Survival of the fittest, ETF-style: Dow Jones Canada Titans 40 ETF to be terminated, while other ETFs see sales rise - Investing in Mutual Funds

Last month I received a call from a distraught advisor who is one of the leading advocates of ETFs. In fact, ETFs form the 'core' and a portion of the 'explore' of every one of his clients' portfolios. He felt that the failure of the lowest MER (0.08%) ETF on the planet was a black eye for the product category. He went on to worry that this might be a sign of things to come and it would furthermore send the wrong message to investors. Nothing could be further from the truth!

The DJ Canada 40 ETF was unsuccessful for three primary reasons. The first mover advantage has been very powerful in the ETF market. The i60 ETF was first, has a large following and has option and future contracts based upon its index. A similar first-to-market advantage can be seen in the SPY versus the IVV (both of which have S&P 500 exposure) and between BBH and IBB (biotech exposure). Second, there was a lack of awareness of the DJ Canada 40 ETF and the underlying index even amongst financial professionals. Obviously, if investors don't know something exists or its rationale, the assets are not going to follow. Finally, much of the time the miniscule MER was overshadowed by a wide bid/ask spread, resulting in significantly higher 'all in' costs to trade the DJ 40.

Most product classes, investment or otherwise, follow a Darwinian process of 'survival of the fittest.' In the early stages of growth, it is actually healthy for the strong to thrive and the weak to perish. The marketplace signals the most desired attributes via support and ignores the laggards. However, as a product class matures, failures tend to escalate as the industry 'churns' for new growth engines. Both ETFs and the mutual fund industry are good examples of this phenomenon.

In the U.S. and Canada, the mutual fund industry has been running at about an 8% failure rate over the past few years. With a universe of over 6,000 funds, that is plenty of closed or merged funds and a resulting survivorship bias in reported average performance figures per asset class! In contrast, there are now 139 ETFs in North America, with the DJ 40 slated to close on November 1st and three U.S iShares (covering chemicals, the Internet and Canada) scheduled to shut down later this year. As the business press has highlighted, long-term mutual funds (i.e. non-money market funds) continue to suffer from net redemptions. In Canada over the two-month period of June and July, $1.OB went out, while a whopping $60B exited U.S. funds. ETFs, on the other hand, saw new investor money coming in totaling over $78M in Canada and $11B in the U.S. over the same time period.

As the accompanying chart illustrates, the global ETF universe continues to grow. Over the past few years in the U.S. we have seen assets increase by a factor of five and the number of ETFs triple to over 100. In Canada, while overall assets have remained basically flat (mainly the result of the market in general and Nortel Networks in particular), the $5B in Canadian ETF assets is now diversified across 16 funds instead of one. Also, the number of unitholders has quadrupled, again indicating investors' strong appetite for low cost, tax smart and precise investment vehicles. And, as if you needed reminding, all of this happening in the poorest equity market environment in years!

So rather than sounding the death knell for ETFs, the DJ 40 wind-up is simply part of the evolution of this innovative and exciting new product class. These new products help investors exercise their investment opinion, whether long, short or neutral, in a very efficient manner. So whether you have started to utilize ETFs as part of your investment strategy or are still considering doing so, rest assured that ETFs are still gaining momentum and likely will for a long time to come.

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Howard Atkinson, CFA, CIMA, is author (with D. Green) of The New Investment Frontier: A Guide to Exchange Traded Funds for Canadians. He is also the National iUnits Marketing Manager at Barclays Global Investors Canada, Ltd. Phone 416-594-4404.

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