ETFs: The great equalizer

When it comes to investing, the deck is truly stacked against the little guy.

The main reason is fairly obvious: it takes money to make money. As an example, a wealthy investor with $500,000 only needs to generate a 5 per cent return to make $25,000. That’s a pretty safe bet with the right mix of stocks and bonds.

An investor with a more modest $50,000, on the other hand, must generate a 75 per cent return to come up with that $25,000. Returns like that require a level of risk comparable to a craps table – the kind of risk that could leave the investor with nothing.

That’s life, but a less obvious inequity is in the basic structure of Canadian investment industry.

The best financial advisors from the best investment firms serve the wealthiest investors because they are normally fee-based. That means they are compensated each year through fees as a per cent of the total amount invested. One per cent on $1 million pays a $10,000 fee. Investors with $50,000 would pay $500 – and that won’t even get them in the door.

The mutual fund trap

That leaves little choice other than mutual funds for the investor with less than $300,000 who wants a professionally managed, diversified portfolio.

Mutual funds are baskets of stocks or bonds that can focus on specific geographic regions, sectors or asset classes but are basically one-size-fits-all for investors.

The managers, administrators, marketers and people who sell them are compensated through annual fees, typically from two per cent to three per cent. In addition, flat fees are often imposed when the fund is bought or sold.

That’s a big cut of the profit when you consider that in most cases the average mutual fund underperforms its benchmark index. The average Canadian equity fund, for example, has returned 0.3 per cent annually over the past five years while the TSX has returned 1.8 per cent.

In most cases, it’s the fee that prevents mutual funds from outperforming their benchmark indices.

So, why not buy the index?

Since there are so few big publicly traded stocks in Canada, Canadian equity funds bare a striking resemblance to each other and the TSX Composite Index. Most hold the big banks and resource companies. So why not buy the index?

You can, through an exchange traded fund. Many companies offer ETFs as a way to get broad exposure to an asset class without sacrificing returns through fees. One example is the iShares S&P/TSX 60 Index Fund, which trades on the TSX under the symbol XIU. You get 60 of the largest Canadian stocks for a single trading fee, plus an annual fee of 0.2 per cent. Returns vary slightly but if the TSX 60 goes up 5 per cent, the corresponding ETF will rise 5 per cent minus the 0.2 per cent fee.

Big institutional investors have been buying ETFs for decades and it is one of the few areas of the market where the playing field is level with small retail investors.

There are now thousands of ETFs on the market, providing access to just about every sector, in every corner of the globe through broad exchanges like the S&P 500 and MSCI EAFE or individual indices.

In addition to giving investors broad exposure to global markets they can also reduce the risk of just having a few stocks. As an example, Apple and Research In Motion (now Blackberry) are both components of the Nasdaq 100. In 2012 shares in Apple rose 35.6 per cent while shares in Research in Motion fell 22 per cent. Over the same year the ETF that tracks the Nasdaq 100, the PowerShare QQQ, advanced 16.7 per cent.

With the help of an investment advisor, ETFs can compliment an investment portfolio or make up a portfolio on their own.

It still takes money to make money, but at least it’s a fair game.