditional benefits of ETFs -- low-cost access to indices in which the risks are clear and understood -- turning them into fringe investments that have traditionally surprised and disappointed investors, who knew not what they had purchased. I have seen many a marketer ruin a good basic product over the past three decades. (They will also call me a fuddy-duddy.)

Some of these new ETFs are innovative, and some are going to be useful in our practice, if we can figure them out and avoid future surprises. I strongly encourage you to conduct that same research and due diligence before you invest. Make sure you understand the product and how it will behave in a variety of situations, good and bad.

I sympathize with marketers, who need new features to differentiate themselves from competitors. My fear is that like many 20-year-olds who are out trying new things for the first time, they will make mistakes, maybe write off a few cars, maybe worse.

In this case, though, this 20-year-old will be using your money.

David Christianson is a fee-for-service financial planner and portfolio manager, whose team at Wellington West Total Wealth Management Inc. provides comprehensive financial advice and management. You can email him at dchristianson@wellwest.ca or visit his blog at www.davidchristianson.com

Republished from the Winnipeg Free Press print edition April 30, 2010 B11