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Mediocre fund managers beware: ETFs are gaining clout, says RBC

Mutual fund sales total $2.29-billion in August

Stefan Klein/iStockphoto

Exchange-traded funds, which are growing in popularity, pose headwinds for actively managed funds over the next decade, warns a report by RBC Dominion Securities.

"ETF product offerings should continue to expand and gain market share," RBC analyst Eric Berg wrote in a report released on Tuesday. "We believe that this will come at the expense of actively managed funds."

While passive investing through ETFs has gain more attention lately, Chicago-based fund research firm Morningstar Inc. estimates that ETFs still only represent about 12 per cent of total U.S. ETF and mutual fund assets.

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The asset management industry is evolving with winners and losers, said Mr. Berg, who co-authored the report with Bulent Ozcan, a director of ETF analysis. "The future will be less promising for assets managers with mediocre track records. Performance will become increasingly important as ETFs cut pricing even further."

ETFs are increasingly being used by investment advisers as a portfolio management tool to increase or reduce exposure to certain asset classes, said Mr. Berg, who covers U.S. money managers. "Traditional approaches, such as the buy and hold strategy, produced demoralizing results during the financial crisis. In response, advisers are transitioning to an asset strategist role, de-emphasizing picking funds based on investment style or style drift and focusing more on asset allocation strategies."

While passive investing will gain a larger share of the market, "we believe there will continue to be a strong demand for top stock pickers," said Mr. Berg.

On Monday, U.S.-based Charles Schwab, which recently cut fees sharply on its ETFs to get a bigger share of the ETF market, announced it was acquiring ThomasPartners, known for its active management. It would not have done this deal if ETFs were set to take over the asset management industry, he said.

But investors are increasingly focusing on investment management fees because active managers can't outperform indexes consistently, Mr. Berg wrote. "Going back to 2001, we found there were only two years [2005 and 2009] in which a majority of [U.S.] actively managed funds beat their respective benchmarks...The lack of performance is why investors have turned to ETFs."

Mutual funds will remain under pressure to reduce fees because most mutual funds "lack consistent performance," and more investors realize that fees are a major drag on performance, the analyst wrote.

"We think that active funds that can move across sectors and geographies, such as absolute return funds, will have an edge over funds that have investment constraints. Likewise, we believe that boutique asset managers with a strong track record will appeal to investors. These managers have fewer assets to manage and can react to changing macro environments faster than large funds."

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ETF providers will also cut fees further, the report noted. Late Monday, BlackRock Inc.'s iShares unit, the largest ETF company in the world, announced it was slashing fees on six U.S.-listed ETFs and two Canadian-listed ETFs. Both BlackRock and Charles Schwab are trying to compete against Vanguard, which has been successfully attracting assets, Mr. Berg said.

In Canada, Horizons Exchange Traded Funds Inc. recently sliced its fee on its Horizons S&P/TSX 60 ETF by 2 basis points to a rock-bottom 0.06 per cent for at least a one-year period. Last week, BMO Asset Management Inc., the second largest provider of ETFs in Canada, also cut fees on a U.S. stock index and bond ETF.

Fees could even go as low as zero per cent because ETF providers can make money lending the securities that they own in their funds, Mr. Berg said. "This would mean that ETFs that track broad indices could reduce their fees further."

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