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Discussing the outlook for Exchange Traded Funds (ETFs) with Howard J. Atkinson, President of Horizons ETFs

Update: This post was mentioned in the Globe and Mail

ETFs. They’re everywhere. It almost seems as if an ETF is launched everyday. At this rate, it’s no wonder that some are predicting ‘Exchange-traded funds may pass US$2-trillion in worldwide assets by 2011, up from just over US$1-trillion now‘. If you don’t own an ETF, you’ve definitely heard of one. But with so many of these funds available and new ones popping up each day (case in point: iShares & JP Morgan Chase have filed with the Securities and Exchange Commission (SEC) to launch their own physically-backed copper ETFs), we turned to one of the most knowledgeable experts in Canada to help us make sense of this growing trend. We’re super excited to present this interview and we really hope you like it (like really, really).

Let us know your thoughts in the comments below and consider sharing the post via Twitter, Facebook or any other means if you like it.

Howard J. Atkinson is the President of Horizons ETFs Inc.

Biography: Mr. Atkinson has 23 years of investment management industry experience. He joined BetaPro Management Inc., an affiliate of Horizons ETFs, as Executive Vice-President in October 2006. Prior to joining BetaPro, Howard was responsible for the Exchange Traded Products business at Barclays Global Investors Canada Limited and has held positions with a national investment dealer and major mutual fund companies. He is a past President of the Toronto CFA Society board of directors and is a member of the S&P/TSX Canada Index Advisory Panel. In addition, he recently achieved the ICD.D designation from the Institute of Corporate Directors.

Mr. Atkinson is the author of four books including the New Investment Frontier 3: A Guide to Exchange Traded Funds for Canadians, (Insomniac Press, 2005) and “Les Fonds Négociés en Bourse: Un outil de placement novateur pour l’investisseur avisé” (Transcontinental, 2003). He has been a contributing writer and frequent analyst referenced in many major Canadian newspapers, including The Globe & Mail, National Post, Toronto Star, Vancouver Sun, and Ottawa Citizen. In February 2010 he was recognized by ACTIF, Quebec’s premier financial education co-operative, as the Top Educator for his efforts to foster financial literacy among Canadians.

Q: Mr. Atkinson, many might not know this but Canada was home to the first successful ETF in the world. What do you make of the growth in ETFs so far? Has the popularity and growth of ETFs plateaued?

A: Despite the phenomenal growth of the ETF market, I don’t think that ETFs have come anywhere near a plateau. ETFs are essentially cost-effective alternatives to mutual funds. In Canada alone, there is still more than $600 billion in Canadian domiciled mutual fund assets versus slightly more than $30 billion in ETFs. Granted, probably another $30 billion of Canadian investment dollars are in U.S. listed ETFs – but that would still only make the ETF industry in Canada 10% the size of the mutual fund industry.

When I look at mutual fund mandates, I would argue that the vast majority of them could be replaced by an active or passively managed ETF, which would offer a whole new set of cost efficiencies and flexibility for the investor. As an industry, we have a long way to go in terms of asset growth. In terms of financial products, I do believe the next 10 years will be “The Decade of the ETF”.

Q: Do you think there might be too many niche ETFs on offer? Where do you see the ETF space 2 years from now in terms of new products (what kind?), prices, usage rates (volume) etc.?

A: As stated before the ETF industry is going to continue to grow, and most of that growth will be driven by existing ETFs in the market, which represent popular assets classes and have high amounts of liquidity.

I think you’re going to continue to see a torrent of niche ETFs launched because sometimes a niche asset class turns into a blockbuster. Who would have thought that a physically backed, SPDR Gold Shares ETF (GLD:NYSE) would become one of the largest investment funds in the world a few years ago? Investing in physical bullion was considered an alternative investment at the time of that ETFs launch.

Asset allocators of ETFs like efficient and specific asset class exposure. As the investment appetite for using ETFs in portfolios grows, I expect you’ll see more uptake of the niche ETFs. Of course, a number will be shut down, as robust innovation always involves some attrition, I don’t expect people will stop launching niche ETFs anytime soon.

I wouldn’t be surprised to see more physically backed commodity ETFs launched, as commodities are expected to see a continued growth in demand from the industrialization of the emerging markets.

Q: The new BetaPro S&P/TSX 60 exchange-traded fund (HXT/TSX) has a management expense ratio (MER) of just 0.07%, plus HST. It seems that nowadays a number of similar ETFs are being launched where the main differentiator is price. Should we continue to expect the trend with ETF management expense ratios (MER) to move lower? Will we ever see an ETF with no expense ratio?

A: I would anticipate that the management fees on the broad based equity index-tracking ETFs will continue to drop. Investors want access to certain indices for certain markets, so for the U.S. large cap equities, the S&P 500 will be the most important index, the S&P/TSX 60™ Index will be the most important index for Canadian equities, the MCSI World Index for global equities etc. As more investors embrace index-linked ETF investing, those are indices that will continue to see asset growth, and it’s natural that there will be competition.

One of those key differentiators will be price, which is the tack that Vanguard has taken in the United States, and is one of the competitive advantages we offer on the S&P/TSX 60 Index. There is no sense competing in a market with a more expensive alternative to the existing suite of options. You have to come in at the lowest cost possible.

