Kevin Greenard: Ten reasons to be cautious with Canadian equity ETFs

An ETF is a commonly used abbreviation for Exchange Traded Fund. Canada was the first country to launch an ETF in 1990 with one provider. Known as the S&P/TSX 60 Index, it essentially held the largest 60 stocks in Canada. This ETF still exists today and trades under the symbol XIU.

When this ETF was first launched, many immediately compared the lower cost of this passive approach against the cost of actively managed mutual funds. Advocates of ETFs quickly highlighted the performance of ETFs versus many mutual funds, net of fees. After close to 30 years since the launch of the first ETF, there have been numerous other entrants into the Canadian ETFs market, including Blackrock Inc., Vanguard Investments Canada Inc., Wisdom Tree Canada, AGF Management, BMO Asset Management, Invesco, Claymore Investments, First Trust, Horizons ETFs Management and Hamilton Capital Partners Inc.

Much debate has occurred since this time about the comparison of holding ETFs versus mutual funds. Whenever I read these types of articles, I always feel they are leaving a third option out — hold neither equity ETFs nor equity mutual funds. My approach as a portfolio manager is to hold the individual securities directly and not have them wrapped up in anything.

I could write several articles on the pros and cons of holding ETFs, mutual funds or direct holdings. The purpose of this article, however, is to outline our concern with equity ETFs. Below are ten reasons we feel investors should be cautious.

1. Equity ETFS that cover the broad market naturally have a Beta close to one. This means they are equal to the risk of the market. When the markets are doing well, then ETFs will track that. Using the S&P/TSX 60 Index (XIU) as an example, it has a beta of 1.04 — higher than the S&P/TSX Composite Index. In June 2008, the XIU was $22.81 per share. In March 2009, the XIU traded as low as 11.41 per share. The XIU essentially dropped 50 per cent. The S&P/TSX Composite Index hit a high of 15,154 in June 2008 and declined to a low of 7,480 in March 2009. A decline of approximately 51 per cent. After the markets have had an extend run, we get particularly nervous about ETF style investing. Are you prepared to accept the complete downside of the market if it pulls back quickly?

2. Advocates of ETF investing are proud to highlight the returns that equal the market. I have never felt that the end goal of investing is to just own the market and have returns equal to the general market. Our approach at the beginning of every single year is to beat the market. Beating the market really comes down to not having an equal position in everything. You have to concentrate on a much smaller group of stocks and exclude everything else. Our end goal is to have our equities outperform the general market — not just equal the market.

3. I am not convinced that a completely hands-off approach is the best approach. If you are using ETFs, then we feel that you still have to manage the ETFs to ensure you are in the correct ETFs. When we hold individual holdings we can shift the holdings, making good strategic allocation decisions, based on economic conditions. By strategic allocation decisions I mean asset mix (per cent in cash, fixed income and equities), sector exposure, geographic exposure, and tax efficient strategies. We feel that there is extreme value in having a good portfolio manager that can help you make both tactical asset allocation and strategic asset allocation decisions.

4. Although ETFs are a lower-cost option when compared to mutual funds, they do have costs. They have costs to purchase and costs to sell. They also have embedded costs within the ETF. The embedded costs with an ETF are lower than mutual funds. If an investor is seeking the lowest-cost option, buying individual equities and never trading them is the lowest long-term cost option. You have a one-time cost of purchasing them with no ongoing costs. We don’t recommend this approach because we feel the markets are changing and you have to adjust the equity holdings accordingly. We also feel that rebalancing and making both tactical asset allocation and strategic asset allocation decisions enhances returns. We feel couch-potato investing (buy ETFs and do nothing) is not the best option for investors who have discovered working with a portfolio manager.

5. Some ETFs will have hundreds or thousands of holdings. In our model portfolios we typically limit the number of equity holdings to 25 to 35 individual common shares. We prefer to focus on the best companies and concentrate on those holdings rather than spreading the capital out over hundreds or thousands of names. I strongly believe that concentrating on the best names is a better strategy than having numerous small holdings.

