I’m confused by a lot of things in investing, but the enduring influence of market forecasts is the one that stumps me the most. Year after year, expert predictions, estimates, forecasts and projections prove to be profoundly wrong. And yet next year we seek them out again. It’s like repeatedly pounding your thumb with a hammer and expecting that at some point it will stop hurting.

One of the reasons we still listen to forecasts is that the media love to celebrate the few that turn out to be right. Those that are wrong—which are the vast majority—are rarely held accountable.

With that in mind, I thought it would be interesting to look at the 2011 Fearless Forecast, the latest edition of a report published for 20 years by Mercer. The Fearless Forecast compiles the  consensus opinions of Canadian and global investment managers regarding the capital markets and the economy. The 2011 edition included input from 56 investment management firms, including some of the most prestigious asset managers in the world.

The last shall be first, and the first shall be last

The managers were asked to identify which asset classes they believed would be among the top and bottom performers in 2011. The most popular picks in each category are listed below, along with the percentage of managers who predicted that asset class would be among the best three and worst three performers. Where it was available, I’ve also included their average estimate for the returns of that asset class, followed by the actual index return for 2011.

It should be clear from the above table that the forecasts were not merely useless: they were spectacularly harmful to anyone who acted on them. An investor who followed these consensus opinions would have been slaughtered in 2011. They would have been helpful only to the strict contrarian: if you shorted all of the top picks and leveraged all of the bottom picks you would have made out like a bandit.

Dissecting the sectors

Let’s go one level deeper and see how the experts made out when forecasting the performance of  individual sectors of the Canadian economy. After all, active managers know when to get defensive during difficult markets, right?

Below is the percentage of managers who picked each sector as one of the best or worst performers, along with the actual 2011 return for that sector. (I was not able to find index data for the other four sectors—industrials, consumer discretionary, telecom and health care—but none of these make up more than 6% of the economy.)

The message here is not that these investment managers are fools. On the contrary, the participants in this survey are among the smartest folks around. They have a deep understanding of the markets, and access to more data than you and I will ever have. The point is that their superior knowledge and skill give them absolutely zero ability to predict what’s ahead. Their predictions were far worse than you would expect from random chance.

Human beings take comfort in forecasts because we detest uncertainty. But if you’re going to be a long term investor, you need accept that uncertainty is part of the deal. Since we can never be sure of what lies ahead, the most prudent strategy is to diversify.

All of the asset classes in the table above have positive long-term expected returns, but all of them will behave unpredictably over the short term. Rather than engaging in the futile attempt to guess next year’s winners and losers, hold all of them in your portfolio all the time. Rebalance once or twice a year. And make a pact never to listen to market forecasts again.

H&R Block tax software winners

Thanks to everyone who entered the draw for the H&R Block tax software. The five lucky winners are Michel, Mike, CCP Fan, Aziz and Rick. I will contact the winners by email to make arrangements.

If you’re investing outside of tax-sheltered accounts like RRSPs and TFSAs, you need to choose your investments carefully—otherwise you risk giving a big slice of your returns to the good people at the Canada Revenue Agency. Today we’ll look at ways to create a tax-efficient index portfolio using some innovative ETFs.

Swapping dividends for capital gains

In Monday’s post, I explained that Canadian dividends are not always as tax-advantaged as people believe. Capital gains are not only taxed at a lower rate in the highest tax brackets, but investors can also control when to take them—dividends, on the other hand, are taxable in the year they’re paid, even if you reinvest them.

Horizons’ swap-based ETFs—which I wrote about here—were designed to address this issue. They use a type of derivative that allows investors to earn the same return as the index, without collecting any distributions. Dividends paid by the companies in the index are reflected in the fund’s return, but all of the growth is characterized as capital gains and deferred until the fund is sold. There are currently just two funds in the family: the Horizons S&P/TSX 60 (HXT) for Canadian large-cap stocks, and the Horizons S&P 500 (HXS) for US large-caps.

