by Salman Ahmed

I like ETFs (exchange-traded funds). Sounds odd coming from a guy working at a mutual fund company, but it's true. They can be a good solution for a small subset of the population - experienced do-it-yourself investors who have time to spend on their portfolio and can work around some of the limitations (no dividend reinvestment programs, discount/premium to NAV, liquidity, etc.).

However, that’s not the main reason I’m a fan. It’s more so because the mutual fund industry is threatened by them. In general, Canadian mutual funds are expensive, poorly managed, and unnecessarily confusing. Due to these factors, investors need an alternative, and ETFs are attempting to fill the void. Further, a viable threat like ETFs may force the mutual fund industry to clean up its act.

Like any growing industry, the Canadian ETF space is changing, but many of the changes will lead to a poor investor experience. ETF providers are increasingly engaging in the same bad behaviours that the mutual fund industry has been guilty of.

Product proliferation: Since the start of 2015, about 130 new ETFs have been launched in Canada. That’s impressive considering there are just 17 ETF providers.

Flavour of the month: Actively managed ETFs are hot right now. A few months ago, it was rules-based strategies, which are sometimes referred to as “smart beta”. Don’t be fooled by the marketing, these are also active funds. Before smart beta, low volatility ETFs were en vogue.

Around 80% of ETFs launched in the last 18 months have an active element to them. These are far from the low-cost, broad market, passive funds ETF enthusiasts advocate for.

Confusing: Simplicity used to be a big selling feature of ETFs. Our media still uses this as a reason to use ETFs, however, as more ETFs enter the fray, providers are more often using complexity as a way to differentiate their products. Here’s a direct quote from an ETF fund fact sheet:

The Fund will invest in the equity markets by (i) writing cash covered put options to reduce the net cost of acquiring securities and receive premiums and (ii) directly investing in equity securities and writing call options on these securities to receive dividends and premiums.

Say what? I doubt most investors understand this strategy, let alone appreciate the unique risks.

Costs: The median Canadian mutual fund charges around 0.85% in management fees (before admin fees and taxes) for share classes that exclude fees for financial advice. The median ETF, sold in a similar way, charges around 0.65%. That price difference is meaningful, but the gap is trending the wrong way with the launch of active ETFs. For example, Mackenzie’s recently launched active bond ETFs are priced the same as its similarly managed mutual funds.

ETFs, like mutual funds, are simply vehicles that an investment manager uses to implement an investment strategy. Both have strengths and weaknesses. It’s how a manager decides to use the vehicle that really matters. As it stands right now, you have to wade through a lot of crap before finding the worthy mutual funds. More and more, ETF investors are having to do the same.