Asked why Canadians are pouring more money than ever into exchange-traded funds (ETFs), Gordon Ross doesn't mince words. "The two things that are driving the growth of ETFs are the subtle but increasing pressure on mutual-fund fees and disclosures – and marketing campaigns," says Mr. Ross, a portfolio manager at the Vancouver office of Index Wealth Management Inc.
Index, which also operates out of Calgary and Winnipeg, manages about $150-million for clients who include individuals and affluent families. As part of its portfolio construction, the firm uses ETFs, groups of securities that are packaged and traded as units on stock exchanges. Besides relatively low fees, these products offer transparency and diversification by tracking an index.
In this country, ETFs have been gathering assets at a record clip – a sign that investors of all stripes are eager to cut costs in today's low-return markets. But before jumping in, buyers should know what they want from an ETF investment.
Last year, inflows to ETFs in Canada hit a historic high of $12.1-billion, up 28 per cent from 2011, National Bank of Canada reports. This haul left them with a total of $56.4-billion in assets, versus $43-billion the previous year.
The biggest increase was in fixed-income ETFs; they claimed $7.1-billion of the total, a 54-per-cent surge. For the second year running, Bank of Montreal attracted the most assets. It gained $5.1-billion, compared to $4.7-billion for U.S. money manager BlackRock Inc., which finished second.
There are now about 250 ETFs offered in Canada, according to the Toronto-based Canadian ETF Association. They still only account for 6 or 7 per cent of the Canadian mutual fund market, says Mary Anne Wiley, Toronto-based head of iShares for exchange-traded product business at BlackRock Asset Management Canada.
But in 2012, ETFs captured one-quarter of net new long-term investment dollars, Ms. Wiley notes. "They're outpacing mutual funds in terms of growth rate," she says.
This trend boils down to low cost, says John Gabriel, a Chicago-based ETF analyst with investment fund research firm Morningstar Inc. "In a market like Canada, investors are waking up to the fact that mutual-fund fees are among the highest in the world."
In a 2011 survey of the mutual-fund industry in 22 countries, Morningstar ranked Canada the worst of all for fees and expenses, giving them the only F grade. It found that the median asset-weighted expense ratios for Canadian equity and fixed-income funds were 2.31 per cent and 1.31 per cent, respectively. Those costs include so-called trailer fees, hidden commissions that mutual-fund providers pay their salespeople.
Investors are becoming more aware in general, says Ms. Wiley, who reckons that iShares's Canadian ETF business is split evenly between institutions, advisers and self-directed individuals. For example, events such as the disastrous Facebook Inc. initial public offering have shown how tough it is to pick individual securities.
"You can get burned on stocks that you think are going to deliver," Ms. Wiley says. "ETFs allow you to diversify away that risk."
And lately, active management hasn't delivered the returns that investors need, she adds. "ETFs, by design, give you exposure to the asset class without having to worry about whether you've picked the right manager and are they going to underperform the market."
That's a legitimate concern. Ms. Wiley points to Standard & Poor's' SPIVA Canada Scorecard, which measures mutual-fund performance after all costs. At the end of 2011, just 8.5 per cent of actively managed Canadian equity funds had beaten the S&P/TSX Composite Index for the previous three-year period.
In the equity market, investors are better served by tracking the index, Mr. Ross contends. "To do that, you want the lowest fee possible and you want the broadest or most liquid ETF possible."
To purchase ETFs, investors must go through a registered broker; just 20 per cent of Canadian financial advisers are licensed to trade them, notes Mr. Gabriel.
"The nice thing about an ETF is nobody associated with the ETF is selling it to you," Mr. Ross says. "You're buying it on the stock exchange."
But investors should know that ETFs are being vigorously marketed, he adds. "Why are they being marketed so hard? Because the adviser community knows that the pressure will only get higher on mutual-fund fees."
As for ETF fees, Mr. Ross suggests avoiding products with management expense ratio (MER) of more than 1.25. "We stay way below that," he says of his firm. "But the individual investor can very easily get fixated on costs, and we have to always remember that the cheapest is not always the best."