Commissions have been one of the few drawbacks to ETFs because they can chew up accounts of investors who prefer to invest through dollar-cost averaging. This was once an area where mutual funds had an edge, but no more at Schwab and other brokerages who may follow suit (Preet wonders if this is what the Bank of Montreal — BMO — has in mind with its ETFs). So mutual-fund executives could be on the Maalox now. And so too might executives at ETF companies with no brokerage arms.

But how is it possible for Schwab to charge no commissions and MERs as low as 0.08%? In a previous post, I thought it would be possible for ETFs to get their MER costs down lower, even all the way to 0%, by using fees earned from lending out securities to cover operating costs. This seemed less fanciful a speculation when a few months later, as Preet noted in a blog post, some ETFs had emerged in Europe with 0% MERs.

So that would be my guess in this case. Schwab is diverting the revenues from its securities lending operations to cover off its operating costs. With sufficient volumes of business, they could still turn a profit while giving investors big breaks on fees.  This is what Tom Lydons of ETF Trends thinks it might be too.

Indeed, it’s conceivable, as competition heats up, for MERs on ETFs such as Schwab’s to move to the 0% mark. It may not happen overnight or not at all, but there is a potential. Also, one wonders if established ETF families like Barclays Global, which currently pocket 50% or more of the securities-lending fees for themselves, might now feel pressured to switch their cut toward lowering MERs. Could they even possibly pay investors to buy their ETFs — or otherwise reimburse their trading commissions?

And it wasn’t really a recommendation: it was more of a reporting piece that observed BNI seemed to be Buffett’s “one best idea” judging from how big his recent acquisition of shares had been. Indeed, anytime I personally recommend a stock, you best run in the opposite direction, or at least view it with a healthy dose of skepticism — remember those past posts on Nortel Networks anyone?

Anyway, with Buffett now approaching 80, there may not be too many more “one best ideas” to cull from Berkshire Hathaway’s regulatory filings, regrettably. The days of riding Buffett’s coattails would seem to be near their end.

Then again, Buffett’s bold move could signal he is intent on deploying the mountain of cash in Berkshire Hathaway’s coffers before he leaves the helm. Rather than just leave it sitting there for his successors to possibly fritter away, he may be thinking he can do it better (and leave his life’s work on a more secure foundation).

The Burlington Northern deal will claim close to 60% of Berkshire Hathaway’s cash hoard — leaving $9 billion (U.S.) on the balance sheet (using figures from Richard Beale of breakingviews.com). So there could be a few more ideas flying out those regulatory filings over the next few quarters (with the third-quarter report due out mid-Nov.).

As he points out in today’s Breakfast with Dave: Market Musings & Data Deciphering, Australia has a great deal more exposure to accelerating growth in China. Only 3% of Canadian exports go to China while 24% of Australian exports go there. Furthermore, Canada has much greater exposure to the moribund U.S. consumer: 75% of its exports go to the U.S versus 6% for Australia.

Yet, interestingly, the Aussie dollar lost ground after the central bank’s latest rate hike in a “sell-the-news-buy-the-rumor” kind of move. Bank of Canada Governor Carney no doubt noticed that response and might accordingly be less fearful a rate hike would strengthen the loonie (as happens most of the time due to capital inflows). And no doubt he would love to raise rates to head off the bubble-like conditions fermenting in the housing market – especially if the loonie remains well behaved and doesn’t inflict any more pain on the already hard-hit export sector.

A good financial planner or book on personal finances could have set them straight. Roy Miller, the wealthy barber in David Chilton’s classic book, initially had the same problem. “There was nothing left at the end of the month …. I had tried budgeting and it hadn’t worked,” he tells David, Tom and Cathy.

Then old Mr. White told the barber: “Pay yourself first.” That is, have 10% taken off your paycheck and put into a bank account or investment fund before you get your hands on it. Budgeting may work for a business because the owner wants to keep costs down but budgeting for a person is hard because wants tend to evolve into needs.”

You won’t notice it, the wealthy barber says of the automatic deduction: “I never did miss that money. My lifestyle didn’t change at all.”

