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(John Foxx/(c) John Foxx)
(John Foxx/(c) John Foxx)

Streetwise

Canadian ETFs are less risky, and less profitable Add to ...

Exchange traded funds aren't nearly as profitable on this side of the pond.

On Tuesday, Streetwise wrote about the huge profit margins European ETF managers make, citing a Deutsche Bank reported that estimated these companies earn somewhere in the range of 55 to 65 basis points.

To set the record straight, Som Seif, chief exeuctive officer of Claymore Investments, reached out to explain how Canada's market differs. Mr. Seif has good reason to clarify any misconceptions: ETFs are marketed as low-fee alternatives to mutual funds. If the ETF providers are raking in big margins, investors have reason to be skeptical.

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But he also wants to point out how much safer North American ETFs are, compared to Europe's, which benefits investors.

Here in Canada, almost all ETF products are of the traditional type, meaning that when an investor buys one dollar of the ETF, that dollar goes toward buying the underlying portfolio. Over in Europe, Mr. Seif estimates that only about 55 per cent of all ETFs are of this nature.

The rest are synthetic ETFs. These are much more dangerous because they are constructed using a swap, which Mr. Seif has serious issues with. If the investment bank that is used as a counterparty defaults (and Lehman proved they can), retail investors can lose all their money.

This isn't to say Canada doesn't play around with the traditional type. There are leveraged accounts, most notably from Horizons BetaPro, but they don't carry the same counterparty risk.

Because most Canadian ETFs are more vanilla, the fees earned are lower. Generally, for low cost products, ETF providers here will earn 5 to 7 basis points, while higher cost products bring in 20 to 30 basis points. Leveraged ETFs can earn more because they typically charge higher management fees that typically range from 1 to 1.25 per cent.

Those numbers differ drastically from Deutsche Bank's report, which estimated profits around 60 basis points for traditional ETFs. Mr. Seif said that the big difference between North America and Europe is that the securities held in ETFs here don't earn much money by the way of securities lending. The Deutsche Bank report's authors estimated 26 basis points on securities lending.

Why such a big difference? In Europe, investment banks are the big providers of ETFs, with everyone from UBS to Deutsche Bank to Credit Suisse selling their own suite of products. Here in North America, the big ETF providers are largely independent fund management firms such as Claymore, Horizons BetaPro, Vanguard and State Street.

North American ETF providers also don't benefit from the sales and trading activities Deutsche Bank rewards to synthetic ETF providers. Why don't they get involved in that business? Canadians just don't have the appetite for swap-based products, Mr. Seif said, whereas Europeans are much more comfortable with things like structured notes.

Still, Canadian firms are in a big race to ramp up in ETFs, with players such as Bank of Montreal and Royal Bank of Canada getting involved. Mr. Seif attributes that to potential growth of the industry, rather than the margins.

"If you're in the mutual fund business and you're not growing as quickly, which a lot of these guys weren't, you say 'I want to be a part of that,'" he said.

But he cautions that success in mutual funds doesn't guarantee success in ETFs. "The ETF industry isn't like the mutual fund industry," he said. It's not based on distribution to your bank channel." Instead, it's centred around innovation and providing the best lower cost products. If a bank simply brings its own version of another low-cost product, the market may not respond well.

That scenario has played out in the U.S. Huge ETF growth caused a number of firms to jump in, but some big mutual fund players simply haven't been successful. Northern Trust pulled out after its first attempt to enter the game, and Mr. Seif said Russell Investments also isn't doing very well.

In Canada, BMO and RBC are pushing hard to sell ETFs, but Mr. Seif said their sales numbers can be misleading. Banks can use their mutual funds to buy their own ETFs, and they also construct ETFs that hold other ETFs, so there isn't as much new money entering the space.

 

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