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Battle heats up between mutual funds, ETFs

With RRSP season fast approaching, marketing skirmishes between investment fund providers have already started


Andrew Jordan is a deserter.

After more than a decade of salting away cash in mutual funds, he began dabbling in exchanged-traded funds (ETFs) last April. Using a discount broker, he's now smitten with buying and selling funds that trade like stocks.

Mr. Jordan has been able to make money by moving up to $30,000 into and out of ETFs and he's even borrowed money to do so. "I don't think I will ever go back to mutual funds," enthuses the 30-year-old Calgary-based manager at a food company.

For mutual fund companies, it's a dangerous sentiment and one that highlights the rising tension between the mutual fund and ETF worlds.

Canadians will pour billions of dollars into registered retirement savings plans over the next few months. What's different about this RRSP season is that a lot more investors will seriously look at ETFs as a viable option for those dollars.

ETFs have risen from obscurity to become a "legitimate competitor" to mutual funds, said fund analyst Dan Hallett. "Fund companies would be in denial if they thought ETFs were not a threat."

Mutual fund companies took in about $3-billion in net sales in the last RRSP season - the worst in five years - amid a devastating bear market.

M Partners fund company analyst Scott Chan expects mutual fund sales to jump to between $5-billion and $6-billion this season amid calmer stock markets, but it's still a far cry from an average of $8.6-billion in the bull market years from 2005 to 2008. And ETFs "will attract a "greater piece of the pie," he said. With more ETFs available in Canada, including 13 new ones launched since last summer by Bank of Montreal, "that will definitely take away some mutual fund assets going into RRSP season," Mr. Chan suggested.

The marketing skirmishes between mutual fund and ETF providers have already started. "They're like mutual funds ... only better," boasts a newspaper ad by Toronto ETF provider AlphaPro Management Inc.

Mutual fund giant Mackenzie Financial Corp. responded with a brochure aimed at financial advisers called "I thought I wanted an ETF" which challenges the touted advantages of ETFs.

Some mutual fund players can smell the trail of money, and are already playing both sides of the fence - albeit differently. Bank of Montreal began selling its BMO ETFs last summer along with its BMO mutual funds. And Invesco Trimark Ltd., a fund firm, recently launched six mutual funds that invest in U.S.-listed ETFs.

"ETFs are unlikely to beat mutual funds in terms of net assets in the near future," said Tyler Mordy, director of research at Hahn Investment Stewards & Co. Ltd., which has been using only ETFs for individual portfolios since in 2003. "But their growth rates have been phenomenal."

Global ETF assets have been growing at about 37 per cent per year over the past decade to $942-billion (U.S.) at the end of October, according to estimates from U.S.-based BlackRock Inc. which now runs the iShares ETFs.

In Canada, growth has come as more players enter the market. Toronto research firm Investor Economics indicates ETF assets have grown at about 29 per cent a year since 2007 to $29-billion (Canadian) at the end of November.

Mr. Jordan sought out ETFs after becoming unhappy with the performance of his mutual funds. He likes the fact that ETFs still offer him some diversification, in contrast to having to bet on a single stock. While experimenting with ETFs, he even made a profit a few times by holding an iShares Canadian-stock ETF for only a day.

He has also become more conscious of mutual fund fees eating away at returns. "I was tired of the higher fees, and lack of service for the mutual funds," he said.

ETFs have also gained converts among financial advisers, but they are in a minority.

Tony De Thomasis, president of De Thomas Financial Corp. said that seven out of about 50 of his firm's advisers, including himself, use only ETFs or index funds for client portfolios.

They did so after examining data showing most U.S. fund managers had trouble beating the market over the longer term.

"The other advisers - while some use index investing on a partial basis - are not fully convinced that they cannot find that extra money manager who is better," he said.

Clouding the issue of ETFs versus mutual funds is an emerging breed of active ETFs. Like mutual funds, these new ETFs rely on stock and bond pickers to select securities to try to outperform the market.