The tax advantage is especially large for HXS, because dividends from US companies are fully taxable, while capital gains are taxed at half that rate. Consider this: if you held the iShares S&P 500 Index Fund (XSP) in 2011, you received $0.24 per share in cash dividends, a yield of about 1.6%. At the highest tax bracket, you would have lost almost half of that to taxes, reducing your return by about 80 basis points. If you held HXS instead, you would have received a similar 1.6% price appreciation instead, and you would have paid no tax. If you eventually sell the fund at a profit, you’ll pay tax on only half the gain.

Forward thinking

Claymore’s Advantaged ETFs—read a detailed description here—use forward contracts that “recharacterize” bond interest or foreign dividends as capital gains or return of capital (ROC). Unlike swap-based ETFs, which pay no distributions, the Advantaged ETFs are design for investors who want current income.

Return of capital is the most tax-efficient of all distributions, though it’s not a free lunch. ROC is not taxed in the year it’s received: instead, it lowers your adjusted cost base, and if you sell your shares at a profit in the future, you’ll incur a capital gain. So you’re not getting truly tax-free income—you’re really just getting your own money back—but you are generating tax-deferred cash flow. This document from Claymore explains the idea.

You can see why ROC is preferable to bond interest, which is fully taxable. In 2011, the Claymore Advantaged Canadian Bond (CAB) returned 6.8%. Roughly half of that came from price appreciation, while the other half came from distributions. However, unlike every other bond ETF, those distributions were return of capital, not interest. So you would have collected that entire 6.8% return without a tax bill.

Before you get too excited, there are downsides. All of the 2011 distributions from Claymore’s Advantaged ETFs were return of capital, but that won’t always be the case. In 2010, for example, CAB’s distributions were all capital gains. These would have been taxable—albeit at only half the rate of bond interest.

More important, the Advantaged ETFs have considerably higher costs than plain-vanilla index funds, which will lower their pre-tax returns. Those added costs offset some of the tax savings, and may even wipe out the advantage altogether. For example, both the iShares DEX Universe Bond (XBB) and BMO Aggregate Bond (ZAG) returned well over 9% last year—dramatically outperforming CAB. Even if you lost half your interest income to taxes, you might still have been better off with XBB or ZAG.

If you’re out of RRSP and TFSA room, you could use these ETFs to build a reasonably well diversified and tax-efficient portfolio of Canadian stocks (HXT), US stocks (HXS) and bonds (CAB). In some years—including 2011—you’ll have no tax payable at all. Just spend some time researching these complex products first, and don’t invest in anything you don’t understand simply because you think you’ll save some tax.

H&R Block software giveaway

Speaking of tax, the folks at H&R Block have offered to give away copies of their DIY tax software to five lucky Canadian Couch Potato readers. To enter the draw, leave a comment below or tweet this post to your followers before midnight EST on Sunday, January 29. I’ll announce the winner next Monday.

If your investments include RRSPs, TFSAs and taxable accounts, asset location is an important consideration. The returns of various asset classes—such as bonds, Canadian stocks, and foreign stocks—are treated differently under tax law. So by selecting the most tax-advantaged assets for your non-registered accounts, you should be able to keep more of the returns for yourself.

As most investors know, eligible dividends from Canadian companies are taxed at a much lower rate than interest and foreign dividends. In fact, for Canadians who make less than $40,000 or so, the tax rate on dividends is actually negative, which means you can use them to lower the amount of tax you pay on other income. That’s why the conventional wisdom is that Canadian dividend-paying stocks are the most tax-efficient asset class.

That is true in many cases, but the dividend tax advantage is often overstated. For taxable investors who have above-average incomes, it may not make sense to focus on dividends at all.

Dividends v. capital gains

Recall that stock returns come in two flavours: dividends and price appreciation, or capital gains. While dividend investors unleash the hounds on me whenever I make this argument, these are two sides of the same coin: a company’s earnings can either be reinvested (which causes the value of the stock to rise) or paid to shareholders as cash dividends (which causes the stock price to fall), or some combination of both. Ignoring taxes, a stock that appreciates by 5% and pays no dividend delivers the same return as one that appreciates just 2% but also pays a 3% yield.