I support these student-sponsored initiatives and also have a practical suggestion for ensuring that employees of corporations, governments, and non-profits act more responsibly: get HR onside.

HR executives and managers have control over six opportunities to really entrench CSR at an operational level: job descriptions, recruitment, on-boarding, training, performance evaluation and compensation, exit interviews.

If corporate responsibility was integrated in each of these areas it would go a long way to ensuring that people who take MBA oaths actually live up to what they’ve promised,

Plus, because these are all ongoing initiatives, integrating CSR could be done for viryually no incremental cost!

Seven teams of MBA students presented their ideas about the best ways for a company operating in the oil sands area to improve their CSR initiatives. Needless to say this is very difficult territory – it’s clear that the impacts of oil sands operations are under scrutiny from advocacy groups around the world, the situation is extremely complex, and that there are no easy answers.

However, the judges were very impressed by the degree to which the teams understood the still-emerging discipline of corporate social responsibility, recognized the challenges for corporations with oil sands operations, and had developed creative approaches to help mitigate environmental impact and maximize business value.

The presentations also made me think about a simple framework for effective CSR planning:

1. Establish clear business and social/environmental objectives

2. Identify and prioritize the stakeholders that matter most (often very difficult to do due because of the many key groups that are involved including: employees, regulators, media, suppliers, customers, local communities, advocacy groups, etc.)

3.  Establish internal credibility at an executive level by focusing on areas where success can be demonstrated early and where the risks are lowest.

4.  Develop a communications plan to reach and influence the stakeholders that have been selected as priorities in a way that seen as authentic/genuine.

5. Make sure that you have built in an effective evaluation process. This is essential for internal credibility and continuous improvement

I think all the judges would agree with me that the students understood the situation extremely well and that each team’s presentation was remarkable.

I left feeling really inspired to know that the next generation of business leader will be placing such a high priority on doing the right thing.

Congratulations to Prof. Tina Dacin, Mandy Daniel, and especially to the Queen’s MBA students who did such a great job.

Hardy would have us believe their fates were intertwined with their characters but in speculating on grain prices, the efficient market theorists of today would say both men cast their lot to the random winds of chance. One, Farfrae, got lucky while the other, Henchard, did not. Needless to say, in both cases, today’s adherents to the school of buy-and-hold, passive investing would be appalled by their endeavors in this realm.

In the early going, Farfrae was Henchard’s right-hand man in a thriving grain-dealing business that had made Henchard one of the wealthiest men in Casterbridge as well as its mayor. But Henchard was, as Hardy wrote, a person, “…who might not inaptly be described as Faust has been described – as a vehement gloomy being who had quitted the ways of vulgar men without light to guide him on a better way.”

Jealous of Farfrae’s growing popularity in the town, Henchard dismisses him from his employ, whereupon Farfrae sets up shop in the same trade and shortly emerges as a rival. His commercial aggrandizement seems largely based on an active, short-term trading approach in grain markets. In Farfrae’s own words (speaking to Lucetta):

“Yet I’ve done very well this year. O yes,” he went on with ingenuous enthusiasm. “You see that man with the drab kerseymere coat? I bought largely of him in the autumn when wheat was down, and then afterwards when it rose a little I sold off all I had! It brought only a small profit to me; while the farmers kept theirs, expecting higher figures– yes, though the rats were gnawing the ricks hollow. Just when I sold the markets went lower, and I bought up the corn of those who had been holding back at less price than my first purchases. And then,” cried Farfrae impetuously, his face alight, “I sold it a few weeks after, when it happened to go up again! And so, by contenting mysel’ with small profits frequently repeated, I soon made five hundred pounds–yes!”– (bringing down his hand upon the table, and quite forgetting where he was)–”while the others by keeping theirs in hand made nothing at all!”

When Lucetta spurns Henchard for Farfrae, it’s the final straw. Henchard sets out to ruin Farfrae financially by outsmarting him in the grain speculation business. He says to his new foreman, Jopp:

“I sometimes think,” he added, “that he [Farfrae] must have some glass that he sees next year in. He has such a knack of making everything bring him fortune.”

