BMO’s Wolves in Sheep’s Clothing

Since Bank of Montreal entered the ETF business in May 2009, it has managed to grab only a tiny market share. Last week, however, BMO made a move designed to attract new investors to its ETFs. Ironically, it did so by packaging and selling them as mutual funds.

Following a unitholder meeting on September 13, BMO announced that it would make changes to its existing family of index mutual funds. These will now be known as the BMO Canadian Equity ETF Fund, the BMO U.S. Equity ETF Fund and the BMO International Equity ETF Fund. Instead of holding the individual stocks in their respective indexes as before, the three mutual funds will now simply hold one or more BMO ETFs in the same asset classes.

For example, instead of tracking the S&P/TSX Composite, the Canadian equity fund will now simply hold shares in the BMO Dow Jones Canada Titans 60 Index ETF. For now at least, it appears that the new mutual funds will also hold derivatives that promise the same return as the respective ETFs.

Many advisors can’t sell ETFs

What’s the point of wrapping up an ETF inside a mutual fund? Simple: it allows more financial advisors to sell them. Only advisors licensed by the Investment Industry Regulatory Organization of Canada (IIROC) are permitted to sell individual stocks. ETFs, even though they are diversified baskets of securities, are considered individual stocks by the regulators. Advisors who are licensed by the Mutual Fund Dealers Association (MFDA) — and there are many more of these — are not permitted to sell them. However, these advisors can sell mutual funds, even if those mutual funds contain nothing but ETFs. No, it doesn’t make any sense, but that’s how it works.

BMO is not the first financial institution to exploit this regulatory oddity. Late last year, Invesco Trimark packaged several PowerShares ETFs (which are listed in the US) in mutual funds for Canadian investors. R.N. Croft Financial Group Inc. also launched its line of PIE Funds, which each hold several ETFs and function as complete portfolios. The move isn’t even entirely new for BMO, who this past spring launched several Guardian Funds, which are also ETF portfolios in a mutual fund wrapper.

It appears that advisors are getting a lot of questions from clients, probably along the lines of, “Why can’t I use ETFs, since they’re so much cheaper than the mutual funds you use in my account?” Now these advisors can steer clients toward this new funds and say, “You want ETFs? You got ’em,” even if that’s not entirely true.

Unfortunately, BMO has not lowered the fees on its three equity index funds. Investors will still pay a 1% management fee or more for the newly branded mutual funds, compared with 0.15% to 0.46% for the underlying ETFs purchased directly. That said, this is a far better deal than what advisors’ clients are getting from actively managed funds or wrap accounts, where they’re likely paying over 2.5%. Indeed, if they’re now able to use index funds and get ongoing advice, they may be able to reduce their overall costs by more than full percentage point and get good value.

Does the term “ETF” mean anything?

Still, it’s hard to jump for joy over these new “ETF funds.” They’re not meaningfully different from BMO’s older, overpriced index funds. In fact, they now track less diversified indexes for the same fee. And they certainly don’t offer anything for do-it-yourself investors, who can get lower priced index funds from TD, RBC and Altamira.

What’s more troubling, BMO’s decision to rebrand its index funds smells like a marketing ploy. As investor advocate Ken Kivenko of Canadian Fund Watch explains, funds tend to change their names when they want to be associated with what’s hot, and right now ETFs are snowballing in popularity. “This appears to be the motivation here,” Kivenko wrote in a recent report, “building on the word ‘ETF.’ Mutual fund investors, the most vulnerable of investors, risk being fooled by these more expensive misnamed hybrid funds.”

In the end, I have to agree with Kivenko. “ETF” used to be synonymous with passive index investing. That hasn’t been true for a years: leveraged, inverse and actively managed ETFs are now among the most actively traded on the TSX. But until BMO’s move last week, at least the term always meant “exchange-traded fund.” No longer. Now, apparently, it can also refer to a mutual fund.

The waters are getting so muddy that you can’t blame the average investor for being confused.