Episode 6

August 05, 2022


006 - Exchange Traded Funds – what they are & why you need them

Hosted by

Vincent Heys
006 - Exchange Traded Funds – what they are & why you need them
Financial Wellness with Vincent Heys
006 - Exchange Traded Funds – what they are & why you need them

Aug 05 2022 | 00:22:55


Show Notes

If you’ve ever wondered what ETFs are, and how you can include them in your investment portfolio, listen to Patrick Keeley’s evidence-backed case for their potency in financial growth.

Vincent Heys and Patrick (President at Inukshuk Capital Management) discuss the basics of ETFs and why they’re worth a second look.

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Episode Transcript

Vincent Heys: [00:00:00] From wealthstack.ca Welcome to the financial wellness podcast series, where we discuss all kinds of financial principles, concepts, and products. Our aim is to make money matters. Simple again. Hey there. Have you ever wondered how you can use ETFs in your portfolio and what it means? Warren buffet says it's one of the best and most cost effective ways of investing for retail investors. While in this podcast, we will unpack the history, size and reasoning for using ETFs in the portfolio. Vincent Heys: Patrick Keely, president of Inukshuk Capital is in the virtual studio with me today. Inukshuk is one of the first companies I came accross uses ETFs as a building block to build and actively manage portfolios for clients. So basically instead of using stocks to manage a portfolio for a client, they use ETFs. Vincent Heys: It therefore makes sense [00:01:00] to chat to Patrick today, to give our listeners a better understanding about ETFs. Vincent Heys: Hey Patrick. Patrick Keeley: Hi, Vincent. Vincent Heys: It's great to have you in the show today. Patrick Keeley: Thank you. It's nice to be here. Vincent Heys: So let's talk about ETFs and just start the convers. Describing to our listeners, what is an ETF? Vincent Heys: And then secondly, the broad types available for investors. Patrick Keeley: Okay, well ETF is an acronym for exchange traded funds and that means they're a composite of securities that make up for the most part. An index and, and the launch of ETFs began in 1990 in Canada with an ETF being issued that would track indexes and largely by use of, of institutions initially. Patrick Keeley: But since that time they become a very mainstream. Retail product as well as an institutional product. And most of the [00:02:00] growth since that time, if you look at you'd see quite a large transition away from mutual funds into ETS mutual funds were much more popular in the nineties and much more widely adopted and accepted, but they've become far more adopted by both retail and institutional investors since. Vincent Heys: Patrick often people equate ETMS to passive investments. Mm-hmm is, is that the right analogy to use normally? What, what is Patrick Keeley: passive? So passive, meaning you're buying something and, and holding it. You're not You're not trading it. You're not shifting from one thing to the next. And so ETFs were launched to be passive investments, to give people exposure to specific indexes things that you could draw a line around and ETFs were being issued to give people specific exposure. Patrick Keeley: Since that time there are ETFs. Have a more active approach, but for the most part where they're best known and most widely [00:03:00] used, particularly for institutions and, and retail investors is to have a passive exposure to something specific. So Vincent Heys: is it, is it fair to say that, that if I, if I buy a Vanguard ETF that tracks the S and P 500, for example, that that ETF would effectively buy small portions or mirror, small portions of each of those share. Vincent Heys: In that, in that index, based on the market capitalization in that. Patrick Keeley: Yes. That's exactly correct. And when you think about the application of that for a retail investor, for example, who wanted to have a diversified portfolio in order to buy exposure to each of the holdings in the S and P 500, it would be very difficult to do with the likes of, of what most of our portfolios look like as retail investors, but with. Patrick Keeley: With very little amounts of money, you can have exposure directly to the S and P 500 by owning an [00:04:00] ETF and ETFs are very cost effective and tax efficient. So you're not you you're, your returns are not being gobbled up by fees. Like they would be perhaps in, in some of the larger and higher cost mutual funds. Patrick Keeley: Rather you're giving, you're getting very cost effective exposure to the broad index. And as you say a relative. Proportionate amount of each of the holdings in that index with one with one trade, basically. Vincent Heys: So that, yeah, so that's what you're say in terms of the costing is a lot cheaper to buy the ETF and get exposure to the, in this case 500 stocks, as opposed to individual go and buy them. Vincent Heys: For. Patrick Keeley: Not to mention just the logistics of it all are quite challenging. So it, it, as I said, was invented primarily for institutions. And to this day, if you look at, you know, pension funds or sovereign wealth funds, these are. These are funds that have billions of dollars in them. In many cases, you'll if you looked at their holdings, you'll see. Patrick Keeley: In [00:05:00] many cases, the portfolio managers of those large sums of money are often using ETFs to gain exposure to indexes like the S and P 500. Vincent Heys: So, I mean, it is interesting to think about, yes, I'm buying an index, which people normally say it's passive. Because I don't make active decisions around those stocks that's in that