“He’s deep beyond all honest men’s discerning, but we must make him shallower. We’ll undersell him, and over-buy him, and so snuff him out” ….

The season’s weather seemed to favour their scheme. The time was in the years … when … the wheat quotations from month to month depended entirely upon the home harvest. A bad harvest, or the prospect of one, would double the price of corn in a few weeks; and the promise of a good yield would lower it as rapidly ….

It was June, and the weather was very unfavourable. Casterbridge, being as it were the bell-board on which all the adjacent hamlets and villages sounded their notes, was decidedly dull.

Henchard, supported by Jopp, “read a disastrous garnering [harvest], and resolved to base his strategy against Farfrae upon that reading.” But before acting, he sought confirmation from a weather prophet. After paying him a crown, Henchard hears the following prediction:

“By the sun, moon, and stars, by the clouds, the winds, the trees, and grass, the candle-flame and swallows, the smell of the herbs; likewise by the cats’ eyes, the ravens, the leeches, the spiders, and the dungmixen, the last fortnight in August will be–rain and tempest.”

The last part was just what Henchard wanted to hear.

“The next Saturday Henchard bought grain to such an enormous extent …. When his granaries were full to choking all the weather-cocks of Casterbridge creaked and set their faces in another direction …. The temperament of the welkin passed from the phlegmatic to the sanguine; an excellent harvest was almost a certainty; and as a consequence prices rushed down ….

Henchard had backed bad weather, and apparently lost. He had mistaken the turn of the flood for the turn of the ebb. His dealings had been so extensive that settlement could not long be postponed, and to settle he was obliged to sell off corn that he had bought only a few weeks before at figures higher by many shillings a quarter….

But he had to enter the Casterbridge Bank that day for reasons which had never before sent him there …. It was rumoured soon after that much real property as well as vast stores of produce, which had stood in Henchard’s name in the town and neighbourhood, was actually the possession of his bankers.

- On Making Ethical Choices in Business: The recession lowered the ethical water mark so that people and business who weren’t doing the right thing became more conspicuous. The danger may be that with an improving economy inappropriate behavior may be become more difficult to discern.

- On Young Business Students Today: Boy these people are smart! Perhaps more important than this, the people I spoke with also know a lot about social issues and are deeply interested in what it means to be responsible. What will business look like when these folks become executives?

Finally, my colleague Andrea O’Reilly at Impakt sent me a great quotation this morning: “Pain nourishes courage. You can’t be brave if you’ve only had wonderful things happen to you.” Mary Tyler Moore

Over and out.

Monthly rises in August were 2.7% in Toronto, 2.0% in Calgary, 1.7% in Vancouver, 1.5% in Ottawa, 1.2% in Montreal and 0.6% in Halifax. “For Toronto it was the fourth consecutive rise of 2% or more, taking the cumulative gain to 9.4% in just four months,” noted the monthly report from Teranet and National Bank.

Montreal, Halifax and Ottawa prices in August are now above their respective peaks attained during the housing boom. August house prices remain below boom-era peaks in Toronto (-3.0%), Vancouver (-7.7%) and Calgary (-12.9%).

This recent leap in house prices is putting housing back into overvalued territory at the national level, going by the IMF model. As for traditional valuation yardsticks (as mentioned in the IMF study) the existing state of overvaluation is becoming more substantial.

The IMF developed an econometric model from economic fundamentals such as disposable incomes, demographic trends, and mortgage credit for the period 1993Q1 to 2009Q2. It then used the model to compute equilibrium prices for housing in the five largest provinces.

The IMF study also looked at traditional valuation measures. At the end of June (before the recent spurt in prices), the house-price-to-income ratio was about 15% above its historical average (U.S. close to its historical average); the house-price-to-rent ratio was about 60% above its historical average (twice the U.S.).