Of course, you can’t ignore taxes if you’re investing in a non-registered account, and for Canadians with relatively low incomes, these two types of returns are taxed very differently. For an Ontario taxpayer with an income of $42,000 in 2012, the marginal rate on eligible Canadian dividends is just 3.8%, while the rate on capital gains is more than 12%. (My source for all tax rates in this post is TaxTips.ca). Obviously, someone in this situation would prefer Canadian equities that paid a high yield at the expense of lower price appreciation, and therefore might reasonably choose a dividend-focused ETF in a taxable account. Something like the iShares Dow Jones Canada Select Dividend Index Fund (XDV) would be an excellent choice.

For higher-income Canadians, however, the difference in tax rates between eligible dividends and capital gains is much less significant. In Ontario, for example, with an income of $81,000, eligible dividends are taxed at 19.9%, while the rate on capital gains is actually a bit lower at 19.7%. And at the highest tax bracket, capital gains are taxed at a much lower rate: for income over $132,000, the rate is approximately 23% for capital gains and 30% for dividends.

The differences are similar for high-income investors in British Columbia, Manitoba, and Quebec. They are smaller in Alberta, Saskatchewan and the Atlantic provinces.

Should you really prefer dividends?

Equity investors who are building index portfolios in taxable accounts should think carefully about whether they really should focus on Canadian dividends. If you’re in a high tax bracket, it might make sense to look at Canadian equities that pay less in dividends and deliver most of their returns in the form of price appreciation.

As you can see from the above chart, the iShares Dow Jones Canada Select Growth Index Fund (XCG) has seen much greater price appreciation than the than the iShares Dow Jones Canada Select Dividend Index Fund (XDV). However, because growth stocks, by definition, don’t pay generous dividends, the yield on XCG is only about 0.7%. Meanwhile, XDV pays about 3.8% in dividends annually.

As it turns out, over the last five years, the two ETFs delivered virtually identical total returns: 1.85% versus 1.87% annualized. However, investors in a high tax bracket would have kept more of XCG’s returns for themselves. Because capital gains are only taxable in the year they are realized (that is, when you sell at a profit), an investor who held XCG in for the whole five years would have only paid tax on that very small dividend.

The information in this post should in no way be considered tax advice for individuals. Always consult an accountant or qualified advisor before making any investment that has tax consequences.

On the day his company announced it was acquiring Claymore, BlackRock’s CEO Bill Chinery called ETFs “electric cars in a world of internal combustion engines.”

What he meant was that ETFs, despite the attention poured on them by the media and DIY investors, are still only a small part of the fund industry. ETFs in Canada now manage about $43.1 billion in assets. By comparison, Canadians have $778.5 billion invested in mutual funds—about 18 times more.

That’s a big gap, but it’s been closing for a few years now. According to a recent report, ETFs in this country saw more than $7.6 billion in new sales in 2011, increasing their total assets by nearly 13%. Compare that with another report from the Investment Funds Institute of Canada. Canadian mutual funds, it says, now manage $8.8 billion less than they did at the beginning of 2011. Of course, part of that decline is a result of negative equity returns and not investor withdrawals. But the stats do make it clear that the mutual fund industry is moving in the opposite direction of ETFs:

• Balanced mutual funds saw inflows of $27.7 billion in 2011—a hefty sum, but almost $1 billion less than the previous year.

• Bond mutual funds accepted $8.87 billion in new money last year, compared with $11.1 billion in 2010, about a 20% decrease.

• Equity mutual funds saw net redemptions of $10.8 billion during 2011.

ETFs may still be electric cars, but the mutual fund industry is looking more and more like a tractor trailer with a hole in the fuel tank.

Every silver lining has a black cloud

Not everyone agrees that ETF growth is encouraging. “To me, the ETF sales numbers are both underwhelming and disappointing,” wrote Tom Bradley of Steadyhand Investments this week. “In the context of a wealth management industry with over $1 trillion in client assets, $7 billion doesn’t represent much of a market share swing.”

I also share Bradley’s other concern: “I have to wonder what portion is being used by individual investors to implement low-cost, long-term strategies.” Indeed, while it’s tempting to see the growth of ETFs as a triumph for Canadian index investors—who are finally waking up to the fact that they’ve been paying too much, for too little, for too long—the numbers don’t support that:

• About $900 million of the new money that went into ETFs in 2011 (12% of the total) went into the iShares S&P/TSX 60 (XIU), which is mostly a tool for institutional investors. It’s unlikely that much of that $900 million came from newly sprouted Couch Potatoes.

