Will ETFs take the place of stocks?

Will ETFs take the place of stocks?

Will ETFs take the place of stocks? It might not be too long before Canadian stock investors find themselves with more baskets than individual equities to choose from.

With forces such as the rise of private capital, increasing regulatory burdens for public companies, and takeovers engulfing small firms at play, publicly traded stocks are declining in Canada, according to the Globe and Mail.

Ten years ago, the TSX listed only 25 ETFs; today, it has 465. Last year saw only three corporate IPOs and 77 new ETFs. Among the structured products on the TSX, which include closed-end funds and special-purpose acquisition corporations, ETFs account for a large majority.

If things continue like this, the number of structured products such as ETFs listed on the TSX could exceed the number of operating companies. “You could see as many investment vehicles as you will actual companies to invest in, which is going to be a ridiculous moment,” Bryce Tingle, holder of the Murray Edwards chair of business law at the University of Calgary, told the Globe and Mail.

Not that the average investor is going to complain. ETFs offer them a crucial cost advantage: they allow exposure to segments of the stock, bond, and commodities markets, but for much lower fees than mutual funds. ETFs also offer passive exposure to the markets, which more and more studies suggest brings superior returns compared to active strategies like stock-picking.

The benefits of ETFs have led to increasing demand, which fund providers have been all too happy to cater to. The upshot: a continuing surge in ETF investment. April saw global ETF assets breaking past the US$4-trillion mark, powered by year-to-date net inflows of US$235-billion. Also in April, Merrill Lynch introduced the NYSE Arca-listed ETF Industry Exposure & Financial Services ETF trades, which is the world’s first ETF of ETFs.

With increasing interest in ETFs, various experts have voiced concerns over possible market distortion. Most arguments suggest that ETFs indiscriminately plow money into broad indexes without considering the fundamentals of the underlying stocks. Some also suggest a risk of increased equity correlation — in other words, stocks may rise and fall in unison.

Erick Kirzner, a professor of finance at the University of Toronto’s Rotman School of Management, dismisses such calls for concern. According to him, ETFs represent too small a share of the market to cause any significant shifts. US equity ETFs hold around $1.7 trillion in assets, just 6% of the $27 trillion held in the domestic stock market. In Canada, ETFs reached $126 billion in assets in April, just 4% of the TSX’s total value.

Another argument against doomsayers is that index funds can be used in active investment. “Many of the users of ETFs are not passive investors but are actively involved in picking themes, trends, sectors and countries. They’re active global asset allocators,” Tyler Mordy, president and chief investment officer at Forstrong Global Asset Management, told the publication.

While the use of ETFs in active strategies defuses the possible threats from passive investing, it also lessens its power. Yves Rebetez, managing director and editor of ETF Insight in Ontario, is concerned that investors using ETFs in active plays will undermine the whole point of index exposure. “As the ETF wave continues to expand, you’re likely to see the financial industry try to convince people of the merits of trading and adjusting positions, just as they did for individual stocks,” he said.

As individuals start using ETFs like stocks, they may also expose themselves to the same self-defeating tendencies one can fall prey to in stock-picking: buying high, selling low and trading too much.

“Investors can cheat themselves out of a significant chunk of the benefits, just as they did with individual stocks,” Rebetez said.

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