As more exchange-traded fund products come to market, both passive and active, Jeff Hull, senior financial advisor at Manulife Securities, says it’s up to educated advisors to help their clients separate the ETF wheat from the chaff.

“There are many great ETF options available among an array of sectors and styles, but the best are truly ahead of the rest,” says Hull. “Also, sadly, there are some poorly designed offerings available to investors. [So] it is also best if investors utilize the wise counsel of a professional advisor who is knowledgeable, able and honest who can guide them.”

Filling the gap

Hull cites a list of benefits of ETFs, including: filling the gap in an investor’s portfolio in a specific area; a low-cost way to access and gain exposure to markets; tactical exposure to certain asset classes and reducing costs of the client’s overall portfolio. When it comes to transparency, advisors point to the fact that actively managed mutual funds need only report their holdings on a quarterly or even semi-annual basis, whereas ETFs disclose their holdings daily.

Manulife Asset Management launched its four multi-factor ETFs, sub-advised by Texas-based Dimensional Fund Advisors, in April – all of which are active rather than passive, says Hull.

While active ETFs often have a higher fee, they also include a higher level of action and monitoring than their passive counterparts. Hull says active ETFs also tend to reset their holdings more often, ensuring the fund remains on target and within their mandate.

“If investors think active – or advice – is more expensive, they should consider instead the ultimate cost of poor advice – or worse, no advice,” says Hull.

Another new player in the ETF market is Desjardins Global Asset Management, which announced the launch of seven new ETFs in early April.

Jay Aizanman, director of Investment Strategies and Asset Allocation with the Desjardins Group, characterizes the ETF market as one that has evolved to the point where solutions are being produced for just about any situation. “Where previously mutual funds or segregated funds were produced for multiple situations, ETFs are now the wrapper vehicle that is highly in demand for a specific subset of the advisory market.”

Multi-factor strategies

Aizanman says some of Desjardins’ new ETFs are what’s known as “multi-factor strategies,” developed by French specialists in smart beta quantitative modelling. Their purpose is to give investors a smoother ride during a volatile market and allow them to participate on the upside of a market after a downturn, rather than lag the general market.

Because commissions are not embedded in ETFs as they are in mutual funds, Aizanman says ETFs are particularly attractive to fee-for-service advisors.

While preferred stocks may be difficult to find for the average investor, he says they can be found in certain ETFs, complete with dividends and other payouts. The accessibility and liquidity of ETFs have also made them a major driver in the institutional market.

Traded on stock exchanges

Under regulations, life-licensed advisors are not authorized to sell ETFs, unless they also have a securities licence. Those with a mutual fund licence can also now take advantage of a new policy by the Mutual Fund Dealers Association (MFDA) to sell ETFs if they meet a minimum set of proficiency, education and training standards.

ETFs are traded on stock exchanges and it has been extremely difficult for MFDA advisors to sell these investments unless they are aligned with a company which has access to the exchange and are regulated by the Investment Industry Regulatory Organization of Canada (IIROC). Some firms, however, have developed mechanisms for independent mutual fund firms to have access to the stock exchange.

“It’s not that elegant, it’s still a little bumpy, so you have not seen a big movement so far,” said Marshall Beyer, a senior director at Moody’s, which bought the Canadian Securities Institute in 2010 and handles licensing courses and exams.

Derivatives-based

This course alone will not enable advisors to deal in all types of ETFs – some are derivatives-based or leveraged and won’t fall within the purview of mutual fund advisors, said Beyer.

The topic of ETFs is now a chapter in the Canadian Securities Course where previously it had been just a small section, said Beyer. “They have become an important part of the product universe,” he added. “We joke sometimes that the Toronto Stock Exchange should be renamed the Toronto ETF Exchange.”

The MFDA is expected to issue a formal rule proposal for public comment by the end of this year or early next on MFDA continuing education requirements, which Beyer expects would attract more advisors to the ETF courses. Requirements for continuing education credits, if approved, would apply to all MFDA-licensed advisors. At that time, advisors would be able to meet both their MFDA continuing education requirements and gain eligibility to deal with ETFs, says Beyer.

Other MFDA-approved courses that are considered acceptable to meet ETF product training requirements for mutual fund advisors will be offered by IFSE Institute and Smarten Up Institute.

As of the end of August, ETF assets under management (AUM) in Canada rose to $133.8 billion. AUM for mutual funds stood at $1.4 trillion as of the end of July.

While ETF assets are increasing, Hull said he has a couple of important rules he uses as a guide:

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Choose ETFs whose firms and managers have size, proven talent and resources to do the best job

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Understand an ETF’s parameters, limits and what it can and what it cannot do.

For example, if an ETF is based on an index that is market cap weighted, one large company can take down virtually the entire exchange. Remember when Nortel made up almost a third of the TSE300 index, and when it plummeted it took hundreds of investors with it? Stock in pharmaceutical company Valiant was the most valuable market capitalized stock on the TSX a few years ago before it too tumbled, taking much of the market with it.

“If an ETF is market cap weighted you may not realize you are actually increasing risk, and may have too much exposure inside the ETF to riskier holdings,” said Hull.

Another “danger zone” that Hull explains has to do with ETFs that offer different amounts of leverage. “These never seem to work as advertised and their existence is dangerous,” said Hull. “Their attempt to amplify gains by juicing up the ETF with leverage can be a toxic brew.

“My advice is to stay clear of these. These are the ETFs I am most concerned about for investors. These need better and deeper scrutiny by regulators, advisors and investors.”