• Another 16% of ETF inflows ($1.2 billion) went into covered call ETFs. While these ETFs may have a role in some portfolios, such widespread enthusiasm for covered calls probably has more to do with chasing yield than prudent investing. The enticing distributions paid by these ETFs (often 7% to 9%) are not likely to be sustainable.

• As Bradley points out, there’s “some serious performance chasing going on.” Fixed-income ETF assets were up 44% in 2011, a year that saw excellent bond returns. But other than XIU, equity ETFs saw very little new money—just $400 million, or barely 5% of the total inflows. In a year where emerging markets performed poorly, investors pulled $45 million out of the Claymore BRIC ETF.

I’m encouraged that Canadian investors are putting pressure on the mutual fund industry, and pleased to see that more are embracing ETFs. But part of me thinks they’re doing the right thing for the wrong reasons.

Larry Swedroe’s new book, Investment Mistakes Even Smart Investors Make and How to Avoid Them, includes 77 common behavioural blunders. I don’t think there’s anyone alive who hasn’t made at least a dozen of them. In fact, I know two investors who recently fell prey to Mistake 11—and one of them was me.

Mistake 11 in Swedroe’s catalogue goes like this: “Do You Let the Price Paid Affect Your Decision to Continue to Hold an Asset?” This error is what behavioural economists call the endowment effect. It’s what makes us place a greater value on something just because we happen to own it.

Imagine that you want to attend a hockey game. You don’t yet have a ticket, and you decide that you’re willing to pay no more than $100 for one. The next day, you win a ticket to the game in a radio contest. If a friend offers to buy that ticket from you, for what price would you be willing to sell?

If you were purely rational, you would accept any price over $100, since that’s the maximum value you placed on the ticket before you had one. But if you’re subject to the endowment effect, the ticket is likely to be worth much more to you now that you’ve got one. In one famous experiment, subjects said they were willing to pay a median of $150 to buy a ticket, but their median selling price was $1,500. Somehow simply owning the ticket increased its value tenfold.

Too cheap to sell, too expensive to buy

I recently spoke to an investor I’ll call Stephanie, who provided a perfect real-life example of this odd behaviour. Her advisor had purchased a small-cap energy company in her portfolio, and the stock had since lost over half its value. She wasn’t just bothered about the loss—she was also angry that the advisor had purchased the stock in the first place, since she wasn’t interested in speculating on junior resource companies.

“Why don’t you sell the shares and buy something more suitable?” I suggested.

“I think the stock might come back a bit,” Stephanie replied. “I’ll give it another six months or so.”

I thought about that for a second. “If you didn’t own this stock already, would you buy shares today?”

“Of course not,” she said. “Why would I do that? I just told you that risky stocks like this aren’t  part of my strategy.”

You can probably spot the irrational thought process here. If she thought the stock was incompatible with her investing strategy, then she should have been prepared to sell all of her shares immediately. The fact that she already owned shares in the company should not have had any bearing on the decision. Indeed, if she truly thought the stock was going to go up in the next six months, why not buy more shares?

To avoid falling prey to the endowment effect, Swedroe suggests asking yourself: “If I didn’t already own the asset, how much would I buy today as part of my overall investment plan?” If your answer is “none” or “less than I currently own,” then you should sell the asset now and replace it with something that suits your long-term strategy. (One caveat, which Swedroe acknowledges: the decision to dump an inappropriate investment is not so simple if you’d face a large tax hit on the capital gains.)

Another real example

I can’t be smug about Stephanie making Mistake 11—I admit I’ve fallen prey to this cognitive error myself. When I set up my Complete Couch Potato RRSP in early 2009, I used the iShares S&P/TSX Capped REIT (XRE), since it was the only option for real estate at the time. The following year, the BMO Equal Weight REITs (ZRE) was launched, and it uses an equal-weight strategy that I believe is preferable for sector funds that include a small number of companies. That’s why I recommend ZRE it in my Model Portfolios.

