Debunking ETF Myths with Warren Steinwall

Michael Hainsworth:
The first exchange traded fund in the world was created in Canada. Since 1990, ETFs have provided diversification, allowing investors to spread their risk across a wide range of assets, such as stocks, bonds, or commodities, without the need to individually select and manage each investment. This diversification has helped mitigate the impact of individual asset price fluctuations. ETFs also offer transparency: they typically disclose their holdings daily, enabling investors to make informed decisions. ETFs are also known for their liquidity, as they can be bought and sold throughout the trading day, providing flexibility for investors to enter or exit positions swiftly. ETFs often have lower expense ratios compared to mutual funds, which can help investors keep more of their returns. We’ve known this for more than 30 years. But myths still persist. For his perspective i turned to Warren Steinwall, the chief investment operations officer at Ninepoint Partners. We began by discussing what makes an ETF an efficient investment vehicle.

Warren Steinwall:
At the end of the day, an ETF is no different than a mutual fund just happens to be listed, which is the main difference. And because it's listed, it gives you that ability to transact throughout the day, unlike a mutual fund. So we tell advisors or our investors, hey, if you have a view of the market at 10 o'clock, you can dive in right at 10:00. You don't have to wait like a traditional mutual fund till four o'clock. And by that point, the market could have grossly moved from where you were expecting, in the opposite direction, and might be no longer a viable trade for you.
So that's one of the biggest benefits is from an investment standpoint, an ETF helps. The other thing is for a lot of the traditional advisors who run model portfolios, an ETF is definitely a viable option because they can bulk trade, especially if they're running models where they're constantly adjusting weights back and forth. It's definitely more cost-effective, and easier to execute, than traditional mutual funds. So those are some of the nuances that kick into why one would use an ETF versus a traditional mutual fund.

Michael Hainsworth:
The point you made right off the top is interesting to me, because we are always taught not to time the markets, but when it comes to ETFs, that's a myth. I was surprised to learn that there is a good time to trade and a bad time to trade.

Warren Steinwall:
Agreed. Yeah, no, there is for sure. So the way an ETF works at the end of the day is that the market makers, who the ETF provider engages to be that conduit to the street, they literally price that fund the ETF on a tick-by-tick basis. And what they do is they roll up all the underlying securities, all the prices of those securities in order to come up with the ETF price. Sometimes some of those positions are not fully liquid for thing in the morning, and hence why we advise clients try to avoid trading first thing in the morning when the market opens. Because those prices, if they're not fully fed into those dealer systems when they're calculating the ETF price may end up causing it to give a larger bid-ask spread, which means you might be not paying the true fair market value that you should be paying for it.

So avoid the first 15 minutes in the morning. Same thing at the end of the day because all the ETF market makers typically de-risk their books from whatever they've taken as a position throughout the day. So you don't want to be trading at market close as well, because generally they're at the market either dumping positions or buying to de-risk their books. So that's why it's better not to, first thing in the morning or at four o'clock. The other thing is also try to avoid trading ETFs. For instance, if you're buying a heavily US-weighted ETF, but it's still a Canadian fund, but the US is closed. If you do that, you might end up paying a higher spread because again, the US market for that underlying holdings are closed for the day. So the market makers are somewhat guessing what they think the price will be the next day. So they kind of err on the side of caution and they basically put a larger spread to that price.

So keeping those in mind, try not to trade during those times or when there's a market close in one of the key markets that that fund is holding.

Michael Hainsworth:
That last point's important too. In all my years on Bay Street, no one would ever want to make any significant moves when the Canadian market was open, but the American market was closed. This was an opportunity to take an extra day off. Do you in fact take the day off when the Americans are off as well?

Warren Steinwall:
Not really, because still FX markets are open, futures, markets are open. They pretty much trade 24/7, so nothing really closes. Even though equity markets might be closed in one market or one country, still activity goes on, especially in the Canadian side. Like you said, the US is closed, but the ETF market in Canada is open. Still, people are buying and selling, so we still have to price the fund. We have to make sure trading is happening. So yeah, there's no really a day off as such, but it's definitely lighter, but not a day off.

Michael Hainsworth:
Well then obviously you are way more ambitious and dedicated than I would ever be. But another myth to bust here is tied to that bid-ask spread, they can look quite large, and we are taught that this is a sign of an inefficient market.

