Rights & Money

ETFS: An Investment Worth Exploring

With lower fees than mutual funds, fixed-income ETFs are growing in popularity

By Olev Edur

Photo: iStock/scyther5.

Over the past decade or so, retirees have been struggling to survive on the paltry incomes they’ve been getting from interest-bearing investments such as Guaranteed Investment Certificates (GICs) and government bonds. And while interest rates finally began to pick up in 2019, offering a glimmer of hope, it now appears they’re headed back downwards again in several countries, notably the United States; Canada’s rates may not be far behind if predictions of a looming global economic slowdown prove accurate.

Not good news, to be sure, but the fact is that there have always been some better-paying and still relatively safe alternatives to securities that have been yielding 1.5 to two per cent a year lately. According to Fundata statistics for the period that ended on September 30, 2019, for example, Canadian fixed-income mutual funds generated average annual compound returns of 3.02 per cent over the preceding 10 years. Not a scintillating figure, to be sure, but certainly better than GICs.

Now there’s an alternative even more attractive than fixed-income mutual funds, courtesy of a burgeoning exchange-traded fund (ETF) market. Although equity-based ETFs have been available in Canada since 1990 (a world first!), it’s only in more recent years that fixed-income ETFs have proliferated, too; Fundata stats show that there are now 35 different providers in Canada offering more than 200 fixed-income ETFs.

“There are now [as of press time, in December 2019] a total of 872 ETFs available in Canada and more than 200 of these are fixed-income ETFs, although it depends on how you count them,” says Pat Dunwoody, the executive director of the Toronto-based Canadian ETF Association (CETFA). “An ETF may be hedged or unhedged, or denominated in Canadian or US currency—these all count as different funds.”

Dunwoody adds that fixed-income ETFs represented about $192 billion in investor capital as of November 2019. “We’ve averaged 20 per cent year-over-year growth for the past 10 years,” she says, although she admits “that growth figure is starting from a very small base.” And many of these new investors have been retirees: CETFA statistics indicate that by September 2019, the over-65 age cohort represented one-fifth of all ETF investors.

Indeed, even most large mutual fund issuers have now jumped on the ETF bandwagon. BMO, for example, has become a major player, with a slew of ETFs to accompany their mutual fund offerings. Mark Raes, the head of product at BMO Global Asset Management in Toronto, points out that the firm now has 83 ETF-based strategies. “That includes hedged or unhedged, as well as Canadian- or US-denominated ETFs,” he says.

“Are we competing with ourselves?” Raes asks rhetorically. “Not really. Different approaches appeal to different investors, and for those wanting low fees, ETFs can be appropriate. By and large, we don’t view it as competition; we view the two products [ETFs and mutual funds] as being complementary.”

The Low-Fee Performance Advantage

For readers unfamiliar with these new products, ETFs are much the same as mutual funds, in that they are diversified pools of professionally managed investor capital. The big difference, as the name implies, is that unlike mutual funds, ETF units can be traded like ordinary shares on exchanges such as the Toronto Stock Exchange (TSX). Therefore ETFs aren’t subject to the types of trading delays, restrictions, and fees (or “loads”) that may apply to the buying or selling of mutual fund units.

And because the exchange-traded feature eliminates the issuer’s need for internal trading infrastructure, the management expense ratio (MER) of an ETF tends to be significantly lower than that of a comparable mutual fund—leaving more money in investors’ pockets.

(Canadian mutual fund management expenses have been the subject of many complaints in recent years because they’re among the highest in the world. In part as a response to these complaints as well as to the ETF incursion, many Canadian mutual fund issuers are now lowering their expense costs, introducing lower-fee equivalents such as D Series funds, or introducing their own ETFs.)

Another reason many ETFs have lower fees than their mutual fund counterparts is that the majority are merely passive replicas of benchmark indices, as opposed to being actively managed portfolios of individually selected holdings. Passively managed ETFs require little or no analytical resources beyond simply keeping the portfolio’s holdings aligned with the underlying benchmark.

How much lower are these fees? Fundata statistics for September 2019 show that the average MER for Canadian fixed-income mutual funds was 1.19 per cent of total assets per year, and 1.78 per cent for Canadian equity funds. While the Fundata stats don’t provide breakouts for ETFs alone, figures from CETFA indicate that the average MER for all ETFs in Canada—both equity and fixed-income—at the end of 2018 was 0.36 per cent.