If I was building my portfolio from scratch today, I would certainly use ZRE. But I confess I haven’t switched yet. It might have something to do with the fact that my position in XRE is up more than 84% based on my average price, which is pretty satisfying. But as Swedroe reminds us, the price I paid in the past is not relevant: it is far more important to hold the asset that is best suited to my long-term strategy going forward.

So next time I add money to my RRSP, I’m going replace XRE. In the future, I hope I’ll be less likely to fall victim to the endowment effect. Now it’s time to start working on the other 76 mistakes.

Announcements in the ETF world are mostly tedious these days—usually they involve the launch of another exotic and increasingly narrow new product. That’s why yesterday’s announcement that BlackRock is buying Claymore Investments was a shocker. I’m not the only one who didn’t see that coming.

BlackRock, of course, is the parent company of iShares, the largest ETF provider in Canada, with about $29 billion in assets—about 75% of the market. Claymore’s family of ETFs and closed-end funds currently have about $7 billion under management. Together, the two families will be a powerhouse in the ETF space in this country.

It’s way too early to tell what this will mean for Canadian investors, but overall I expect it will be a positive development. I’ve always liked Claymore’s entrepreneurial spirit and its desire to innovate. For example, the company was the first to create preauthorized contribution plans that allow investors to add money to their holdings each month without incurring trading commissions. Their recent partnership with Scotia iTrade—which makes all Claymore ETFs available with no brokerage commissions—was also a game changer that prompted Qtrade to follow suit. (Claymore’s DRIP program, in my opinion, was not as innovative or as significant as often believed.)

But as refreshing a presence as Claymore has been, I think BlackRock will take them to the next level. The iShares products are probably the most prudently managed ETFs in the country, with consistently low tracking errors, even when the funds are small. I’ve also found them to be among the most transparent and straightforward firms to deal with as a journalist. The Claymore ETFs are now in good hands.

Opposites attract

In some ways, the two ETF families are unlikely allies. iShares was among the pioneers in the industry more than a decade ago, and they’ve remained steadfast in their position that traditional indexing—plain vanilla, cap-weighted funds that track third-party benchmarks—is still the best solution for investors. Claymore, on the other hand, has been a vocal critic of cap-weighting and the leading Canadian proponent of RAFI fundamental indexes.

But the ETF industry is changing, and both companies recognize that. Investors already have access to plenty of low-cost traditional index ETFs, so there’s little room for growth in that area. The only way a new player could compete in the traditional ETF space would be to lower fees even more. That’s what Vangaurd has done with its Canadian launch, but they are the only company with the size and influence to pull that off. No one else is going to be able to compete on price.

BMO is competing with superior distribution: they have an army of advisors (most of whom have little or no interest in passive portfolio strategies, by the way) selling their products—and they’re doing that extremely well. RBC looks poised to do the same. Meanwhile, other ETF providers will have to compete with each other by offering more and different product choices.

With that in mind, Claymore and iShares are actually a perfect fit. Although they have 82 ETFs between them, there is almost no overlap. I can’t think of a single ETF that is an obvious candidate to be closed or merged with another as a result of this merger. While many asset classes are covered by both Claymore and iShares products, the funds usually track use very different indexes and strategies.

Index investors will be watching with interest as this one unfolds over the next few months.

The 2011 performance results are now in for my model Couch Potato portfolios. Many thanks to Justin Bender at PWL Capital in Toronto for providing these data. Complete performance results are available here, and an updated PDF is posted monthly on my Model Portfolios page.

It was a challenging year: the MSCI World Index, which measures the equity markets in all developed countries, was down 3.2% in 2011, and emerging markets plummeted over 16%. But broad diversification once again proved its mettle in 2011, as a multi-asset-class portfolio did much better:

Breaking it down

While equities were down overall, there was a lot of variation. Europe, Japan and emerging markets got clobbered, and Canada was down about 9%. However, US stocks finished in the black for the year. Currency diversification helped too, as the loonie declined against the US dollar, Japanese yen, and British pound.

