Are ETFs Growing for the Wrong Reasons?

By Dan Bortolotti on January 19, 2012
Estimated reading time: 3 minutes

On the day his company announced it was acquiring Claymore, BlackRock’s CEO Bill Chinery called ETFs “electric cars in a world of internal combustion engines.” What he meant was that ETFs, despite the attention poured on them by the media and DIY investors, are still only a small part of the fund industry. ETFs in [...]

On the day his company announced it was acquiring Claymore, BlackRock’s CEO Bill Chinery called ETFs “electric cars in a world of internal combustion engines.”

What he meant was that ETFs, despite the attention poured on them by the media and DIY investors, are still only a small part of the fund industry. ETFs in Canada now manage about $43.1 billion in assets. By comparison, Canadians have $778.5 billion invested in mutual funds—about 18 times more.

That’s a big gap, but it’s been closing for a few years now. According to a recent report, ETFs in this country saw more than $7.6 billion in new sales in 2011, increasing their total assets by nearly 13%. Compare that with another report from the Investment Funds Institute of Canada. Canadian mutual funds, it says, now manage $8.8 billion less than they did at the beginning of 2011. Of course, part of that decline is a result of negative equity returns and not investor withdrawals. But the stats do make it clear that the mutual fund industry is moving in the opposite direction of ETFs:

Balanced mutual funds saw inflows of $27.7 billion in 2011—a hefty sum, but almost $1 billion less than the previous year.

Bond mutual funds accepted $8.87 billion in new money last year, compared with $11.1 billion in 2010, about a 20% decrease.

Equity mutual funds saw net redemptions of $10.8 billion during 2011.

ETFs may still be electric cars, but the mutual fund industry is looking more and more like a tractor trailer with a hole in the fuel tank.

Every silver lining has a black cloud

Not everyone agrees that ETF growth is encouraging. “To me, the ETF sales numbers are both underwhelming and disappointing,” wrote Tom Bradley of Steadyhand Investments this week. “In the context of a wealth management industry with over $1 trillion in client assets, $7 billion doesn’t represent much of a market share swing.”

I also share Bradley’s other concern: “I have to wonder what portion is being used by individual investors to implement low-cost, long-term strategies.” Indeed, while it’s tempting to see the growth of ETFs as a triumph for Canadian index investors—who are finally waking up to the fact that they’ve been paying too much, for too little, for too long—the numbers don’t support that:

About $900 million of the new money that went into ETFs in 2011 (12% of the total) went into the iShares S&P/TSX 60 (XIU), which is mostly a tool for institutional investors. It’s unlikely that much of that $900 million came from newly sprouted Couch Potatoes.

Another 16% of ETF inflows ($1.2 billion) went into covered call ETFs. While these ETFs may have a role in some portfolios, such widespread enthusiasm for covered calls probably has more to do with chasing yield than prudent investing. The enticing distributions paid by these ETFs (often 7% to 9%) are not likely to be sustainable.

As Bradley points out, there’s “some serious performance chasing going on.” Fixed-income ETF assets were up 44% in 2011, a year that saw excellent bond returns. But other than XIU, equity ETFs saw very little new money—just $400 million, or barely 5% of the total inflows. In a year where emerging markets performed poorly, investors pulled $45 million out of the Claymore BRIC ETF.

I’m encouraged that Canadian investors are putting pressure on the mutual fund industry, and pleased to see that more are embracing ETFs. But part of me thinks they’re doing the right thing for the wrong reasons.