Investment evolution

THE investment world, like nature, is perpetually evolving. Just as a species of plant or animal must adapt to its environment to survive, the investment industry is always concocting new products to attract investors to survive in an increasingly competitive marketplace for our money.

Recently, a Toronto-based investment fund firm came to Winnipeg to meet investment advisers about a relatively new product that could be the next step up in the evolution of investment.

Called an actively managed exchange-traded fund (ETF), this hybrid of stock and mutual fund offers Canadian investors active management of a mutual fund without the high fees, and it can be traded on a public exchange like stock.

The firm that made the presentation, AlphaPro Management, is the only provider in Canada of actively managed ETFs, and it is the largest provider of its kind in the world. If the product sounds new, that's because it is. The first actively managed ETF hit the market in 2007, and AlphaPro started selling it first -- the Horizons AlphaPro Managed S&P/TSX 60 ETF -- early last year.

But AlphaPro Management's president, Ken McCord, made a stop in Winnipeg late last month to talk up three new actively managed ETFs: Horizons AlphaPro North American Growth (HAW), Horizons AlphaPro North American Value (HAV) and Horizons AlphaPro Dividend (HAL).

While this new investment creature makes up only a small sliver of Canada's investment market, McCord says high-fee mutual funds' days may be numbered.

"I truly believe investors will buy ETFs as their vehicle of choice for active management, because now they have that option," McCord says.

Although active-management ETFs are new to the game, their predecessor, passive ETFs, have been around for more than two decades. In fact, Canadians -- who pay some of the highest mutual-fund fees in the world -- invented them. The world's first, the Toronto Index Participation Fund, started in 1987, a fund that traded on the TSX while reflecting the performance of 35 of the largest companies on the exchange.

Since then, ETFs have spread across the world, gaining momentum in recent years as investors become more concerned about the high management expense ratio (MER) in fee structures of mutual funds.

An equity mutual fund, for instance, may charge you fees amounting to 2.5 per cent of your money in the fund every year, regardless of performance, whereas an ETF charges about 0.20 per cent.

Most ETFs available today are passive-management funds. That means they aren't really managed at all and instead are a basket of stock that reflects a market index. For example, an ETF that mirrors the S&P TSX 60 -- a measurement of Canada's largest and most widely traded companies -- would rise and fall in value in much the same way as the index. If the TSX 60 is up 10 per cent on the year, so too is the ETF.

Of course, the opposite happens too. When the TSX is down, so is the ETF. Despite the volatility, many investors are buying these ETFs, realizing the fees they pay for mutual-fund management may not be worth the cost, because rarely do managers outperform their benchmark index over long periods of time.

"There's an overwhelming amount of evidence that passive portfolio management outperforms active management," says Winnipeg-based chartered financial analyst Alan Fustey, pointing to research by Standard & Poor's, a well-known research firm that provides comprehensive analysis on stocks and bonds.

Standard & Poor's Indices Versus Active Funds Scorecard for 2009 found only 30 per cent of Canadian equity actively managed funds were able to outperform the S&P/TSX Composite Index, and less than eight per cent were able to outperform the index over a five-year period.

In other words, management doesn't seem worth the additional cost.

"What an ETF is designed to do is replicate a financial index, and you're supposed to do it as cheaply as possible," says Fustey, vice-president of Elysium Wealth Management, which specializes in passive ETF portfolios that are hedged with option strategies.

McCord says he is "agnostic" about the passive versus active management debate, but he argues that statistics regarding fund performance can be misleading.

"Phil Mickelson could break par on any golf course he plays, but if I said to Phil, 'I'm going to tack an extra stroke onto every hole you play,' he's going to have a tough time breaking par," McCord says. "That's what fund managers do when there is a 2.5 per cent MER on the fund they manage, and that's why most managers cannot beat their benchmark index."

With active ETFs, this obstacle is largely removed because ETFs have a lower fee structure, he says.

The Horizons AlphaPro North American Value, for instance, has a 0.70 per cent MER.

"Then you have -- like any fund, whether it's an ETF or a mutual fund -- expenses on top of that, which are your classic legal and audit fees, so you'd add another 20 basis points," McCord says. "So we should keep it under one per cent."