portfolio. Vincent Heys: But to some extent, if you think about it, you know, if a certain stock drops in market value and falls outside of the S and P 500, it doesn't, it's not part of that index anymore. And at the same time, if a stock does very well from a market capitalization perspective, And it moves into that index then by default, it's part of the ETF. Vincent Heys: So yes, I mean, it is passive, but I guess there is always some level of let's call it active management that I don't perform, but it will find it kind of itself [00:06:00] into that portfolio eventually. And, and yes, most of the industries are driven by market capitalization, but I mean, you do have MIH, you do have ins created that are. Vincent Heys: Not based on that one factor, but it's based on a number of other beater. Driven factors, which is not just market capitalization. Patrick Keeley: Correct. So to your point about the S and P 500, the S and P itself will make decisions around securities in the index. And from time to time, take some out and add some in. Patrick Keeley: So all you have to do is an investor is own the actual ETF, and that will happen for you. You don't need to rebalance, but there is some level of rebalancing that goes on, but ETFs do. People the opportunity to be exposed to specific industries or themes that they may be quite optimistic about or, or have an interest in. Patrick Keeley: So for example for people who are quite fascinated with. Technology, there are ETFs that [00:07:00] have investments in what they refer to as innovation. So there have been some ETFs arc being one of them, which is made headlines in 2020 with very spectacular returns that were driven largely by the pandemic. Patrick Keeley: And you know, just to look at that example, it. It's performed less well over the last couple of years, but it's given people exposure to an index of companies that are chosen by a portfolio manager as being leaders in their space in innovation. If somebody wanted to have an investment, for example, in robotics, they could, or genetic. Patrick Keeley: Or to use another example in the pandemic when we were all buying pets and pet accessories one of the ETF companies wisely issued an ETF that tracked companies in the pet and pet related industries. So you can be very specific about your investments by using ETFs. And it seems like, you know, on a regular basis as. Patrick Keeley: Themes change as interests evolve. The ETF companies have [00:08:00] been very clever about finding ways of giving investors, passive exposure to specific areas of the stock and bond market. Vincent Heys: Thanks, Patrick. I know that there's also ETFs that came out in Canada, I think last year before that tracks Bitcoin, but also something like shorts. Vincent Heys: It, it, there are in indexes that are tracking the short market. So. I make money when the market falls. So what you kind of just say is that really there. There are ETFs that can really track anything. Patrick Keeley: You know what it, it's getting pretty close to that. Anything is a pretty extreme term, but I think we're almost there. Patrick Keeley: I think that in, in, in our creative minds, we would probably find it very difficult to, to be stumped about ETFs that don't exist around themes. We might create, for example. So as you point out ETFs were. Invented to give institutions exposure to [00:09:00] large markets. And since that time they've evolved to give people exposure to specific niche markets regions, for example, parts of the stock market. Patrick Keeley: Of course, that includes now the bond market as well, but you can also bet against the, the markets themselves by using ETFs. There are ETFs that are designed. To short or bet against the market. So in other words, they will go up in value if, if the market that they are shorting goes down. So some people use them to hedge their positions. Patrick Keeley: Other people who have a very are very convinced, meaning they have a very bullish view of something. They are ETFs that give you leverage added exposure. For example, you could buy. An ETF that gives you twice the return of the S and P 500. Even some of them are three times the return, which works in, in, in your favor and can work against you, obviously. Patrick Keeley: So if you're right, if you're convinced that a particular index or sub index [00:10:00] is going to go up, there are many ETFs that give you three times or two times the exposure to it. But I can tell you as a portfolio manager, I've watched many retail investors get that bet wrong, and it will be you know, proportionately hurtful if, if things go down because it's three times the problem basically. Vincent Heys: So, no, that's great. So there are definitely a I, I guess the, the most assets of ETFs are really in vanilla kind of offerings. Like, as we said, the S and P 500. The Toronto stock exchange, but, and then we also get these exotic ones that you talked about just quickly in terms of pricing. What is the, the price range that you've seen in the market with, with et. Patrick Keeley: For the most part. I mean, there are ETFs like massive index ETFs that some companies are offering without there being any management fees. But I, I would say, and I, I'm not sure I understand the di the dynamics of that or how that even works. So I've been somewhat suspicious of it to be honest, [00:11:00] but I think that, you know, when we look at the types of ETFs we use for our clients for broader index ETFs, you can generally find good quality ETFs with very accurate tracking of the underlying investments for as low as. Patrick Keeley: You know, three to 10 basis points. So meaning less than one 10th of 1% to own a market like