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(Yong Hian Lim/Getty Images/iStockphoto)
(Yong Hian Lim/Getty Images/iStockphoto)

PORTFOLIO STRATEGY

ETF wars: How low can prices go? Add to ...

This is what it has come to in the ETF business after about 15 years in Canada: Companies are now competing with price cuts that amount to mere cents on a modest investment.

Some may mock this as a sign the ETF business has run out of ideas to attract new customers, but not people who understand that low costs are one of the foundations of successful investing. Switch funds over a difference of 0.02 of a percentage point on fees? That’s pointless. Put the fund with the lowest fees on your short list of places to invest new money? Definitely.

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Low costs leave more money on the table for investors. Do they also translate into more business for ETF companies, and thereby encourage more price cutting? We are starting to see evidence that the answer to this important question is yes.

Exhibit One is the $460-million that has flowed into the Horizons S&P/TSX 60 Index ETF (HXT) in the first eight months of the year. HXT is a somewhat complex fund that cannot be considered as an automatic choice for mainstream investors. But it is the lowest-cost ETF option for holding Canadian stocks, and investors have responded with enough enthusiasm that Horizons ETFs has just launched two more funds that can be considered low-cost leaders.

The sales success of HXT in the past 12 months can be seen in the fact that, in a lukewarm market for Canadian stocks, it has almost doubled in size. Horizons president Howard Atkinson said HXT’s appeal lies in part in its tax efficiency and its ability to cleanly track its target index. But low fees have been a big driver of sales, too.

“In this low-return, low-interest-rate world, fees matter even more than previously,” Mr. Atkinson said. “If an investor can save some money and increase their returns, they’re going to look at that opportunity, and that’s what we’ve seen.”

Granted, it’s largely institutional investors who are moving over to HXT. But there are advisers who are using it as well, including Bruno Mercier of National Bank Financial in Edmonton. He describes HXT as his go-to ETF when he’s looking for broad exposure to Canadian blue-chip stocks. He sees a number of advantages with this ETF, but the low MER of 0.06 per cent stands out. “You can’t get lower than that,” he said.

The standard management expense ratio for HXT is actually 0.08 per cent. However, Horizons announced a promotional fee cut to 0.06 per cent last fall and recently decided to extend it to October, 2014.

By comparison, the $11.9-billion iShares S&P/TSX 60 Index Fund (XIU) has an MER of 0.18 per cent.

Data from National Bank Financial show HXT has seen its assets grow 96 per cent through the first eight months of the year while XIU’s asset base fell 14 per cent. More evidence that low fees attract investors can be seen in the success that the U.S. ETF giant Vanguard has had in Canada lately. NBF numbers show the firm had the Canadian ETF industry’s highest inflows of money in August for the second month in a row.

Lower fees don’t automatically mean sales success, however. NBF numbers show that the BMO S&P/TSX Capped Composite Index ETF (ZCN), with an MER of 0.17 per cent, has seen greater outflows of money this year than the iShares S&P/TSX Capped Composite Index Fund (XIC), with a fee of 0.27 per cent.

Investment products such as ETFs generally need to have a history of three or four years before institutional investors such as pension funds will use them. Mr. Atkinson said HXT got some attention on its two-year anniversary a year ago as a result of its fee cut and its ability to minimize tracking error. An ETF should ideally undershoot the returns of its target index by the amount of its fee – any extra is called tracking error.

Acceptance of HXT has been complicated by the fact that it’s built differently than most other index-tracking ETFs. Instead of holding the same stocks as the target index, HXT uses a complex but low-cost financial tool called a swap to replicate index returns.

The swap-based arrangement involves an outside financial company, or counterparty, that commits to providing unitholders with index-tracking returns. This leads to what’s known as counterparty risk, or the danger that the counterparty will not be able to deliver as expected.

Mr. Mercier says National Bank, parent of his firm, is the counterparty with HXT and that suggests minimal risk. He notes that National Bank has been rated one of the world’s Top 20 strongest banks by Bloomberg.

A firm that avoids swap-based ETFs because of counterparty risk is Cougar Global Investments. “As an ETF portfolio manager constructing globally diversified portfolios, we use exclusively ETFs that hold the physical underlying securities,” Susanne Alexandor, managing director at Cougar, wrote in an e-mail. “We, and our clients, like the transparency of owning a small piece of the securities inside the ETFs we select.”

Another issue is that swap-based ETFs don’t pay dividends. Instead, changes in the value of these funds are calculated using a total return based on index moves plus reinvested dividends.

This structure is obviously unsuitable for income-seeking investors, but it does work well for those who want growth. In fact, a fund like HXT solves the problem of how to efficiently reinvest the dividends paid by an ETF. Alternatives are to pool the dividends and pay a brokerage commission to buy new shares, or set up a dividend reinvestment plan.

Another benefit of the swap-based structure is tax deferral in non-registered accounts. Instead of paying taxes on dividends on an annual basis, investors will simply have capital gains or losses to deal with when the fund is sold.

The two new swap-based ETFs are the Horizons S&P/TSX Capped Energy Index ETF (HXE) and the Horizons S&P/TSX Capped Financials Index ETF (HXF), both of which have fees that come in well below competing products from the BMO and iShares families.

One more swap-based ETF is the Horizons S&P 500 Index ETF (HXS), which has been around since November, 2010. This fund has also grown considerably in size over the past year, although asset levels are still modest at $61-million. The MER of this fund is 0.17 per cent, but its all-in cost when trading expenses are considered is a hefty 0.45 per cent.

One reason why this fund still has some appeal is that it offers an opportunity to get exposure to the U.S. market in tax-free savings accounts, where dividends paid into your account are reduced by U.S. withholding taxes. With HXS, your units give you the total return of the S&P 500 and no dividends.

Read more from Portfolio Strategy.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).

Follow on Twitter: @rcarrick

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