In addition, the funds charge a performance fee of 20 per cent of the amount that they outperform their underlying index, the S&P 500.

Even with a much lower fee structure than equity mutual funds, Fustey says he isn't convinced actively managed funds are worth the cost.

"Why ETFs have been popular is because active management hasn't outperformed passive management, so the key is, why pay for that?"

But, McCord says, Horizons AlphaPro's actively managed ETFs are worth the additional cost because they are managed by some of the leading fund managers in the industry.

The Horizons AlphaPro North American Value ETF, for instance, is managed by Vito Maida, one of Canada's best-known value investors, a strategy made famous by Warren Buffet, probably the world's most successful investor.

Yet, actively managed ETFs are still new to the marketplace, so it is hard to judge the value of the management based on performance, says finance professor Rick Robertson at the Richard Ivey School of Business at the University of Western Ontario.

"It's not obvious to me that because a person has beat the market for the last two years, that they'll do it next year, anymore than if I flip a coin I will get heads two times in a row."

That doesn't mean money managers cannot "outsmart" the market over the long haul, Robertson says. But it's hard because the market is so unpredictable.

"I'm not convinced Warren Buffet is just lucky, but I'm also not convinced there are a lot of Warren Buffets out there."

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Are mutual funds dinosaurs facing extinction?

Not likely, says Ken McCord, president of AlphaPro Management, which offers active-management ETFs. "There is clearly still a place for mutual funds." ETFs can only be sold by advisers who have a full securities licence. Most advisers are licensed only to sell mutual funds, which do not trade on a stock exchange. Also, mutual funds are often better options if you want small, yet diversified micro-cap strategies or direct exposure to foreign securities in different time zones.

Keeping pricing in line

One reason why it's difficult to create actively managed ETFs that contain assets traded on foreign exchanges in different time zones is because of the system used to ensure active-management ETFs trade at a price reflecting their net asset value (NAV) -- the total worth of the assets in the fund.

Like stock, ETFs are traded on the open market, but unlike stock they have to trade at approximately the NAV of the assets held within the fund. Stock and other securities traded on open markets are priced according to supply and demand. Obviously, a higher price reflects higher demand and vice versa.

One of the mechanisms ensuring accurate pricing on stock is the bid-ask spread. This represents the difference between the highest stock price a seller is asking and the lowest price a bidder is willing to pay. The more a stock is traded, the smaller the bid-ask spread will be because of competition among both buyers and sellers.

To ensure actively managed ETFs trade within a bid-ask spread near the value of the underlying assets, the company that created the fund uses a market-maker.

"This market-maker, which in our case is National Bank, is always carrying an inventory of units on its books," McCord says. "Its obligation is to meet supply and demand at net asset value, plus or minus its bid-ask spread."

To achieve this, the market-maker needs to hedge its ETF holdings so it doesn't assume too much risk to ensure the ETF trades near NAV. "In order to hedge themselves properly, they need to be able to deal in the same securities the ETF does on a regular basis," he says.

With smaller-company stocks, there may not be enough supply and demand for the market-maker to trade the stock quickly enough to hedge its risk.

In addition, a market-maker for an actively managed ETF of assets traded on foreign exchanges in different time zones would not be able to hedge its risk properly if the ETF is traded in Toronto, because it can be traded when the foreign markets are closed.

Passively managed ETFs, however, use a different means -- called arbitrage -- to ensure they trade at the value of the indices they reflect. Arbitrage involves taking advantage of the difference in the prices of a stock or bond sold in two different markets.

For instance, many Canadian stocks are sold on both the New York and Toronto stock exchanges. If the stock price on the New York exchange is even a cent lower in value (factoring in the currency exchange) than the same stock trading in Toronto, a trading desk somewhere would exploit that difference quickly, making a very large trade, which would, in turn, bring the two prices back in line. The same mechanism works for passive ETFs, says CFA Alan Fustey. "If the ETF gets too far out of line with what the value is of the underlying securities, somebody can make money by buying all those securities and turning them in for the ETF," he says. "It's called an in-kind transaction."

Republished from the Winnipeg Free Press print edition March 6, 2010 B12