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Growing interest in ETFs by the wealthy ignites an old debate

We often read that wealthy people build their portfolios with complex investments such as hedge funds, private equity and personalized portfolios of stocks and bonds.

Yet a growing number of wealthy investors are turning to more modest vehicles because of their low cost. According to a late 2015 survey by Illinois-based Spectrem Group, exchange-traded funds (ETFs) are making up a larger portion of portfolios of the wealthy, at least in the United States.

It found that, among those with $100,000 to $1-million in assets, 14 per cent of their portfolios consisted of ETFs. Among ultra-high-net-worth individuals, those with assets between $5-million and $25-million, 43 per cent held them, up from 40 per cent the year before.

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Figures are harder to come by in Canada, but financial advisers say wealthy Canadians are opting for ETFs, too, for multiple reasons. Among them are low fees, diversification opportunities and the fact that they can be traded easily.

Yet whether high-net-worth investors seek out ETFs ultimately depends on which side they fall in one of the biggest debates in the investment industry: the merits of passive management compared with active.

"Much of their interest in ETFs stems from the low fees, and in part that flows from the fact that a lot of active [mutual fund] managers have underperformed their benchmarks," says Ben Jang, a portfolio manager with Nicola Wealth Management in Vancouver.

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Passive strategies have done well particularly in the past decade, he says, and correspondingly so have ETFs in terms of their popularity because rather than trying to beat the index, ETFs generally try to mirror its performance.

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"If you were a passive investor, you would have done extremely well," because in a bull market most companies listed on an index, good or bad, perform well, he says.

"But over the long term, focusing on quality companies is a better approach," says Mr. Jang, whose firm ascribes to active management strategies such as selecting individual stocks, bonds and funds with strong track records of profitability over the long term.

Millennial investors are particularly interested in ETFs, Mr. Jang adds. The Spectrem survey also found that younger wealthy investors hold ETFs in higher proportions than older investors do.

Mr. Jang says this makes sense because many millennials started investing following the Great Recession and have mostly experienced rising market conditions since.

But it's not just millennials who are drawn to ETFs, says Graham Westmacott a portfolio manager with PWL Capital in Waterloo, Ont., which offers ETF-based portfolio management.

High-net-worth investors of all ages are seeking out firms like PWL, he argues, because they believe a passive strategy is superior. "There's overwhelming evidence that over longer periods active managers will underperform their benchmark index and a comparable portfolio of ETFs," Mr. Westmacott says.

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It's not just the higher fees associated with active management that are an impediment to outperforming the benchmark, he says. It's also the sheer number of professional investors seeking to beat the market.

"There are simply fewer mistakes [mispriced assets] to be exploited," he says. "What we've seen over the past few decades is increased competition and professionalism among active managers," making it difficult "to out-compete."

As a result, wealth management firms such as PWL use ETF strategies and focus their efforts more on risk management and other issues.

Money management for wealthy people isn't only about selecting an ETF or an actively managed portfolio, says Susan Latremoille, a portfolio manager who heads a high-net-worth practice with Richardson GMP in Toronto. It's also about tax and estate planning and helping clients foster fiscal management skills in their children so the next generation can be good stewards of wealth.

For her part, Ms. Latremoille says she is "agnostic" about passive versus active management. "ETFs have a role to play at times, and active management does, too."

For example, ETFs also tend to serve investors better in some markets. She says ETFs generally work well for providing exposure to the S&P 500 because it's difficult for active management to beat this diversified and widely followed basket of stocks.

In contrast, ETFs may be less effective for the Canadian equity market because buying an ETF that mirrors the TSX Composite can lead to overconcentration in the financial and energy sectors, she says.

Indeed, overconcentration is one of the main arguments against passive investing, Mr. Jang says. By design, ETFs provide increased exposure to the most liquid and largest companies because indices are weighted by market capitalization.

Moreover, ETFs are not useful to provide exposure to the alternative investments favoured by the wealthy, such as private equity or real estate, which have higher yields and are generally uncorrelated with public equity and bond markets, he says.

Yet Ms. Latremoille says a decisive answer as to whether one strategy works better than the other is unlikely ever to emerge because both have merit and drawbacks.

What's more important is developing a comprehensive wealth strategy. By fixating on stock picking versus ETFs, she adds, high-net-worth clients are likely to get "answers to the wrong questions."

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