The are 109 ETFs listed in Canada. The iShares Canada ETFs, which typically track conventional indexes, have about 80 per cent of the market share. Smaller players include Claymore Investments Inc., Bank of Montreal and BetaPro Management Inc. and sister firm AlphaPro.

Howard Atkinson, CEO of BetaPro and AlphaPro, suggested that firms like Mackenzie, which sell only mutual funds, are obviously concerned by the growing ETF competition.

Canadians have about half of their ETF money in Canadian-listed ETFs, while about $30-billion actually sits in U.S. ETFs that have been purchased on a U.S. exchange, he said.

It's not just individuals who are buying into ETFs: there's about a 50-50 split between institutional and retail investors. Mr. Atkinson points to that as an implicit stamp of approval: "If fund managers use ETFs, why shouldn't the rest of us?"

David Feather, president of the fund arm of Mackenzie Financial, said his firm's ETF brochure to advisers was only meant to counter generalizations made by the ETF industry on price, performance, tax efficiency and transparency that are not that clear cut. "Why shouldn't we defend our product?" he asked. "We don't feel the mutual funds' side is properly explained," he said.

For instance, "when you actually check out how mutual funds have performed against passive ETFs, it is clear that passive investing in the Canadian large-cap space [iShares CDN LargeCap 60] has been a pretty good place to be over three and five years, but not over one and 10 years," he said. "When looking at U.S. and international data, mutual funds rank very well against the largest ETF in the space."

Heather Pelant, head of iShares Canada, dismissed the Mackenzie brochure as "marketing material designed to sell Mackenzie funds ... It is not surprising to see the [mutual fund] industry taking notice of the extraordinary growth," she said. "There are near 1,000 new ETF filings globally so this industry is about to explode."

In Canada, BMO joined the ETF party last summer, but it is unclear if other banks will follow. "They [banks] will need to defend their turf at some point, but it may depend on how successful we are," said Rajiv Silgardo, head of ETFs at Bank of Montreal.

ETFs used to focus on the broad-based market capitalization indexes. Now they come in different flavours - from financial sector funds to country and commodity ETFs.

The ETF industry has even come up with an answer to the mutual fund industry's argument that its offerings are better for smaller investors since brokerage fees to buy and sell ETFs can become costly.

Claymore Investments, for instance, has arranged with some brokers to allow clients to make regular commission-free contributions to its ETFs. "We are the first in the world to do that, so we have levelled the playing field between mutual funds and ETFs for smaller investors," Claymore CEO Som Seif said.

Invesco Trimark's move to launch mutual funds investing in PowerShares ETFs has blurred the line further between ETFs and mutual funds. It has been able to do so easily as PowerShares is a sister firm.

Peter Intraligi, president of Invesco Trimark, argued it may be more difficult for rival Canadian mutual fund players to create similar products without a connection to an ETF provider. They will have to start layering on more fees or hurt their profit margins, he said.

But it is really ETF provider AlphaPro that has thrown down the gauntlet by starting to offer ETFs that try to outperform a market index, and charge a performance fee if it manages to do so. AlphaPro expects to offer 12 to 15 active ETFs by the end of next year.

"In a mutual fund, the fees remain the same whether the manager outperforms or underperforms," Mr. Atkinson said. "Now, we are saying that you can have the best of both worlds."


Mutual funds versus ETFs

The case for ETFs

1. Lower expenses since most replicate an underlying index

2. Index ETFs have often beaten active managers (the jury is out on active ETFs)

3. Can be traded throughout the day (mutual funds must be redeemed at the end of the day)

4. Are more transparent because they disclose all holdings daily

5. Low turnover helps make for greater tax efficiency The case for Mutual Funds

1. A cheaper way to invest smaller amounts of money on a regular basis

2. Mutual fund managers try to and may outperform benchmarks

3. Can provide better diversification than a benchmark

4. Can outperform in a down market because these funds can move to cash

5. Early redemption fees can discourage investors from selling at the wrong time

© 2007 The Globe and Mail. All rights reserved.

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