Warren Steinwall:
It's true, but it's not true as well, because for an ETF, people get spooked because they look at a stock and bond and they go, oh wow, that bid-ask spread is really high. But what they don't realize is it's just an arithmetic, I guess a roll up effect of the underlying securities of that ETF. So like I said before, the market makers, they literally price using all the underlying securities tick-by-tick. And if the underlying securities of that fund has illiquid positions, that illiquidity is going to make its way into the bid-ask spread of the ultimate ETF as well, because if a bunch of those names are thinly traded, then those prices will be pretty wide the bid-ask spreads, and those bid-ask spreads when they're aggregated back up to the ETF, is going to make its way to being a higher bid-ask spread. So it's not that it's bad or wrong, it's just, the underlying holdings will derive the bid-ask spread, how wide it's going to be when the ETF is quoted by the market makers.

Michael Hainsworth:
I think that when ETFs came about in the 1990s, that part of it was a response to the mutual fund industry, and the fees that get tacked on associated with that. And so we often compare mutual funds to exchange traded funds, and one of the myths of ETF investing is that the trading volumes directly translate into liquidity. But even though volume does exist on mutual funds, they're not even reporting that to the market.

Warren Steinwall:
Agreed. And in fact, a lot of people confuse... I guess looking at the ETFs volume to a stock. For a stock, you're absolutely right. Volume matters because that's the only way you can get liquidity is through the secondary market. So if you want to buy and there's no one willing to sell, you are kind of stuck. With an ETF, what folks still forget is that while it's exchange traded, it's listed like a stock, it's still an open-ended fund. The difference is that it's only the market makers who can subscribe or redeem units with the fund, but they themselves then be the conduit to the street. So, if there's not enough liquidity, because say someone wants to buy a ton of units of an ETF and there's not enough liquidity in the market volume, the market maker will be the other side. It's a contractual obligation for the main market maker for a fund known as the designated broker.

They do have a fiduciary duty to be the other side of every trade if no one else is there, and that's tick-by-tick. So there is never a case where that won't be liquidity, because no one's going to be there. There is going to be somebody always there. It's a matter of sometimes working through the fund company, the ETF providers say, hey, I want to trade a large trade. I don't see someone quoting the same volume. Then we would step in to pinging the market maker saying, hey, we do have a client who wants to trade a big order. Then they will make sure that they put up on the board the volume that counterparty is willing to trade. So there's always a party waiting to be on the other side of the trade.

Michael Hainsworth:
So what's your favorite example of how an ETF is more efficient than a mutual fund?

Warren Steinwall:
It goes back to the ability to trade intraday. That is my theory because in today's environment, everybody has a view of the market with, like we all say, don't try to time the market, but you also want to access the market at the right time. So that helps you with an ETF versus a mutual fund. I will say that's kind of the key, because cost is these days a relative term because a lot of the mutual funds are getting cost-effective as well, knowing that they have to compete with the ETF market. So I think still there's a cost disparity, but it's shrinking. But I think the other benefits are more the ability to trade anytime during the day.

Michael Hainsworth:
So give us a sense as a compare and contrast against a mutual fund as an alternative investment to an ETF. How big is the ETF market today?

Warren Steinwall:
So the ETF market has been growing leaps and bounds, and that's been the case since 1990s. As of December 2022, the mutual fund AUM across all the funds was 1.9 trillion, while ETFs were totalling around 313 billion. Yes. So ETF market is still way smaller than the mutual fund market, but as of July of this year, the same IFIC reports that they put out, the mutual fund market is still stuck at 1.9 trillion, the AUM. Meanwhile, the ETF market has grown to 356 billion. That's about a 14% growth year to date.
So you can see that the tides are changing. It is shifting, where the mutual fund market still is a big Goliath. The ETF industry is getting there, but the pace of growth for ETFs is way higher than mutual funds. And also, in terms of number of funds, currently there are about 1,375 ETFs and just year-to-date alone, 113 new ETFs were created. So as you can see, almost weekly we see all our peers, plus ourselves, are constantly launching ETFs because there is a demand for it, and it's not going away.

