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The risky new world of ETFs

Choice is a wonderful thing but too much of it can be paralyzing. You can see the problem first hand on a fine summer day when people are lined up at the ice cream stand, deciding which flavour to buy. The long list of sumptuous possibilities is exhilarating but, for most people, it leads to hemming and hawing.

Investors are faced with a similar problem when trying to choose among the vast assortment of exchange-traded funds (ETFs) on the market.

A little more than a decade ago ETFs were rare things. The few that were available were much like the chocolate and vanilla of the investment world - plain but satisfying options. They tracked the big indexes and charged relatively low annual fees (MERs). If you pointed new investors to ETFs in those days, they would likely find reasonable funds on their own. But that was then.

There are now a huge number of ETFs. Sure, conservative, low-fee ETFs still exist. But they've been joined by a variety of trading vehicles that are poorly suited to long-term investors. Even worse, more than a few come with a big side order of risk and charge relatively high fees for what is being delivered.

Novice investors need to examine the options carefully. If in doubt, they should seek professional advice. At the very least, they should take the time to look at what an ETF actually holds.

Doing this can lead to some interesting discoveries. For instance, a few ETFs break one of the cardinal rules of passive investing, which is to diversify widely. These funds are incredibly concentrated and hold only a few stocks, which makes them riskier than they may appear at first glance.

Case in point: the iShares S&P/TSX Capped Information Technology Index Fund (XIT). It follows a grand total of six - count them - six stocks.

Even worse, the ETF does not hold equal amounts of each stock. The top stock, CGI Group, recently represented a whopping 27.2 per cent of the portfolio. The top three stocks made up 68.1 per cent of the fund.

It's a level of concentration that should give investors pause. Among other issues, the fund offers little protection against a downturn in one of its major holdings. Investors who think they're buying a widely diversified basket of stocks are really getting a highly concentrated bet on a tiny handful of equities.

If you truly want to own such a concentrated portfolio, it makes far more sense to buy the stocks directly. Trading commissions are low these days and by going direct you can cut out the fund's 0.61-per-cent annual fee.

To be sure, this ETF has only attracted about $24-million worth of assets. That could be on account of its high degree of concentration. But it might also have something to do with its poor performance record.

It has lost an average of 6.2 per cent annually since its inception in 2001 - an unfortunate side effect of having held huge quantities of both Nortel and Research In Motion over the years. (Each of its positions is regularly capped at 25 per cent of the portfolio but they can briefly grow beyond that level.)

It's not the only ETF to suffer from the problem of being too concentrated. You can see a few of the other offenders in the accompanying table. It shows the number of stocks in each ETF, its annual fee (MER), and assets. It also highlights the percentage of each ETF's portfolio that is made up of the top one, three, five and 10 stocks.

All but one of the ETFs have more than half of their money in five stocks and the sixth ETF comes close. As a result, these ETFs are easy to replicate, in whole or in part, by buying only a handful of stocks.

To make matters worse, these funds charge relatively high annual fees compared to ETFs that track more stocks. For instance, the iShares Russell 2000 Index Fund (XSU) follows roughly 2,000 stocks and has a MER of only 0.36 per cent. That's right: You pay more for a portfolio with six stocks than one with 2,000, which doesn't seem fair.

Most of the ETFs in the table are decidedly unpopular - which is probably good news, all things considered. But that's not the case with the hugely popular iShares S&P/TSX Capped REIT Index Fund (XRE), which has attracted $1.5-billion worth of assets. It charges 0.60 per cent a year (or roughly $9-million a year in dollar terms) and holds a grand total of 13 Canadian real estate investment trusts.

It seems likely that this ETF has found a place in the portfolio of many buy-and-hold investors. Such investors - particularly if they have a good deal of money in the ETF and are withdrawing the income it generates - should consider buying the REITs directly to save on the fees.

It's important to note that while both of the above examples involve iShares products, other ETF providers are also guilty. Rather than looking at which company offers a product, you have to examine the ETF itself.

(And to be absolutely fair, let me add that a few iShares ETFs deserve to be in the portfolios of sensible passive investors. For instance, the iShares S&P/TSX 60 Index Fund (XIU) is a gem as are several of the provider's broad market bond and stock offerings.)

The problem here is not about any particular company - it's about the distressing tendency of the industry to introduce highly concentrated, relatively expensive products to take advantage of the burgeoning popularity of ETFs. Study what you're getting before buying or you might wind up picking the wrong flavour.

Super Concentrated Exchange Traded Funds
Fraction of the portfolio in top stocks
IndexSymbolTop 1Top 3Top 5Top 10# Stocks
S&P/TSX Info techXIT 27%68%95% 100%*6
S&P/TSX Consumer StaplesXST20% 47%73%96%12
S&P/TSX UtilitiesXUT22%52%74%100%10
S&P/TSX REITXRE22%43%58%88%13
Oil Sands IndexCLO11%30%48%85%13
Equal Wt Banc & LifecoCEW11%32%54%100%10
Source: iShares.ca, August 3, 2012, * XIT tracks six stocks


First published in the Globe and Mail, August 10 2012.

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