Canadian investors should be wary of buying these ETFs

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The number of exchange-traded funds (ETFs) has grown so dramatically in recent years that they now represent almost half of the listings on the Toronto Stock Exchange. Of the 1,726 securities listed on the TSX at the end of the third quarter of 2021, 857 or 49.7 per cent were ETFs. As a result, an investor can easily replicate not just mainstream indexes such as the S&P 500 or the S&P/TSX 60 Index, but also more esoteric targets such as Canadian family-run businesses, genomic innovation or women in leadership.

On the face of it, this is good news for the individual investor. After all, an ETF, like a mutual fund, offers immediate diversification into a portfolio of stocks selected, either passively or actively, with a focus on a sector of interest to the investor. Unlike a mutual fund, the management expense ratio (MER) is typically a good deal lower and an ETF can be bought or sold at any time during the trading day without waiting for the market to close.

So, what can go wrong with this scenario? The answers begin to emerge when we examine the market-cap distribution of funds in this sector.

The entire universe of 857 funds represents assets under management (AUM) of $305-billion, for a respectable average asset size of $356-million. When we rank them by size from largest to smallest though, the median or midpoint fund has assets under management of a more modest $64-million. The wide spread between the mean and the median suggests there is a big dispersion toward the lower end of the distribution spectrum. This is confirmed by further analysis: The top 10 ETFs represent $71-billion in assets or 23 per cent of the industry total, leaving 847 funds to fight over the remainder.

This might be a sustainable business if the remaining market share were divided up equally, but that is not the case: 160 of the ETFs have AUM under $10-million while a total of 243 are below $20-million. A fund typically pays the legal, audit, stock exchange fees and prospectus filing fees, so the MER on a small fund will be inflated by these costs and may no longer be a bargain. Equally important, a fund this small indicates a lack of widespread investor interest, so trading activity could be very limited. The NBI Canadian Family Business ETF, for example, reports a return of 46.8 per cent in the 12 months to Oct. 31, 2021, but the AUM evaporated from $20-million to $3.7-million during the first six months of this year. The fund traded on 151 out of 250 trading days according to the latest fact sheet and average daily volume is less than 400 shares. Capturing this return in the real world may be problematic if you own more than a few hundred shares.

More important, a small fund generates only small management fees for the money management firm that sponsors it. If it doesn’t gain traction after a couple of years and the fund objective no longer resonates with investors, the sponsor will begin to look for an opportunity to reduce the administrative burden of running the fund. In that case, the fund may be liquidated, with unexpected taxable gains or losses showing up in your account. More likely, it will be merged into another, larger fund in the same manager’s stable with the promise of a lower MER and more liquidity. This type of rollover is not usually taxable, but the objective of the new fund may be very different from your original vision. Earlier this year, the CI First Asset Canadian Buyback Index ETF was merged into the CI WisdomTree Canada Quality Dividend Growth Index ETF. The latter may be an excellent fund, but it has little correlation to the investor’s original thesis.

The conclusion from this analysis is clear: be wary of buying an ETF with only a few million in assets under management unless you are convinced that the investment theme will gain traction in the near future. Be especially wary if the fund name or theme sounds as if a marketing team put it together during a brainstorming session to develop products based on what is currently trending on the internet. When the topic is no longer trending, investor interest will dry up, the marketing team will have moved on and you will own an illiquid ETF.

Finally, check the disclosure documents regularly to monitor the growth of assets and the frequency of trading days so you won’t be surprised by illiquidity or a forced merger.

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

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