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Since ETFs were introduced three decades ago, the bulk of capital invested has been in low-cost index funds that cover wide swaths of the market.

Murat_MIZRAK/iStockPhoto / Getty Images

The explosion in popularity of exchange-traded funds is driven largely by one increasingly important attribute for investors – they’re cheap.

Since ETFs were introduced three decades ago, the bulk of capital invested has been in low-cost index funds that cover wide swaths of the market. Fund providers continue to whittle away at their costs to attract more investment dollars, while also forcing many of their more expensive mutual fund competitors to cut their fees to better compete.

Still, despite the general tendency to get fees as low as possible, ETF providers are also launching more niche active management and sophisticated strategies that come with higher costs.

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The question for ETF investors is whether cheaper is better for most of us when it comes to performance. Or should ETF investors take a more nuanced approach that includes funds at both ends of the fee universe?

Most investors appear to be opting for simple and cheap: Exactly two-thirds of ETF assets under management are with basic index funds, according to Mark Noble, executive vice-president of ETF strategy with Horizons ETFs Management (Canada) Inc., citing Investor Economics data from March.

A similar amount (62 per cent) is in ETFs with management fees under 0.3 per cent, while only 35 per cent of funds are priced at that level or below.

The majority of funds (55 per cent) carry management fees of 45 basis points or more, yet have attracted only 24 per cent of total assets under management for the industry.

On balance, cheap is good and broad exposure is good, experts say, particularly if you are a younger investor with plenty of years ahead of you. Why pay higher fees in the hopes that an active manager can beat the markets year in and year out?

To back up this argument, Vanguard released a study showing that, for the past 10 years ended in December, 2020, 182 of 223 of its funds – which it says have an average expense ratio of 0.12 per cent compared to an industry average of 0.26 per cent – outperformed their Lipper peer-group average. Most of those funds were passively managed.

“It is not a secret, but if you are going to be invested in large-cap Canadian or large U.S. equities, you can ensure statistically that you have a top-decile performing strategy by simply buying an index strategy,” Mr. Noble says.

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There has been a global shift to index investing over the past three decades, the Toronto-based strategist notes, and for the index focused, he believes low costs should trump other considerations.

“Your biggest determinant of success, if you are an index investor, is to reduce the cost because every basis point that you pay to get exposure to that index is going to work against you.”

However, for some investors, it makes sense to look at more expensive, niche funds. Sophisticated ETFs that do more than track a certain broad index can play a role in meeting more complex investment goals, says Spencer Barnes, portfolio manager and associate vice-president of mutual funds and ETF strategy with Raymond James Ltd.

The growth of niche ETFs “can be a really useful tool when used appropriately by a client or an advisor,” Mr. Barnes says. “The key is making sure those puzzle pieces work together rather than duplicate each other.”

He provides the example of older investors with income needs in retirement.

“Some of these income solutions, although they are more expensive, are exactly tailored to that client: low downside risk, higher stream of income, a monthly stream of income for example,” Mr. Spencer says. “That client should absolutely be in something like that.”

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To fill that specialized need for those looking for a steady stream of income and willing to accept the risk of “reduced upside and modest leverage,” he likes Hamilton ETFs Enhanced Multi-Sector Covered Call ETF (HDIV-T) with a management fee of 0.65 per cent. He cautions it’s a new fund, launched on July 21, so it has a short track record.

For U.S. equities that are tracked via Canadian ETFs, he likes Vanguard’s S&P 500 ETF (VFV-T) with a management expense ratio (MER) of 0.08 per cent and BMO’s S&P/TSX Canadian Capped Composite Index ETF (ZCN-T) with an MER of 0.06 per cent. And for “ultra-low-cost and tax-efficient exposure,” he points to the Horizon’s S&P/TSX 60 Index ETF (HXT-T), which is a corporate class ETF made up of total return swaps, with a currently rebated MER of 0.04 per cent.

For many investors, including younger ones who are decades away from retirement, low-cost broad index funds may be all they need, says Yves Rebetez, an ETF analyst and partner with Credo Consulting in Oakville, Ont.

He recommends investors consider index funds a key holding but cautions there’s a downside to solely relying on the big stock index ETFs – you could be missing out on the next big thing.

“You do run the risk of capturing the returns of the old winners and not the new one,” Mr. Rebetez says.

An example is the long-delayed inclusion of tech stock darling Tesla Inc. to the benchmark S&P 500 index last year.

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Those total market U.S. ETFs include Vanguard’s U.S. Total Market ETF (VUN-T) and the Canadian dollar hedged version (VUS-T), which both carry a MER of 0.16 per cent. They have been climbing steadily since the pandemic-induced market crash of March, 2020.

Mr. Rebetez notes these funds have tracked the performance of thousands of stocks, not just those brought onto the S&P 500 index.

He believes ETFs offering broad market exposure at very low costs are a winning formula.

“For a lot of people, just going low cost, broadly diversified and `buy and hold and forget about’ it is probably good enough.”

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