Real estate went a long way toward offsetting the negative returns in the overall Canadian equity market:

Fixed income once again defied all expectations and delivered outstanding returns, even at the short end:

A portfolio for all seasons

There are a couple of lessons we can take from 2011. The first is that a truly diversified portfolio must include asset classes that have little correlation (or even some negative correlation) with stocks. Real estate helps (so does gold, if you’re so inclined), but the best way to get that diversification is through high-quality bonds. They should be part of just about everyone’s portfolio.

The second lesson is that once again most forecasts proved to be dead wrong. Here’s just one example from a major Canadian bank that predicted: “Equity markets should have another good year,” while “we expect 2011 will be increasingly challenging for bondholders in the developed world.”

Of course, the crystal ball gazing is well under way for 2012. My only prediction for the year is that these forecasts will prove just as unreliable as always. Tune them out, build a porfolio for the long-term, and stick to your plan.

Readers often ask me whether the Couch Potato strategy is suitable for investors  approaching retirement, or even those who have stopped working. In his recent book, Retirement’s Harsh New Realities, Gordon Pape addresses the same question—and I strongly disagree with his advice.

Pape acknowledges that the Couch Potato strategy is simple and low-cost, but “the real questions are how safe the investment is and how much you will end up earning on your money by adopting a passive strategy,” he writes. “I think the couch potato approach fails on both counts, for two reasons: time horizon and human nature.”

Fatal flaws?

“Passive investing requires taking a long-term view, ten years or more,” Pape argues, but “many people, especially those over fifty, aren’t comfortable with the idea of waiting many years for a decent return. They need to see profits sooner.”

Second, he argues, it’s not realistic to expect people to adhere to a passive strategy because markets are too volatile. He offers the massive losses of 2008 as an example: “How many couch potato investors would have had the fortitude to stick with the plan through that debacle?”

Pape goes on to explain how he set up a model Couch Potato portfolio in January 2008 and tracked it to the end of April 2011. During this 40-month period, the portfolio delivered an annualized return of just 1.06%. “Most people would not be happy with that, and with good reason.”

His final verdict: “While it’s true that you might do worse by actively managing your money, at least you, and not the markets, are in control of your financial fate.”

Blurring two ideas

Pape’s book, like his previous work, includes a wealth of excellent advice for Canadians who are nearing retirement, but he badly misrepresents passive investing.

To begin with, Pape is wrong to declare that a passive strategy requires at least 10 years. It’s equity investing that needs a long horizon: active or passive management has nothing to do with it. An investor with a shorter time frame can simply adjust the allocation of a passive portfolio to suit her goals. A 65-year-old who is retired, or a parent saving for a teenager’s education, might keep 80% of the portfolio in a short-term bond ETF and only 20% (or less) in equities. Passive investing is suitable for any time horizon.

Pape writes that “the performance of the portfolio during the 2008 market crash shows that this approach is not risk-free or even low-risk.” I’d love to know who ever claimed that it was. Why should anyone expect indexing to be less risky than active management? Risk exposure is determined by asset allocation, not by management style.

Perhaps Pape was referring to the idea that active managers can change the asset mix during times of crisis to protect against big losses. However, the evidence suggests that they cannot do this reliably, and that over market cycles active management usually underperforms a strategy of buy, hold and rebalance.

Lamenting his model portfolio’s 1% annualized return from 2008 to mid-2011, Pape says: “This is the reality of couch potato investing—timing counts for a lot. If you set up a portfolio a few months before a market plunge, it will take years to recover.” Once again, this is the reality of equity investing, and active-versus-passive is completely irrelevant. Everyone knows that stocks can lose money over periods of 40 months—which is why his model portfolio of 60% stocks is not suitable for that time horizon. If you don’t have several years to recover from a severe market decline, then you shouldn’t invest in stocks, period.

The illusion of control

Pape argues that investors over 50 should not use a passive strategy because they “need to see profits sooner.” He later argues that with an active strategy “you, and not the markets, are in control of your financial fate.” Really?

