The Globe and Mail, Report on Business
Published May 13, 2011

By Tom Bradley

Personal disclosure: I’m a dyed-in-the-wool active manager, but admit to having used exchange-traded funds in my portfolio. I’ve tread on the dark side for tax planning purposes and, occasionally, to hedge certain long-term positions. I also must confess that I’ve taken no issue with our clients using ETFs, despite the fact that our company offers a simple, low-cost mutual fund alternative.

With that out of the way, I must also say that I get pretty steamed about the lack of scrutiny ETFs get. They seem to have an impenetrable halo over their heads, which emanates from their noble roots – cheap, simple and diversified. I grumble because the ETF landscape has been changing at breakneck speed and is now far from halo perfect. Fees are edging up (there are even performance bonuses in a few cases), complexity is emerging as a real risk, and performance often lags behind the target indexes.

I recently read a report on ETFs published by the Financial Stability Board, which is an international body set up to “assess vulnerabilities affecting the financial system.” The report points out that “the speed and breadth of financial innovation in the ETF market has been remarkable in some large financial systems [countries] over the past five years, and has brought new elements of complexity and opacity into this standardized market.”

The authors focus on the structural issues around ETFs and some of the new risks. For example, in Europe, 45 per cent of ETFs are “synthetic,” which means they obtain the desired return by entering into an asset swap with a counterparty, usually a bank. This derivative strategy is in contrast to “plain-vanilla ETFs” that own the actual securities of the index they aim to replicate. The report is balanced in its commentary and sounds an early warning to regulators and market participants about potential areas of concern – illiquidity, counterparty risk, poor disclosure and misaligned incentives.

If the Canadian regulators or industry were to commission such a report, it might raise some of the same issues. Uncertain liquidity and lack of transparency are obvious ones. Fortunately, the structural risks are less of a worry in Canada because, thus far, most of the ETFs are of the plain-vanilla variety.

But where a Canadian report should focus its attention is on the behavioural aspects of the ETF market. While providers pay lip service to the importance of long-term investing, they are enthusiastically encouraging widespread speculation. The reality is that a small portion of the $40-billion in ETFs in Canada are used to form a low-cost foundation for long-term portfolios.

We’re now approaching 200 ETFs in Canada after having just a handful 10 years ago. The flood of new offerings (reminiscent of mutual funds in the 80’s, 90’s and ... er ... well, today) has steadily carved the bond and stock markets into smaller and smaller pieces. The race is on to achieve first-mover advantage, whereby firms try to get their ETFs established as the standard, or benchmark, in as many sectors as possible. As a result of this proliferation, many of our ETFs are highly illiquid – they trade like micro-cap stocks – and need to be bought and sold with great care and patience.

The ETF firms are playing to the active traders and speculators, whether they be individuals in their basement or professionals in office towers. Trading volume and assets under management are focused on the hot and, dare I say, more speculative areas of the market. All of this is fine for the purposeful trader, but the Financial Stability Board isn’t worried about them, and neither am I. It’s the investors who are unknowingly investing less, and speculating more, that is the concern.

I came across a quote a few years ago that reinforces this point. John Bogle, the father of indexing, was credited with saying: “As the splinters get thinner, they grow sharper, and the odds of folks hurting themselves with these pointed objects now approach 100 per cent.”