Some things to consider with active ETFs

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It’s not exactly a secret that money has been pouring into ETFs over the past years.  While uptake has been a little slower in Canada, there is still a steady stream of assets moving from mutual funds to exchange traded funds. With this movement, it might come to the mind of the average investor whether they ought to take part.  Before you dive in though, there are a few considerations. First, let me get this out of the way; I like ETFs and they are fine for the right situation and right purpose!

 

It’s not the buying, it’s the selling:  A few years ago, there were a lot of companies launching boutique products.  Did you have a thesis on investing in Mongolian agriculture? You could probably find an ETF to give you some exposure. It was a little over the top. And while these were well enough intentioned, the issue was liquidity.  If you’re the only person buying the ETF, how do you sell it when the time comes? There are no buyers. You might think that with big names involved that this isn’t an issue today.  Not so fast. I looked at several these mandates this week and the volumes aren’t significant.  You can buy units and in some cases the providers will help you take a position, but what happens on the way out? How do you sell to rebalance or just plain need the money to live on? At this point its hard to say. 

This is a significant concern.  I brought it up with one company who told me liquidity is not an issue because the underlying companies in their fund are very liquid.  That isn’t the same thing though; investors need to be wary of being able to sell the actual units they hold, and now that appears to be constricted.

 

It’s all about performance:  Even though these mandates are being brought to market through big, well-known companies, they’re largely brand-new. So, what you see as an investor is almost certainly a back-test that shows you how things would’ve performed if this was around for say, the past decade.  I hate to spoil this for you, but the results of the back-testing you see are always going to look good.  They wouldn’t show them to you otherwise! Put yourself in their shoes for a minute. You’re going to bring a new fund to the market and you have 4-5 strategies to consider.  You run the back-tests for each of them to show the performance over the past ten years and obviously pick the best one. 

Oh, and by the way, that back-test is basically just marketing. Those past results that show a nice graph on a 45-degree angle to the right are meaningless. Unless this next decade is the same as the past one you’re going to get different results.  To top it off, probability tells you that you’re likely going to see worse performance for a few reasons.  The major concern is reversion to the mean.  You’ve gone through and chosen a mandate that has a great back-test and things look bright and sunny. Unfortunately, that same outperformance reflected in the back-testing will eventually come around to be underperformance as things revert to the mean. Just as the mandate has done better than average, it can do worse than average for the same long period of time.  It has been said that “smart beta is just dumb beta with better marketing”.  I can’t take credit for that, but there are some scenarios where it seems quite apropos.

 

Are you really saving money? There are some of these mandates that are simply not cheaper than their mutual fund cousins. It they are cheaper, we’re talking about very small savings (in the order of 0.05% per year…which is about $50 per year for a $100,000 investment. There are those who would have you believe that these mandates are cheaper by their very nature, and in a lot of cases it might be true.  But saving that amount of money is hard to get too excited about for most investors. If you put $100 in this month you save $0.05 this year on that amount, so just make a proper investment decision and don’t get too excited about a nickel. 

 

The point I’m making is that you want to be careful with these products. Companies are responding to calls for lower fees and everyone seems to have an ETF product on their shelves (or will in the coming year).  It’s not that they don’t have their place, but you need to take it easy and examine what you’re investing in.  And for your own good, if you have no idea what you’re buying and what the implications are, get help.