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By David Baskin

A number of our clients have asked us why we do not buy Exchange Traded Funds (ETFs). They tell us that these instruments are inexpensive, efficient and provide good exposure to the market. We do not disagree with these observations, but they do not tell the whole story.

An ETF is really just a mutual fund with no managerial judgment. If the ETF is, for example, designed to mirror the TSX 300, the manager simply buys all the stocks in that index in the same proportion as their weight in the index. No thinking is required. If the index happens to have a huge weighting in energy, as the TSX does, the ETF must follow suit. Even if evidence suggests that energy prices will go down, the manager has no ability to allow for this. The ETF has to hold what it has to hold. In our view, there are three significant problems with ETFs.

In the first place, they remove managerial judgment about which sectors will perform better or worse than others. The TSX 300 has a 24% weighting to materials, a 28% weighting to financials and a 27% weighting to energy. That adds up to 79%. The rest of the economy fits in to the remaining 21%, including important sectors such as retail, utilities, transportation and consumer products. Buying an ETF locks the investor into a sector selection that is narrow, and which may be right for some periods, but may be very wrong for others.

Secondly, while the sector selection is too narrow, the stock selection is too broad. The big five Canadian banks are all in the top ten list of the highest weighted stocks in the TSX. Buy an ETF and you get all of them. You miss National Bank, which beat all the other banks and returned 15% in the first half of the year, but you get CIBC which fell 3%. When you buy the ETF you get the good, the bad and the ugly, and again, the manager has no ability to select.

Finally, ETFs are at the mercy of the institution which composes and calculates the index. Periodically, some stocks are taken out of the index, and others are added. The ones taken out may be good companies which, for one reason or another, no longer fit the index criteria; the ones added may be new listings in trendy industries or sectors – what we call flavor of the month. Once again, the ETF manager has to sell and buy what the index does.

During the first half of the year, every one of our clients did better on the equity part of their portfolios than the Index. We were much less weighted than the index in energy and materials, both of which had poor returns. We were more heavily weighted in stocks such as KeyEra Facilities (+24%), Cineplex (+19%), IGM (+16%) and Onex Corporation (+25%) which have only a minor place in the index, but a significant position in our client portfolios.

ETFs are cheap for a reason. Investors are paying for a mechanical process with no thinking, no judgment, no experience and no plan. As always, you get what you pay for.

Disclosure: The author and clients of Baskin Financial hold shares in the above mentioned stocks.

Source: ETFs: Low Cost, Low Benefit