6. We encourage investors to avoid Canadian ETFs that hold American stocks. To illustrate, we will use an investor named Jill that owns 14 individual common shares of U.S. companies within her RRSP. The U.S. and Canada negotiated a tax treaty that exempts any withholding tax on U.S. dividend income generated within an RRSP. Another investor named Jack decides to purchase a Canadian ETF that holds American dividend paying common shares. As the common shares are held within an ETF, it does not fall under the exemptions listed in the tax treaty. As a result, a 15 per cent withholding tax is applied on all dividend income within the ETF. This 15 per cent withholding tax is an absolute cost and is lost to the investor.

7. A typical client will have a Tax Free Savings Account (TFSA), Registered Retirement Savings Plan (RRSP) and a non-registered investment account (either Joint With Right of Survivorship or Individual). In our July 26, 2019, article we discussed placement of investments in registered and non-registered accounts. This article focused on how to get the best tax benefits from structuring your investments correctly. Individual Canadian equities that pay dividends are best in a non-registered account to claim the dividend tax credit. Individual US dividend paying equities are best in an RRSP account. The article has many tips that we help our clients with. An ETF investor often at times has the same holdings in each account without giving thought to the best tax structure. The ironic part about this is that the ETF investor may be saving a small amount in the ETF fee, but losing even more in tax savings by fixating only on fees.

8. Many companies are introducing actively managed ETFs. When I hear the term actively managed ETFs, I feel it is essentially moving in the direction of a mutual fund. Many mutual-fund companies are also creating passive strategies as well. Many ETFs are moving toward the mutual fund space to justify slightly higher fees, and many mutual funds are moving towards the ETF space by reducing fees and hoping not to lose market share on fee-sensitive investors. These two investment worlds are somewhat colliding. Some ETFs are claiming that they have designed built-in algorithms. This sounds really fancy and it sounds passive. Back-testing data does not guarantee future results, similar to how mandatory mutual-fund disclosure that past performance is no indication of future performance. Prior to purchasing either, it is important to know all the details and consider all options, including holding individual holdings with a portfolio manager.

9. ETF investors have the option of holding one or more ETFs. Both have shortfalls in my opinion. If you are holding only one ETF, which ETF would you hold? If you purchase XIU, for example, then you are completely missing everything outside of Canada. On the flip side, some ETF investors will hold several different types of ETF holdings. They may hold a sector ETF, a broad-market ETF and an ETF that holds only dividend-paying equities. As a portfolio manager, we have tools that retail investors do not have. What we have discovered when we have used these tools is the haphazard approach of combining random ETFs results in underlying holdings may be duplicated and there may be good opportunities that the ETF investor has no exposure, too. The more ETF holdings an investor has the more challenging it becomes to monitor the sector exposure, geographic exposure, and individual company exposure. This becomes even messier when you mix mutual funds and ETFs together.

10. Similar to a mutual fund, it is a little harder to get excited about following your investments when you are not able to see your individual holdings. We find that when our clients hold the individual companies, they are actually engaged in the investment process. Our clients can see the 25 to 35 holdings they own, follow them in the news, and read the annual reports if they so choose. When you hold both ETFs and mutual funds that excitement and level of monitoring is somewhat lost. Many of our clients will put the stocks they own in their phone and they can easily track the current price, read recent news and see the dividends from the companies come into the account. We can print out an income report which will show them the number of dividends they are expected to receive in the year ahead. With mutual fund and ETF investing, I find that this engagement element is somewhat lost as everything is wrapped into one structure, making it hard to visualize the underlying holdings. We feel the more engaged any investor is with respect to their investments, the better the long-term results.

When you buy an ETF for your portfolio, you take away a lot of options for yourself. If you need to withdraw funds from your portfolio and you are only holding a Canadian Equity ETF, then you have put yourself in a position with no choice but to sell to raise funds whether the market is at all-time highs (creating potential capital gains) or at all-time lows. With a well-diversified portfolio of individual holdings, you have the ability to pick and choose which holdings to sell given the market conditions at the time when you require funds.

Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director, wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com Call 250-389-2138. greenardgroup.com