ETF industry mind-set: build it and they will come

By Dan Hallett, CFA, CFP on October 1st, 2010

The Globe & Mail recently reported that indexing giant Vanguard has surpassed Fidelity as the world’s largest mutual fund company.  The article poses the question of whether this event indicates a growing interest in index-investing.  I think it is but not for the reason that may be apparent.

Touched on in that piece is that long-established index mutual funds – most of which are offered by banks – haven’t seen much growth in assets over the past few years.  The growing interest in index-investing is most obvious in Canada’s growing exchange-traded fund (ETF) market. I was quoted as saying the following on this trend:

With more choice from ETFs, there is going to be some money that migrates there,” Mr. Hallett said. “And some of the bank index funds are awfully expensive. … I would say the average cost difference between an equity index mutual fund and ETF would be about 30 basis points.”

Some clarification is worthy.  First, my index fund vs ETF cost difference was an estimate – not the result of any recent calculation.  Second, the above quote doesn’t fully capture my view on this.

The ETF industry has adopted too many of the mutual fund industry’s bad habits – i.e. proliferation of  narrow-focus and specialty products.  The ETF industry has grown more than the index mutual fund market in Canada because ETF sponsors continue to pump out product.  If the fund industry taught ETF sponsors anything, it’s that cranking out new products is the key to attracting more money from investors.

Morningstar’s database lists 176 ETFs that trade on the TSX.  But less than 10% of those have existed for five years.  Fully 144 TSX-traded ETFs were born since 2007 – 45 so far this year; 37 in 2009; 35 in 2008 and 27 in 2007.  At least seven Canadian ETFs have folded (i.e. four from TD Asset Management, the original TIPS 35 & HIPS 100 which merged into XIU in 2000, and the SSgA Dow Jones Canada 40).  This growth dwarfs the few launches of quasi-index funds from the likes of Invesco PowerShares, DFA and Pro-Financial.

From a business perspective, the fact that banks have launched very few index mutual funds can be viewed as a negative.  But from the viewpoint of investors, it’s a good thing.  As author Barry Schwartz thoughtfully detailed in The Paradox of Choice, increased choice quickly crosses a point beyond which people are worse off.  I’ve seen the same phenomenon at work for years in the investment industry.

ETFs are elegant vehicles that hold great potential.  But product proliferation combined with ease of trading spell decreased investor returns.  What a bitter irony.

See also ETF Rule:  Keep it simple