the S and P 500 as ETS become more complex. And they require a number of different tools to, to execute what they're doing. Or in some cases, if they're shorting, for example, there might be borrowing costs associated. Patrick Keeley: You can see ETF management fees. Scale up to close to 1%, but rarely beyond that, there are, I mean, there are some, but rarely beyond 1% and relative to mutual funds where sort of your average everyday mutual fund is probably all in has management fees that are well in excessive two and a half percent, two, two, and a half percent. Patrick Keeley: They seem like, you [00:12:00] know, very good value. And there are other reasons from a transparency, liquidity. Tax efficiency. We think personally that they're a better way for the person who's looking to get exposure to something specific. We think that they make more sense than mutual funds. But that being said, people use mutual funds if they don't really know how to approach something and they need a portfolio manager to do that for them. Vincent Heys: So might be just on that point with mutual funds. Patrick, you, you mentioned earlier that the first ETS were started in, I don't know, 1990 or close to there. Mutual funds I guess, were started in the sixties or seventies. I I'm actually not completely sure, but when you look at, when you look at the market flow, the assets flow, where, where does it go? Vincent Heys: Retail money and institutional money. Patrick Keeley: so there, the trends have definitely been leaning in the direction of ETFs quite meaningfully for many years now. And I [00:13:00] think that, you know, I I've been doing this since 1992. And when I think about when I started in this business in the early nineties, People were just starting to, and, and I'm talking about in Canada, people were just starting to adopt the idea of owning mutual funds. Patrick Keeley: And in fact, there was a term that people have been around for a while might recall. But I remember this as a, as a broker, an investment advisor at BMO NSBE burns in the early nineties. There were a number of people that we were getting as new clients who were coming from the banks. And they were people who had invested in GICs their whole lives, but were now being introduced to the idea of mutual funds. Patrick Keeley: And they were being referred to at least in the offices of many of the, the brokerage firms as GIC refugees, people who were leaving the world of GICs and entering the world of mutual funds for the first time. So I think that that's probably when most people can. Think about when they began investing in mutual funds, despite the fact that they were [00:14:00] invented Belo earlier than that, and ETFs were not really a mainstream stream product at that time. Patrick Keeley: So since that time people are using them for different reasons. And if I was just to encapsulate how I would view them as a, as licensed portfolio manager, for someone who like me, who is helping clients and making decisions for them, I prefer to use ETFs. We feel we have some level of education that enables us to decide where client's money should be, which markets, which regions, which sub sectors, for example. Patrick Keeley: So if we're making those decisions for the clients, then the most effective thing we can do is choose. ETFs that give us exposure and we will manage when we're in and out of those, those sectors, for example, but for someone who doesn't have that level of expertise, mutual funds have been an opportunity where instead of buying the sector, you're buying a manager you're, you're giving. Patrick Keeley: The nod to someone who you think has [00:15:00] the expertise and wherewithal to actually outperform the indexes themselves. We're skeptical because the truth is, and there are lots of studies that, that back this up and it's gone on for many, many years is the average portfolio manager underperforms the market over time. Patrick Keeley: The, the numbers are quite convincing. Like it's, it's in their, the league of like se 90% of all portfolio managers will underperform the index over a several year period. So with that information in hand, knowing that, you know, you, you're gonna be lucky if you find the, the, the few that do. We we believe in probabilities. Patrick Keeley: And the probability is that the market itself will outperform virtually all portfolio managers in the world. And therefore we choose to own the market in a tax efficient and cost effective way. And for the most part, we're teeing off from the front tees every time. So, so that's, that's the rationale that I think has backed up the [00:16:00] momentum shift in, in, in investing to, to cause institutional and retail investors alike to say, I'm happy, just owning the index because for the most part, you line it up against almost any mutual fund in the world and it's gonna outperform most of them. Patrick Keeley: And is Vincent Heys: that is that because most fund managers and mutual funds would be more let's call it more conservative or value driven. So looking for more high dividend stocks and maybe lower price to earnings ones. So fund managers add their value by, by choosing those ones. Whereas. ETFs are by, by the largest part tracking index. Vincent Heys: So it's more growth orient. Patrick Keeley: I think it's a couple of things. I think part of it is the cost structure. So a mutual fund has a big Boge to overcome in that it has, you know, probably two to two and a half percent of fees at minimum, for the most part to cover before that they even would even equal the performance of [00:17:00] their underlying benchmark. Patrick Keeley: But it also boils down to this and even. The likes of Warren buffet