As for an ETF with no management fee, that is highly unlikely.

Q: Consequently, what would this mean in terms of profits for companies like Horizons and by extension, Jovian Capital (JOV:TSX), your parent? Is being the lowest cost provider a conscientious strategy of Horizon’s or is the strategy to gain market share and ultimately name recognition that you hope to capitalize on by drawing customers to products that might have higher fees?

A: Our goal is to be the Canadian ETF provider of choice for domestic and foreign investors. We want to have an ETF shelf that offers everything. We don’t take a view on the market, our concern is building the lowest cost and best designed ETFs for use in any type of portfolio. HXT rounded out that ETF suite for us once the license exclusivity on the S&P/TSX 60™ expired.

It doesn’t make sense to offer another index, that’s the index for large-cap Canadian equities. Some of our competitors have chosen to follow other indices for large-cap offerings, but the premier large cap Canadian equity benchmark is the S&P/TSX 60™ Index.

On the S&P/TSX 60™ Index for example, we now offer seven different ways to get exposure to that index. We have one times, two-times daily leveraged, single and two-times inverse exposure, an equal weight version, a 130/30 strategy and actively managed version.

Ideally, Canadian investors will come to us for all their ETF needs, and so we have to offer a robust ETF suite for that to happen.

Q: We don’t hear too much about this, Mr. Atkinson, but can you talk a little bit about how ETFs make money by lending out the securities in their portfolios? How significant is this function in terms of profits for companies like Horizons?

Securities lending is standard industry practice. ETF unit holders benefit from the activity, the resulting income helps to offset fund expenses.

Q: What are your thoughts on Active ETFs at the moment and going forward? Are you seeing the demand you hoped for active ETFs? If not, what is it about Active ETFs in your opinion that isn’t catching on with investors?

A: Active ETFs are in their infancy. In my opinion they will be the fastest growing ETF category over the next 10 years. Passive ETFs took time for investors to adopt; I anticipate it will be the same for Active ETFs.

There is more than $400 million in assets under management with Horizons AlphaPro, our actively managed ETF provider, which is pretty good achievement considering the company is only in its second year.

One area that is generating a lot of interest is fixed-income. Passive management doesn’t necessarily have the advantages in fixed-income investing that it may have in certain equity indices. From a practical standpoint, some fixed-income benchmarks are nearly impossible to replicate. Low-cost active management is great way to invest in fixed income. In fact that the Horizons AlphaPro Corporate Bond ETF (HAB) is already one of the largest actively managed ETFs in terms of asset size in the world.

Q: What are your thoughts on claims that say the biggest hurdle that’s discouraging widespread adoption of the Active ETF structure from active managers is the daily transparency required of actively-managed ETFs – which could potentially result in front running of trades executed by the portfolio manager and dilution of the stock selection prowess when portfolio holdings are revealed daily?

A: Not an issue in Canada. Registered market makers have access to the real-time net asst values of our AlphaPro ETFs, so that they trade efficiently near NAV with tight bid/ask spreads, even with large orders. Our holdings are publicly disclosed every month, more frequently than many mutual funds.

Q: Mr. Atkinson, do you think the increased usage and penetration of ETFs have anything to do with the increased correlations in asset classes that we have seen recently?

A: I know there has been growing concern about this issue. Quite frankly, I don’t think it’s even a consideration on the equity side of things, when you compare the size of ETFs to the amount of long-only money in mutual fund, other investment vehicles and single securities.

It would seem more likely that a physically-backed commodity ETF could skew the prices in the commodity markets. That doesn’t even seem to be the case. In fact, the assets flows in our leverage inverse ETFs and those of U.S. leverage ETF provider ProShares tend to run in the opposite direction of a run-up. That is to say, while oil for example was closing in near its high of $147 a barrel, assets flows were being piled into the inverse ETFs. Under the hypothesis that ETFs skew correlations, that should have put brakes on run-up in oil, but it had no impact at all. Why? Because the asset flows are still miniscule compared to the size of the capital markets, or even high beta actively managed mutual funds.

Q: There have been some negative connotations associated with ETFs that use derivatives and swaps – do you think this is a valid concern (why or why not)?

A: The swaps and derivatives we use in our ETFs are extremely low-risk. For example in the total return swap used for HXT, 100% of the investor money sits in a third-party custodial account in cash. The credit risk associated with the swap is governed by regulations. Specifically counterparties must maintain minimum credit ratings and exposure is limited to 10% per counterparty.

These types of transactions are done all the time between institutions, such as the CPP and Ontario Teachers Pension Plan. The risk is extremely low, and the structure leads to lower tracking error and better tax efficiencies for the end-investor.

Q: If you were to give a nascent ETF trader/investor some tips on the tax efficiency and cost considerations of ETFs, what would they be? Are ETFs more tax efficient for institutional investors or retail investors?

A: This is purely based on the design of the ETF. Some mutual funds are very tax efficient. Generally speaking, it’s ideal to have returns characterized as capital gains if possible. You want an ETF that minimizes transaction costs and therefore distributions if that’s not what the investor is looking for. Most ETF providers do a good job of limiting the tax liability for the end-investor.

Thank You, Mr. Mr. Atkinson!

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