The study mentions several factors that help to support house prices, They include:

• revival in commodity prices
• lenders have full recourse to borrowers which makes escaping loans harder (unlike U.S.)
• loan-to value requirement of 80% for uninsured mortgages
• mortgage-backed securities represent 20% of the market in Canada (third of the U.S.)
• government initiatives such as buying up mortgage-backed securities, expanding the Canada Mortgage Bond program to 10-year maturities, expansion of CMHC programs and a temporary home-renovation tax credit.

From trough to peak during the boom period, new house prices were up 97% in Alberta, 120% in Saskatchewan, and 41% in the rest of Canada. Existing house prices showed similarly huge increases during the run-up phases.

Dave in BC writes:

“Basically, under a personal flat tax system all income is taxed at one low rate, maybe 8-10% – no exceptions (subject to exemptions on income for single moms, people who are below the poverty line, handicapped people, etc).

All returns could be done on one page and the tax rules & guidelines would be simplified down to a small book – not the current messed up set of rules on rules. It can be done and as a revenue neutral project to government – but who will undertake this on our behalf??

As I see it … Canada must streamline its cumbersome & messy personal tax system. To me, the best way to really make it simpler, more efficient and, most importantly, as FAIR to all taxpayers as possible – the flat tax is far & away the best model I have ever seen….

In its purest form, income from all sources (employment salaries & commissions, bonuses, stock options, investments, etc) & of all types (capital gains, income, dividends, etc) is taxed from dollar 0 at one fixed rate. Really simple, isn’t it?

In the real world, one would expect to see some modifications to a flat tax structure; possibly as an exemption for a certain minimal earnings amount for folks with very low income, disabilities, students, the elderly etc. This would replicate the relief they get under the current system and would be seen as fair & equitable by most of my fellow citizens who are a charitable lot at the end of the day. Still, a one page tax return is totally doable!

Government could calculate what the flat tax rate should be tomorrow based on the revenue they currently get in the Great Canadian Tax Grab. TFSA’s & RRSP’s would remain the same as tax shelters.

A flat tax system is mainly about fairness and efficiencies – but there would be a few casualties. For instance, the tax dept would not need thousands of the employees they currently employ to process our returns annually. Also, tax return booths that spring up each tax year may not get as much business.

Think about the big picture for a minute though – a pure flat tax is ultra-efficient, it’s easy to calculate & administer, it’s going to encourage economic growth (and may encourage foreign investment but I need to chew on this one a bit more); and most of all – it’s FAIR.

Right now, there are office buildings where the cleaning staff pay more tax than the CEO & CFO. Honest. The cleaning staff have little or no tax dodges & loopholes.

In a flat tax plan, you pay a percentage tax on everything you earn in a year. So all of the corp. exec’s & hedge fund mgrs that are under the gun currently for huge bonuses & salaries would pay a flat tax on everything. We would no longer need the …“Robin Hood” mentality where government steals from the rich to pay the poor….

Don’t for a minute think this is a brand new idea, either folks. It’s already up & running in something like 24 countries. Because it is so successful in places like Russia (tax rate 13%), Lithuania (24%), Czech Republic, Latvia, Romania, Serbia, Slovakia, Iceland, Mongolia & others – many western European countries are currently considering a flat tax too. They feel they will be at a disadvantage if they do NOT install one as eastern European countries have higher economic growth rates now with it & they feel “left behind”.

John Wesson writes:

Larry you seem to be planning a flat tax feature soon, and I am very much in favour of that for many reasons, but I fear the lobby in favour of the status quo will crush it like a bug underfoot. Lobbyists representing accountants and tax firms will mount such an anti flat tax campaign that it might take years for parliament hill to recover. It would, however, be nice to dream about a flat tax system for personal taxation in Canada.

Think about all the time currently wasted by millions of Canadians wading through the annual tax time drudgery. And what about the unbelievable amount of money ordinary Canadians pay to tax accounting organizations in order to avoid the pain of filling out those wretched forms each year. The fact that the Canada Revenue Agency (CRA) has created such a complicated monster is reason enough to adopt a flat tax system.