Those MER figures are averages for all ETFs, but when it comes to fixed-income ETFs, many have even lower fees. The MER of the BMO Aggregate Bond Index ETF, for example, is 0.09 per cent, the MER of the Vanguard Canadian Aggregate Bond Index ETF is 0.13 per cent, and the MER of the iShares Core Canadian Short Term Bond Index ETF is 0.17 per cent. “The BMO Aggregate Bond Index ETF is our most popular fixed-income ETF,” Raes says. “It covers a broad market.” (“Aggregate” means simply that the fund is based on an index such as the Bloomberg Barclays Canada Aggregate Index, which includes mortgage-backed and asset-backed securities (MBSs and ABSs), as well as government and corporate bonds to simulate a more comprehensive universe of marketable debt.)

As for performance, because many of them are relatively new, only a few fixed-income ETFs have 10-year track records. Fundata figures show, however, that those with sufficient history generated 10-year-average annual compound returns through September 2019 ranging from 3.7 to 4.1 per cent; of 19 fixed-income ETFs with five-year track records, almost half delivered annualized returns exceeding 3.5 per cent. Again, not scintillating, yet double the yield of many current GICs and government bonds.

Active Versus Passive Management

While most ETFs are still based on indices, more and more actively managed versions are coming onto the market, and the fees for these funds are predictably higher than for passive index-based ETFs, albeit generally still lower than for comparable mutual funds. The MER of the Dynamic iShares Active Tactical Bond ETF, for example, is 0.56 per cent—quite a bit higher than the fixed-income ETF average, but the ETF is something of an outlier: its MER is higher than that of most of its peers, but its performance has been better, too. For the year through September 2019, it generated a return of 9.9 per cent, compared with 3.5 per cent for other high-yield fixed-income funds (including ETFs) and 7.8 per cent for all Canadian fixed-income funds. (Fixed-income funds and ETFs have all benefited from falling or stalled interest rates over the past year, hence the recent abnormally high overall returns.)

You should note, however, that there’s no sure-fire correlation between the added fees you must pay for actively managed funds or ETFs and the returns they generate. A few actively managed funds generate superior returns relatively consistently, but the trick is to predict the right ones. If you aren’t up to performing the necessary analysis, you may be better off with the certainty that an indexed ETF won’t underperform the broader market.

“In equity investing, active management can make a big difference, but for fixed income, it’s a challenge in the current low-yield environment,” Raes says. “It’s much more difficult for active fixed-income investors to make a difference.”

Of course, there are some variations even when it comes to index funds. Different funds may use different strategies for mimicking those indices (often involving derivative products such as options to varying degrees), although the resulting differences could be relatively slight.

The bottom line is that now there is a plethora of fixed-income ETFs from which retirees can choose to help bolster their incomes. Moreover, these products offer the same advantages as traditional mutual funds—automatic diversification and better yields than government bonds and GICs—but they’re also easier to buy and sell. In addition, low fees translate into the potential for even higher returns than those from comparable mutual funds.

Better Returns, Lower Risk

Finally, as discussed in the box on page 38, fixed-income ETFs (as well as mutual funds) have a strong track record of safety.

“Bear in mind that there are investment-grade bonds in most of these ETFs,” Raes says. “They’re not high-risk, high-yield bonds. Certainly any company’s fortunes can change, but we’re talking about the big banks, leading energy companies, telecoms…these are big stable companies.

“For seniors who are looking for investments with less risk, fixed-income ETFs can provide just that,” Raes adds. “You can get a higher return from an ETF than from a GIC because the risk is higher, so in the end, it depends on your tolerance for risk. But in today’s low-interest climate, you need something more than GICs. Fixed-income ETFs in a balanced retirement portfolio can make a lot of sense. Fixed-income investments provide stability, so when equities run into trouble, you can get some protection from your fixed-income holdings.”

The fact that an ever increasing variety of ETFs—both equity and fixed-income—is becoming available provides investors with more choice than ever before, but it also makes it more difficult to pick and choose the funds that are best-suited to your needs and risk tolerance. As with any fund investment, examine them carefully to ensure you understand what all the costs are and how and in what assets the fund invests; if you’re not sure what you’re doing, get some professional advice