Are there too many ETFs?

Despite complaints of being overwhelmed by choice, investors have largely stuck to the conventional.

Jess Morgan 29 November, 2016 | 6:00PM

Canada's first exchange-traded fund (ETF) arrived on the Toronto Stock Exchange in 1990. Today, there are 400 ETFs on the TSX and over 1,900 listed on U.S. exchanges. According to Karl Cheong, head of ETFs at Toronto-based First Trust Canada, investors are feeling more pressure than ever to choose wisely.

"Across the country, the common pushback I get about ETFs is that there is too much out there," Cheong says. "With very specific niche ideas, [they ask] if these ETFs are really needed."

Mark Noble, head of sales strategy at Horizons ETFs, agrees with those who believe there are too many ETF choices on the market. "But I don't necessarily view that as a negative," he adds. "The market is always changing, and as we've seen with ETF launches, particularly over the last couple of years, we're starting to see them become more refined."

Concern over an abundance of choice has not stopped ETF investors from piling into a few popular products. As of last year,  iShares S&P/TSX 60 (XIU), sometimes called "the granddaddy of ETFs," was by far the best-selling ETF in Canada, with an 11% share of the total ETF market and $9.6 billion under management. Its closest competitor, iShares Core S&P 500 Index (XSP), has $2.7 billion under management. In third place is BMO S&P 500 (ZSP), followed by iShares 1-5 Year Laddered Corporate Bond Index (CBO) and  iShares Canadian Short Term Bond Index (XSB).

These are not diverse choices. All five products offer broad exposure to North American markets. All three equity ETFs track large-cap stocks; both fixed-income ETFs track investment-grade bonds. Four out of five are market-cap-weighted; the exception is CBO, whose underlying index, the FTSE TMX Canada Investment Grade 1-5 Year Laddered Corporate Bond Index, is divided into five equally weighted maturity levels. And four out of five come from iShares, Canada's largest ETF provider.

But growing numbers of Canadian investors are beginning to look beyond the top five. Assets flowing into strategic beta ETFs increased 26% over a 12-month period ending in September 2016. Active ETF assets have grown over 40% over the past three years. With new strategic beta and active ETFs hitting stock exchanges regularly, it's no surprise that investors are wondering if and how they can get better performance than they have by following the broadly indexed, North American, large-cap, cap-weighted script.

According to Noble, who estimates that 80% of ETF assets in Canada are invested in the country's 20 best-selling products, innovation in the industry is welcome. "We don't know what the next iteration of the market will be, but we can't expect that the market-cap-weighted index strategies, which are highly concentrated, will continue to be what works for investors," he says. "You are going to continue to see innovation occur, and you are going to see ETFs come to the market that we haven't even conceived yet."

But ETF innovation has its risks, Cheong says, and a big one is investors' failure to do their research. "From my feedback, as proliferation increases, people just read the name of the ETF," he says. "They assume once they read the name, they know exactly what it does."

He cites the example of an investor who buys BMO S&P/TSX Equal Weight Oil & Gas Index (ZEO) as a commodity play, and is then confused why the performance of the ETF is so poorly correlated with the price of crude oil. Had the investor looked deeper into the ETF, she would have found that it actually tracks Canadian energy stocks. For direct commodity exposure, Horizons NYMEX Crude Oil (HUC), which tracks oil futures, would have been a better buy.

This is the sort of pitfall that can be avoided with the help of a financial advisor, Cheong says. "Picking ETFs is a bit like mixing colours. You can either paint mud, or it can be a beautiful shade. Advisors are there to help you pick the right colours for the shade you want."

For the do-it-yourself investor, Noble recommends asking the following questions:

  • Does this ETF meet your risk/return objectives?
  • Are you satisfied with this ETF's risk-adjusted performance?
  • Does this ETF provide cost-efficient exposure (factoring in both management fees and taxes)?
  • Is this ETF as liquid as you want it to be?

"If something meets all four of those criteria, this is probably an ETF that is going to stick around because it's doing what it's supposed to do for a large swath of ETF investors," Noble says.

As providers continue developing new strategies, some ETFs end up shutting down within three to five years under the pressure of gathering assets. This is especially likely to happen as a result of poor construction or an overly narrow mandate, Cheong says. "At the end of the day, investors are going to make the decision whether ETF proliferation has gotten out of hand. They will be ones who vote with their money."

About Author

Jess Morgan

Jess Morgan  Jess Morgan is the associate editor of Morningstar Canada’s website. She began her career as a television producer and freelance writer, often making appearances on TV and radio as a commentator on politics and culture. She holds a BA in communications from the University of Winnipeg and a diploma in Creative Communications from Red River College.