Saying that older investors “need profits sooner” is like saying farmers need rain next week: it might be true, but there’s nothing they can do about it. As Alexander Green explains in The Gone Fishin’ Portfolio, six factors affect a portfolio’s performance: how much you save, how long your investments compound, your asset allocation, how much you pay in expenses, how much you lose to taxes, and the return on your investments. We can control the first five—and only two (costs and taxes) are closely linked to the active-versus-passive question. No one can control the return they get on their investments, whether they admit it or not.

Whether you’re 20 or 97, the markets give what they give. If you need market-beating returns to reach your goals, then you either need to take more risk (which opens you up to larger losses), or you need to lower your expectations and save more money. Building a retirement strategy without understanding this is downright dangerous.

Passive investing is not for everyone, but the choice to become a Couch Potato has nothing to do with your age, or how close you are to retirement. Make sure your investing decisions are based on facts, not myths and misinformation.

The Couch Potato strategy thrives on simplicity, but advanced index investors (geeks) should understand what goes on under the hood of ETFs. One of the most important concepts is how ETF shares are created and redeemed. I’ll warn you that this gets a bit technical. But it turns out that this process is the single most important difference between ETFs and index mutual funds.

Let’s begin by looking at how a mutual fund creates new shares (or units). When you make a $2,000 contribution, your money goes directly to the mutual fund’s manager, who uses it to buy more securities. If the fund’s net asset value (NAV) per share is $20, the manager then creates 100 new shares ($2,000 ÷ $20) just for you. This is what’s meant by the term open-end fund: the number of units changes every time money moves in or out.

Closed-end funds, by contrast, do not create or redeem new units. They are launched with a finite number of shares, and if you want to invest in the fund you have to buy your shares from another investor who is willing to sell.

An open-ended discussion

ETFs trade on an exchange like closed-end funds, but they are open-ended: new shares are created to meet investor demand. Unlike mutual funds, however, ETFs do not create new units every time money flows in.

Instead, whenever necessary, ETF providers issue a large block of shares called a Prescribed Number of Units (PNU), typically in multiples of 50,000. The providers then work in partnership with third-party “designated brokers,” or DBs, who distribute these units to the public. A new ETF might be launched with 200,000 units, for example, and several DBs would  divide these up and sell them on the secondary market. Going forward, when invetsors want to sell their units, the DBs are obliged to buy them back at a price very close to their net asset value.

(Geeky footnote: ETF providers south of the border use different terminology. If you’re reading American books or websites, PNUs are called creation units, and designated brokers are called authorized participants. Feel free to share this fun fact with your friends and coworkers.)

When you purchase $2,000 worth of an ETF trading at $20, the DB will simply fill your order with 100 shares from its inventory. However, if an institutional investor wants to buy $2 million worth of shares, the DB will not have enough inventory. So it will credit the investor’s account for 100,000 shares and simultaneously purchase $2 million worth of the fund’s underlying holdings. Then the broker will deliver that basket of stocks or bonds to the ETF provider, who will create 100,000 new shares and send them to the DB as payment.

That wasn’t so hard, was it?

Redeeming qualities

This creation-redemption process may be complicated, but it has a couple of important benefits.

First, if the ETF is selling at a premium, a designated broker can buy the fund’s underlying securities and simultaneously sell shares of the ETF, thus making a risk-free profit. (If it is selling at a discount, the DB can do the opposite.) This presents an arbitrage opportunity, and when multiple DBs compete with each other to profit from it, the result is that the ETF’s price stays close to the NAV. That, of course, is exactly what investors want.

Second, the process prevents buy-and-hold ETF investors from being penalized by active traders. An inherent problem with mutual funds is they must always keep cash on hand to pay investors who redeem their shares, and this uninvested money is a drag on the fund’s returns. Worse, when investors sell in droves (such as during a market decline), the mutual fund has to liquidate holdings to pay them, which can mean forced sales and tax consequences for the fund’s other investors. ETFs never have to do this: if investors flee, the designated broker can just return blocks of shares to the ETF provider and receive the underlying securities in exchange. Because this is an “in-kind redemption” and not a sale, there is no taxable event.

For more information about the nuts and bolts of ETF construction, I recommend All About Exchange-Traded Funds, a new book by Scott Paul Frush (McGraw-Hill, 2011).

