Active management trumps passive approach
Last week, we discussed the major equity indices used around the world. We also addressed the terminology used and highlighted some of the pitfalls of monitoring the returns on indices.
Exchange Traded Funds are commonly referred to as ETFs. They first emerged as a passive investment approach to mirror some of the major indices.
During periods of uncertainty, we prefer to have an active approach versus a passive approach. Individually selecting securities is preferred over buying an entire index. We have written articles in the past on the pros and cons of holding ETFs, mutual funds, or direct holdings. The purpose of this article, however, is to once again outline our concern with equity ETFs when markets are reaching near historic highs.
On Nov. 29, 2019 we wrote a similar article — Ten reasons to be cautious with Canadian equity ETFs — when the TSX Composite Index (TSX) was at 17,040. Within four months, the TSX Composite Index dropped to 11,173 (or a decline of 34.4 per cent). Once again, markets are approaching all-time highs, despite market uncertainties (i.e. COVID, economic decline, corporate earnings, political uncertainty, trade uncertainty, etc.).
We felt it prudent to revisit the reasons we feel investors should be cautious with index equity investing.
Equity ETFs that cover the broad market naturally have a Beta close to one. This means they are equal to the risk of the market. When the markets are doing well then ETFs will track that. Using the S&P/TSX 60 Index (XIU) as an example, it has a beta of 1.04 — higher than the S&P/TSX Composite Index. In June 2008, the XIU was $22.81 per share. In March 2009, the XIU traded as low as 11.41 per share. The XIU essentially dropped 50 per cent. The S&P/TSX Composite Index hit a high of 15,154 in June 2008 and declined to a low of 7,480 in March 2009. A decline of approximately 51 per cent. After the markets have had an extended run, we get particularly nervous about equity ETF style investing. Are you prepared to accept the complete downside of the equity market if it pulls back quickly?
Advocates of ETF investing are proud to highlight the returns that equal the market. I’ve never felt that the end goal of investing is to just own the market and have returns equal to the general market. Our objective at the beginning of every single year is to beat the market. Beating the market really comes down to not having an equal position in everything. You have to concentrate on a much smaller group of stocks and exclude everything else. Our end goal is to have our equities outperform the general market – not just equal the market.
I’m not convinced that a completely hands-off approach is the best approach. If you are using ETFs then we feel that you still have to manage the ETFs to ensure you’re in the correct ETFs. When we hold individual holdings, we can shift the holdings, making good strategic allocation decisions, based on economic conditions. By strategic allocation decisions I mean asset mix (per cent in cash, fixed income and equities), sector exposure, geographic exposure, and tax efficient strategies. We feel that there is extreme value in having a good portfolio manager that can help you make both tactical asset allocation and strategic asset allocation decisions.
Although ETFs are a lower cost option when compared to mutual funds, they do have costs. There are costs when you purchase and sell. They also have embedded costs within the ETF. The embedded costs with an ETF are lower than mutual funds. If an investor is seeking the lowest cost option then buying individual equities and never trading them is the lowest long term cost option. You have a one-time cost of purchasing them with no ongoing costs. We don’t recommend this approach because we feel the markets are changing and you have to adjust the equity holdings accordingly. We also feel that rebalancing and making both tactical asset allocation and strategic asset allocation decisions enhances returns. We feel couch potato investing (buy ETFs and do nothing) is not the best option for investors who have discovered working with a Portfolio Manager.
Some ETFs will have hundreds or thousands of holdings. In our model portfolios we typically limit the number of equity holdings to 25 to 35 individual common shares. We prefer to focus on the best companies and concentrate on those holdings rather than spreading the capital out over hundreds or thousands of names. I strongly believe that concentrating on the best names is a better strategy than having numerous small holdings.
We encourage investors to avoid Canadian ETFs that hold American stocks. To illustrate, we will use an investor named Jill that owns 14 individual common shares of US companies within her Registered Retirement Savings Plan (RRSP). The US and Canada negotiated a tax treaty that exempts any withholding tax on US dividend income generated within an RRSP. Another investor named Jack decides to purchase a Canadian ETF that holds American dividend paying common shares. As the common shares are held within an ETF, it does not fall under the exemptions listed in the tax treaty. As a result, a 15 per cent withholding tax is applied on all dividend income within the ETF. This 15 per cent withholding tax is an absolute cost and is lost to the investor.