A flat tax would bring a sudden halt to all the pain involved in trying to understand the special kind of geek speak found only on Canadian tax forms. A flat tax system would probably reduce, by a significant number, the depression patients seen by doctors at tax time. Canadians would easily be able to figure out what 18%, for example, of their taxable income is. In fact, I can use my desktop calculator to figure out that problem in just under two seconds. Think of the joy involved in doing your taxes under those circumstances. It’s especially gratifying when you compound that pleasure with the fact that you would also save the money normally spent employing a tax expert to relieve you of the anxiety formerly imposed by the CRA by virtue of their nauseating volumes of tax regulations.

CRA could still provide necessary exemptions to protect low income Canadians, but high income Canadians would certainly have to pay up, especially if they could no longer wriggle out of paying the flat tax rate applicable to their level of earnings.

Some European counties have switched to a flat tax without any adverse effects on their economies or individuals so it’s not like we would be inventing the process. We probably couldn’t change the tax code as it applies to corporations and small business immediately, so that should keep most of the accountants and tax specialists off the dole. For the few who do find their opportunities diminished I hear the Canadian Forces are still recruiting.

1) It leads to sub-optimal investment decisions. People, lured by the tax breaks, take their eyes off sound investing practices and make riverboat gambles with their money. A prime example is Labor Sponsored Investment Funds, where thousands of persons poured money into vehicles that went nowhere. A more recent example comes from blogger Michael James, who drew attention to the incentive thrown up by the TFSA to engage in speculation– i.e. people over-contributing to the plan and investing in risky securities in hopes of beating the 1% a month penalty on over-contributions.

2) It’s antithetical to low-cost investing. All the registered plans, exemptions, etc. create a demand for financial advisors to explain them. Being able to show us how to navigate through the labyrinth and reduce taxes, advisors get a foot in the door to sell a panoply of mutual funds and other financial products with embedded fees. If you’ve cast your lot with John Bogle, David Swenson, Larry Swedroe and other proponents of low-cost investing, it seems to me you have to take a stand against this absurd complexity in our tax system.

3) Look at the huge waste of productive resources that go into tax-planning strategies, the legions of tax lawyers, chartered accounts and other specialists. For a clue of what the costs amount to, look to economist James Payne, an authority on the costs of the American tax system: “he estimates that, for every dollar his government collects and spends, individuals and businesses spend another 65 cents in collection and compliance costs,” noted analyst Peter Holle. Wouldn’t our economy be better off if these people were instead employed in more productive pursuits?

4) And don’t forget the time and effort adult Canadians have to spend on comprehending and complying with the tax system – often arriving at misunderstandings that harm them and their savings. Then there are those with the smarts, or the money to hire the talent, to find loopholes and implement tax planning strategies that make the incidence of taxes more regressive at the aggregate level. As a reader noted: “Right now, there are office buildings where the cleaning staff pay more tax than the CEO & CFO…. The cleaning staff have little or no tax dodges & loopholes.”

Don’t we need a tax system that’s infinitely simpler? I’m no expert in how to get there, but from my limited musings, things like a flat tax look worth considering. To be continued….

From the table on the Horizons BetaPro website, it looks like a strategy of shorting both bullish and bearish leveraged ETFs would be profitable most of the time. However, the past year or so has been a rather volatile period and the year ahead will likely exhibit less volatility. In that case, the shorting strategy may not turn out to be as profitable as it would appear from the Sept. 31, 2009 table.

So, if one wants to give this strategy a try, some due diligence needs to be exercised to pick one’s spots carefully. The odds of success would be higher if one were to target the sectors likely to be most volatile, one of which seems to be the S&P/TSX Global Gold Bull/Bear index.

Another caveat might be the availability of ETFs to short sell. Brokers may not be able to find any units to lend to a short seller.

Million Dollar Journey has a straightforward summary of the proposed changes, which target returns on over-contributions, returns on prohibited investments, asset transfers into TFSAs, and tax room created by the above strategies.

Tim Cestnick says “Most Canadians won’t be impacted by the changes” and offers 8 ways to legally exploit your TFSA.

Michael James points out that a 100% tax on returns derived from over-contributions is a good thing because it prevents people from taking aggressive risks (i.e. making over-contributions and investing them in risky securities in hopes of earning more than the 1% a month penalty on over-contributions).