have been on record many times over saying you're gonna be wrong more times than you're right. So despite all the education we all have all the time we spend studying the markets, it's a very humbling business. And. Most portfolio managers, if not all, will be wrong more times than they're right. Patrick Keeley: It's, it's, it's kind of like looking at baseball where you have a batting average, the best, the best batteries in the world might have hit the ball, you know, less than four out of 10 times. So the same thing goes for stock picking and to, in order to be. You have to be quite exceptional and there aren't that many people who've done that on a consistent basis. Patrick Keeley: So again, going back to probabilities the statistics back this up, the indexes are the gold standards themselves. They outperform almost every portfolio manager in the world, and if you can buy [00:18:00] them in a cost effective way, And tax efficient way like you can with ETFs, then why wouldn't you do that? And I think that's the decision that, you know, we've made as a firm, but institutions have also made and many more portfolio managers and well educated retail investors are doing themselves as well. Vincent Heys: Battery, thank you so much. Let's close the conversation by just talking about management and the different options clients would have. So I had. A previous discussion with Jamie from side and, and we, we discussed this concept, you know, when clients it's ideal for them to have their own portfolio. Vincent Heys: And when it makes sense to go to let's call it a advisor. And then when it makes sense to go to a portfolio manager like, like you, for example, as well. So the first one, how would a. A retail investor used ETF. So what is the, what is the best and, and safest way for retail investors to make use of ETF in [00:19:00] their, in their portfolios. Patrick Keeley: So I kind of view investors as having like, falling into a couple of different streams. There are self-directed investors, people who are quite confident in their own skills to create their own investment portfolios. And for those investors, they have. Plenty of firms, you know, all the banks have self-directed brokerage firms, and then there are other more specialized or technology driven brokerage firms like, well, well simple for example, who have algorithms designed to create portfolios for clients based on certain investment objectives. Patrick Keeley: And you're placing all your faith in. In the algorithms, which are effectively robots. So there's that way of doing it. And you're placing all your faith in, in technology to make these decisions for you, but you're the one driving it. Other self-directed investors feel they have enough education of their own to make those decisions and don't need a robot, so to speak.[00:20:00] Patrick Keeley: And then there are people sort of in between who feel they have a decent amount of knowledge about the market. But not the time or confidence to make decisions themselves, but wanna be consulted along the way. And they would likely work with what referred to in the industry as a full service broker or an investment advisor as they're typically referred to at most of the banks. Patrick Keeley: And then on the other extreme are people who have said, I, I have a, a day job. I'm busy. I don't have time to do this myself. I've accumulated substantial assets. I would like to hand this off to somebody who is a licensed portfolio manager, which requires a substantial amount of accreditation and time in this business. Patrick Keeley: And they would hand it off to people like us, where we're making all the decisions for them. And, and how we do that is by understanding upfront what their objectives are. What they're trying to do, what their risk tolerances are, but really understanding upfront what their expectations and needs are, and then taking it from there on the client's behalf. Patrick Keeley: And, and typically in that model like [00:21:00] ours and probably like C LS, we would, we would establish upfront how frequently we're meeting with clients. Well, I like to ask clients as well. Tell me about things that you've liked and disliked about past relationships, cuz that there's a lot of rich information in that when you're taking the keys from someone and, and taking control they're still in the car, so to speak, but they might be in the back seat and I wanna make sure that I'm not getting chirped from behind. Patrick Keeley: And, and in order to do that, I need to really understand what my clients expect from me. And so that's the model that we work under, where we're discretionary portfolio managers. We charge clients an annual management fee to, to look after their money. Vincent Heys: Patrick, thank you so much that that's a great discussion and, and thank you so much for, for giving our listeners a, a broad overview and, and depth one in terms of the vanilla ETFs available, but also the corner cases and the more exotic ones and how they can use that in in a portfolio for themselves. Vincent Heys: or then you know, to contact [00:22:00] you if if that portfolio is to that level, that kind of makes sense for them to get a, a professional involved to manage a portfolio and in your case on ETFs and not on stocks. So yes, Patrick, thank you so much. It was great talking to you and hope to see you soon again in Toronto. Patrick Keeley: Sounds good. Thanks, Vincent. Vincent Heys: Hey, thank you so much for listening to our podcast today, you can find our content on wealthstack.ca or on LinkedIn. I'm Vincent Heys and you've been listening to the financial wellness podcast series.

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