A typical client will have a Tax-Free Savings Account (TFSA), RRSP, and a non-registered investment account (either Joint With Right of Survivorship, or Individual). In our July 26, 2019 article, we discussed placement of investments in registered and non-registered accounts. This article focused on how to get the best tax benefits from structuring your investments correctly. Individual Canadian equities that pay dividends are best in a non-registered account to claim the dividend tax credit. Individual US dividend paying equities are best in an RRSP account. The article has many tips that we help our clients with. An ETF investor often has the same holdings in each account without giving thought to the best tax structure. The ironic part about this is that the ETF investor may be saving a small amount in the ETF fee, but losing even more in tax savings by fixating only on fees.
Many companies are introducing actively managed ETFs. When I hear the term “actively managed ETFs”, I feel it is essentially moving in the direction of a mutual fund. Many mutual fund companies are also creating passive strategies as well. Many ETFs are moving towards the mutual fund space to justify slightly higher fees, and many mutual funds are moving towards the ETF space by reducing fees and hoping not to lose market share on fee-sensitive investors. These two investment worlds are somewhat colliding. Some ETFs are claiming that they have designed built-in Algorithms. This sounds really fancy and it sounds passive. Back-testing data does not guarantee future results, similar to the mandatory mutual fund disclosure that past performance is no indication of future performance. Prior to purchasing either, it is important to know all the details and consider all options, including holding individual positions with a Portfolio Manager.
ETF investors have the option of holding one or more ETFs. Both have shortfalls in my opinion. If you are holding only one ETF – which ETF would you hold? If you purchase XIU, for example, then you are completely missing everything outside of Canada. On the flip side, some ETF investors will hold several different types of ETF holdings. They may hold a sector ETF, a broad market ETF, and an ETF that holds only dividend-paying equities. As a Portfolio Manager we have tools that retail investors do not have. What we have discovered when we have used these tools is the haphazard approach of combining random ETFs can result in duplication of the underlying holdings and there may be good opportunities that the ETF investor has no exposure to. The more ETF holdings an investor has, the more challenging it becomes to monitor the sector exposure, geographic exposure, and individual company exposure. This becomes even messier when you mix mutual funds and ETFs together.
Similar to a mutual fund, it is a little harder to get excited about following your investments when you are not able to see your individual holdings. We find that when our clients hold the individual companies, they are actually engaged in the investment process. Our clients can see the 25 to 35 holdings they own, follow them in the news, and read the annual reports if they so choose. When you hold both ETFs and mutual funds, that excitement and level of monitoring is somewhat lost. Many of our clients will put the stocks they own in their phone and they can easily track the current price, read recent news, and see the dividends from the companies come into the account. We can print out an income report which will show them the number of dividends they are expected to receive in the year ahead. With mutual fund and ETF investing, I find that this engagement element is somewhat lost as everything is wrapped into one structure, making it hard to visualize the underlying holdings. We feel the more engaged any investor is with respect to their investments, the better the long-term results.
When you buy an ETF for your portfolio, you take away a lot of options for yourself. If you need to withdraw funds from your portfolio and you are only holding a Canadian Equity ETF, then you have put yourself in a position with no choice but to sell the ETF to raise funds whether the market is at all-time highs (creating potential capital gains) or at annual lows. With a well–diversified portfolio of individual holdings, you have the ability to pick and choose which holdings to sell given the market conditions at the time when you require funds.
Asset allocation adjustments are always better done when equity markets are at higher levels. With the many market uncertainties listed above, we have increased cash and increased fixed income in the short term (potentially up to 2 years). We have also selected a smaller number of equity holdings. We feel that this strategic adjustment and active approach will help our clients weather the current environment, especially when compared to an equity ETF or index investing strategy.
Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director of wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC. Call 250-389-2138. greenardgroup.com