Canadian Financial DIY explains, with the help of the Financial Webring thread, just how the asset swaps took advantage of the TFSA (as the asset swapper gets to choose any price in the day’s trading range after the fact, he can deliberately choose a low price when stock leaves the TFSA and a high price when the stock returns)

Canadian Capitalist asks why ban asset swaps into TFSAs – seems to be overkill.

Jonathan Chevreau was onto the TFSA swap strategy way back in January.

Sacha’s TFSA has grown from $5,000 to $12,000 in less than a year – and without any fancy tax planning.

Preet and Four Pillars on ING Direct’s offer to get 2010 TFSA contributions in early (and $25 referral bonus)

“At year’s end he was 100 percent over his $18,000 budget, having spent $36,000. How had he spent $36,000? Like others who try to live by a budget, Fitzgerald discovered that a lot of money had definitely been spent but didn’t fall into any category that budgets provide—there is “leakage.” Of course, in his case, there was more leakage than is customary. Fitzgerald and Zelda prepared what they thought was a complete record of what they had spent running the household—it came to $1,600 a month. Then they added what they had spent on pleasure, trips to New York, the theater, and so on; that came to $400 a month. Together that totaled $2,000, but Fitzgerald knew he’d spent $3,000. Fitzgerald asked, “You don’t mean to say that every month we lose $1,000?” It was impossible. “People don’t lose $12,000 in a year, it’s just missing.” Somehow a “mysterious third of our income had vanished into thin air.”

Hat tip to TaxDetective blog

His name, by the way, is Ed Rempel (CMA, CFP, C.H.F.S.), with Ed Rempel & Associates. Here is his response:

“I don’t believe those numbers [in the survey]. It is like the “dirty little secret” of financial planners — that everyone wants to CLAIM they do planning.

When we talk with advisors we meet at the CFP [Chartered Financial Planners] Conference and ask them about their practice, nearly all claim to do holistic advice and planning. However, if I ask them any details about it, they look at me like I’m speaking Greek.

I often ask: “What nest egg are you finding that your clients typically need at retirement to have the retirement they want?” I usually get dumb-founded responses or they change the topic. If they actually had done any planning, they would be able to recall a detail from some recent plan.

[A participant said] they often see what he calls “fake plans”. Often they are just a questionnaire to determine a need so they can sell a product, an investment projection, or a quick plan based on a rule of thumb.

In our opinion, most of the financial planning software is designed for a quick plan. You can enter a few facts, put in that the client wants to retire on 75% of today’s income, and hit a button. You get a nice plan, with pretty graphs, sometimes complete with generic commentary.

I’ve had people tell me they got a nice, printed financial plan after a 15 minute meeting at the bank, which included time to sell investments.

The same [survey says that 70% of people have worked with a financial advisor, but “fewer than 10% claimed to have actually used these other services” (services other than investments). If so many advisors do planning, then why would less than 10% of the public claim to have used any other advice from a financial planner?

We’ve also found the same tendency among the public, where many people want to CLAIM they have a financial plan. However, after I ask them about it, they don’t know where it is, don’t know what it says, and don’t know what the goals in the plan are.

It takes work to make a plan real for clients, which is what a REAL plan needs. Early in my career, I used to do plans that I thought were thorough, but the client did not understand them or believe them.

In the end, a plan is only a REAL plan if the client understands it, believes it, and accepts that the goals are what they want to achieve.”

I pointed out that several academic studies had found mutual-fund advisers added no value to the selection of funds (indeed, likely subtracted it). So why did ETFs need to be adjusted for trailer fees when doing comparisons with mutual funds? Reader John De Goey (a fee-only financial advisor) took this a little further. He noted:

“Call virtually any discount brokerage in Canada … you will find that they all require their investor clients to use A-Class funds. In other words, investors are obligated to pay the trailing commission on a product for advice that is neither received nor requested. This is scandalous! Imagine if Canadian Tire charged people for a muffler and installation if they simply bought a muffler! The Competition Bureau would step in.”