Here’s another excerpt from my recent interview with Atul Tiwari, Dennis Duffy and Joel Dickson of Vanguard. These questions focus on the types of products we might see from Vanguard in the future. You can read also read Part 1 of the interview here.

Your first family of ETFs have all been plain vanilla funds that track major third-party indexes. What new products are on the horizon?

AT: We’re in the development and design stage for the next suite of ETF products that we’ll launch next year. Before we make any decisions about what those will be, we want to be in the market, talking to clients, talking to advisors, and then we will try to reach a conclusion about the next tranche.

The interesting thing that we have come across in terms of how to bring passive investing to Canada is that the index mutual fund market in Canada is pretty small. It’s concentrated in a few issuers and products that really don’t get much prominence. So we have seen indexing growing in Canada, but clearly the vehicle of choice is ETFs. The growth in the ETF market has been 30% or 35% per year, and predictions are $105 billion by 2016.

The main reason index mutual funds are not popular in Canada is that they’re way too expensive. So it seems to me there is a huge opportunity for someone to come in and grab that space.

AT: We have to start somewhere. You alluded to this idea when you asked about what we are bringing other than passive ETFs that already exist elsewhere, and we obviously think that it is not just low-cost. Our ETFs are the low-cost leaders in the market now, and we all know that low costs are important. But we also are bringing the thought leadership and the education.

The other big difference is our ownership structure: we are a client-owned organization, and we really do put clients first. We are all about continuously finding ways to lower our own costs so we can lower the costs of our investments for clients, and that’s unique. It’s not just unique in Canada, it is unique globally.

Can you explain how Vanguard’s ownership structure works, because there is a lot of confusion around that. I have heard Vanguard described as a nonprofit company, for example, which is clearly not accurate.

AT: The way it works is that in the US, the clients of Vanguard own the funds and ETFs,  and in turn the funds and ETFs own the management company. So we are not a public company, but we’re not a private company either in the classic sense of being owned by a family of shareholders. It’s more like a mutual. We are a for-profit company, but we give all the earnings back to clients in the form of lower expenses.

JD: The management company derives profits from its activities, and those profits are paid to the owners, who happen to be the investors in the US funds. Instead of being paid as a dividend, it is paid in the form of lower expense ratios.

Many investors have asked whether Vanguard will offer US and international equity ETFs without currency hedging.

DD: We have thought about it and I can tell you it is definitely something we are considering when we look at what we will be rolling out in the second tranche. We have done that in other jurisdictions, where we have offered both hedged and unhedged versions. So that’s definitely something we have looked at and will give it some consideration.

Vanguard offers a family of target retirement funds in the US. There seems to be few of these available in Canada, and I have a theory about why. If an advisor says to a client, “I’m going to put you in this target date and we won’t need to switch for 25 years,” the first thing the client is going to say is, “Then why the heck am I hiring you?”

JD: Even among advisors who buy into our philosophy, target date funds are not a huge seller, because advisors do view their job as asset allocation. Even if it is long-term strategic allocation, they want to build that for you rather than having it pre-packaged like a candy bar you buy in the store. So that is a hurdle. We get a lot of questions about how we might create target date funds out of our ETFs, but it’s just not clear what the distribution would be for a product like that.

DD: Much of the appeal of our target date funds has been in the retirement segment, for defined contribution investors. We just launched a series of target date funds in the UK, and that is also something we are looking at as we consider future opportunities in the Canadian market, where there is a huge number group RRSPs and defined contribution plans.

One of the alarming trends in Europe is the move towards synthetic ETFs. Is there any plan to move away from the physically backed ETF model that Vanguard has made its bread and butter?

DD: If we look at what we have launched in the US, the UK, Australia and Canada, having full-replication, asset-backed securities, as opposed to swaps, makes a lot more sense. I would never say never, but it is definitely not the direction that we are planning to go in.

JD: We have 35 years of experience managing physical, full-replication index funds, and that works great in large, liquid, diversified markets. There could be a role for synthetics in hard-to-access markets, where there might be some liquidity issues—where there might be restrictions on your ability to access those markets. Synthetic by itself is not the issue: it is how you negotiate the swap contracts.