This arrangement further raises questions concerning the view that trailer fees are the cost of financial advice. In this context, it appears to be more part of the cost structure of the mutual fund company. No financial advice or service is provided to the buyer.

In the discussion of trailer fees in Part I, attention had also been drawn attention to a survey that found a minority of financial planners did financial plans for their clients – again raising questions about the value of services obtained through trailer fees. Since then I have come across a post by a financial advisor who paints an even bleaker picture. To quote:

“While many financial planners claim to do financial planning and provide holistic advice, very few actually provide comprehensive planning with written financial plans, as taught in the CFP courses.”

The report contains some remarkable findings. Here are a few highlights:

71% think brands and companies spend too much on advertising and marketing and should put more into good causes – up almost 10 percentage points

64% would recommend a brand that supports a good cause – up from 52% last year globally

In Canada, 62% would switch brands if another brand of similar or equal quality supported a good cause , 56% would help a brand promote its products if there was a good cause behind it,  and 55% expect brands to support a good cause.

It’s become very clear that the landscape for consumers and marketers has fundamentally changed. As recently as 5 years ago, cause marketing programs were seen as sidelines to core business. Today, the business case for investing in cause is  unassailable. (In fact, the Edelman research revealed that 55% of consumers surveyed have a better opinion of corporations that integrate good causes into their business – regardless of why they do so).

As per recent posts, it’s important to remember that consumers are looking very closely at what corporations are doing in this area. That means corporate commitment to the cause must be authentic and non-profit partners must be of the highest calibre.

Product integrity

The ETF vs. mutual-fund debate often overlooks important side issues, notably the stability of the products. After an investor purchases a mutual fund or ETF, it may change in various ways. But the changes for ETFs appear to be on a much smaller scale compared to mutual funds. Examples of the changes affecting mutual funds  include:

• turnover in portfolio managers – many investors may buy into a fund because of a well-regarded manager only to see the star later jump ship for another fund, leaving unitholders faced with the decision to stay with a less skilled manager or redeem and pay a rear-end load fee as high as 5%

• changes in the manager’s investing style (style drift) – portfolio managers may stay put but then start trying investment approaches different from what unitholders expected, increasing, for example, the proportion of risky securities in an attempt to juice returns

• termination or merging of a fund with another fund – which again presents unitholders with a disruption in their investing plans

Tax efficiency

While some ETFs may distribute taxable capital gains to unitholders, the incidences are more the exception to rule. Mutual funds, on the other hand, tend to distribute capital gains as a rule rather than the exception. At least that is what the averages would seem to indicate: for example, David Swensen’s book Unconventional Success shows that the average annual distribution of S&P 500 index mutual funds was 1.8% of assets from 1993 to 2002, compared to 0.01% for the SPDR S&P 500 (SPY)

Flexibility

The more one can tailor an investment vehicle to their needs, the more one can maximize their utility; having extra options is a valuable trait to many investors. Some examples:

• ETFs can be bought and sold at a known price throughout the trading day while mutual funds are bought and sold at the price prevailing at the end of the day.

• ETFs can be purchased on margin, sold short, and combined with ETF options to create covered trades and other hedging strategies

Diversification

Mutual-fund defenders say Canadian equity ETFs i) expose investors to the risk of stocks growing to a large weighting in the index, (Nortel effect) and in the case of Canadian broad-market indexes, ii) leave investors weighted toward financial and resource stocks. Let’s deal with these two points in turn:

• as for the “Nortel effect,” Canadian ETFs are no longer exposed to such risk; the fundamental ETFs offered by Claymore in Canada are not market-cap weighted and ETF families using market-cap weighting now limit the weights of individual stocks so that none can have the influence Nortel once had.

• as for achieving a portfolio less weighted toward energy and financial stocks, that would seem to be an asset allocation choice perhaps better left to the individual investor (they can tailor exposures to their preferences better than an equity mutual fund can); ETF investors typically achieve their desired level of diversification through holding a portfolio of ETFs tracking a variety of asset classes such as small caps, U.S. stocks, and international stocks.

Performance

Mutual fund apologists say mutual funds: i) offer the potential to outperform the market, ii) show periods of outperformance, and iii) have relatively better performance in sectors like small caps and U.S. stocks. Let’s deal with these three points in turn.

• as for the potential to outperform indexes, some mutual funds may be able to do so (studies show less than 5% over the long run) — but identifying them ahead of time is hit and miss; odds are that the investor will end up an underperforming fund

• as for periods of outperformance, using more extensive time sampling and adjustments for survivorship and other biases, virtually all mutual-fund-performance studies published in peer-reviewed journals indicate “that mutual fund managers on average underperform their risk-adjusted benchmarks,” to quote Professor Richard Deaves in his book, What Kind of Investor are You? (Deaves own study of the Canadian stock market found that equity mutual funds on average fell short of their indexes by more than 1% a year over the period 1988 to 1998)

• as for relatively better performance in sectors like small caps and U.S. stocks, the odds of picking an outperforming fund may be higher but then again, it is hard to identify ahead of time which funds will do so (or at least avoid management changes, style drift, closure, etc.)

Cost of advice embedded in mutual funds:

 The mutual fund vs. ETF debate often overlooks the fact – as the MacKenzie Financial piece points out (and I have too) — that the cost of most mutual funds contains the cost of financial advice (i.e. trailer fees paid to financial advisors), so comparing the costs of ETFs to mutual funds is comparing apples to oranges. Fair enough. But are investors getting service commensurate to the fees? And, do advisers put their clients in the best funds or the funds that pay the best trailer fees?

•  A survey sponsored by the Financial Planners Standards Council (FPSC) showed only 40% of certified financial planners did financial plans for “most” of their clients in 2006, down from 53% in 2002

•  At least five studies from the academic community conclude financial advisers don’t add value to the selection of mutual funds – indeed, it appears they subtract value (a grey area is ancillary services like tax and estate planning)

Portfolio turnover costs and sales loads:

The mutual fund vs. ETF debate often focuses just on MERs and commissions to buy or sell ETFs – as MacKenzie Financial does. Other expenses to consider are portfolio turnover costs and front- or rear-end sales loads. The latter can add another 1.5% to the average annual MER of 2.5% in Canada for an equity mutual fund, bringing the total “all-in” annual cost to 4%

•  John Bogle in The Little Book of Common Sense Investing estimates the cost of portfolio turnover of the average equity mutual fund adds 1% in annual costs (cost of broker fees, bid-ask spreads, and market impact costs)

•  Front- or rear-end loads can add up to 5% to costs, which for a 10-year holding period, averages out to 0.5% annually (to use John Bogle’s figure); ETFs do have brokerage fees but for order sizes over $3,000, they generally average less than 1% to buy or sell

Bond and money market funds:

The mutual fund vs. ETF debate often just focuses on stocks funds – and so does the MacKenzie Financial article. There are also money market and bond funds. And they are “where mutual funds fees really hurt,” as Rob Carrick says in his book, How to Pay Less and Keep More for Yourself. Money market funds charge MERs that average half or more the interest earned, while bond funds MERs average close to 1.5% when yields currently range 2% to 4.5%. One could also add balanced mutual funds. In non-equity funds, the comparison of long run returns more clearly favor ETFs.

Heterogeneity in product classes and investors:

The mutual-fund vs. ETF debate tends to overlook the high level of heterogeneity in product classes and investors

•  Not all ETFs are good — for example, sector and leveraged ETFs may raise questions.

•  Not all mutual funds are bad – for example, mutual-fund families without marketing and advertising overheads can keep MERs low while providing advice through in-house reps; other useful mutual fund categories may be corporate class (tax advantages) and F-class (no trailer fees); closet-indexing mutual funds would definitely not be on the good list.

•  Since mutual funds reinvest dividends and allow regular deposits without commissions, they could be more cost effective for the small investor with regular, small amounts to contribute

•  Some investors don’t have the time or desire to manage their personal finances so would be not be deterred by extra costs

To be continued ….