Michael Hainsworth:
So then to what do you attribute that demand where we see the assets under management and the mutual fund industry remain stagnant, but we're seeing double-digit percentage growth on ETFs.

Warren Steinwall:
So I think it's a combination of ETFs also evolving from being index-based strategies in the past, because that's how people always equate an ETF to be, which is not the case. Now you've got actively managed ETFs, you got, literally any type, shape, or form that used to be in a mutual fund has been offered now as an ETF. The other part is that, a lot of fund companies, including ourselves, we are offering ETF series. So what that means is that especially for alternative products, like the liquid alts, where you already have a successful fund, you can just bolt on an ETF series and give people that access, who like to trade it as an ETF to now access the fund as an ETF.

So basically the product shelf has evolved, and I think that's given people more options now, and given the fact that they see the efficiency of the ETF market, then I think they're adopting more and more ETFs into their strategy as opposed to the traditional mutual funds.

Michael Hainsworth:
What role does economics play in all of this? We've seen the cost of money go up from historical lows with a remarkable rally, about 500-some-odd basis points in the overnight lending rates in most major economies. How is that impacting the way we look at ETFs?

Warren Steinwall:
I guess because every dollar counts, and especially for the advisors that we deal with, because our client base are all the IROC discretionary advisors. For them, I think, a lot of the advisors that we've spoken to, they sometimes will not trade mutual funds. All their trade is only ETFs. So they may love your strategy, but if you don't have it as an ETF, they will weed you out.
And that's part of the efficiency that I talked about earlier. Because they are running models, they do want to be able to balance/rebalance cost effectively. Also with ETFs, there is no ERF, or early redemption fees. So while we never encourage someone to trade in and out, but if somebody wants to take a view and then change that view a week later, and get out of that trade, they can do that with no penalty, unlike a mutual fund, which generally has an early redemption fee if you don't hold the position for a period of time. So some of those economics do play in when they're deciding that the ETF is the better option, especially in this environment when every basis point counts.

Michael Hainsworth:
We're also getting numbers that show that maybe that talk of a recession is real in this country, and perhaps in the United States as well. What does an ETF look like in a recessionary environment?

Warren Steinwall:
So from my perspective, I don't think it looks any different than a mutual fund, because at the end of the day, they're both the same strategy, just a different structure. So I think, at the end of the day, someone has to decide what they want to be exposed to, and once they decide what they want to be exposed to or not, then ETF is merely a mechanism or an access point for them to then game that access to that strategy based on their views of the market.

Other than that, I don't think there's really too much more to read into an ETF, because its core is still a mutual fund with an investment strategy that you have to perform your own due diligence, do your own risk analysis, and then decide if that's the trade you want to make, and then go from there.

Michael Hainsworth:
Back to your earlier point as well, about how an ETF used to be just about index mutual funds tied to the performance of any given market, but now exchange traded funds are for a variety of different types of investments. And so, that type of investment that you've chosen as part of your strategy, that's what gets impacted by an economic environment, not the actual structure of the investment.

Warren Steinwall:
That's great. Absolutely right, because again, an ETF is merely a structure and an access point.

Michael Hainsworth:
So then, for the investor considering ETFs, who may already be in mutual funds and they're seeing an erosion in the value of their returns because of those fees, what are the risks associated with ETF investing?

Warren Steinwall:
At the end of the day, it goes back to the strategy itself. So as long as the investor is comfortable with the strategy, the ETF is merely a structure and an access point. So as long as, again, you've done your homework, your research, make sure you're comfortable, whether it's an ETF or a mutual fund, the risk doesn't change the underlying strategy that plays into your risk profile. So that's where you have to be more cautious about as opposed to whether it's an ETF or a mutual fund.

Michael Hainsworth:
What's the one thing an ETF investors should look out for that may not be obvious?

Warren Steinwall:
There's no secret weapon there or secret sauce about an ETF. It is merely still a mutual fund. And there's nothing that I can see that someone has to be cautious about or that has something unique about the ETF because it goes back to the strategy as opposed to the ETF itself.

Michael Hainsworth:
So if there's one key takeaway for an investor considering an ETF, what should it be?

Warren Steinwall:
At the end of the day, do your homework, understand how to access an ETF. Be familiar. Don't get spooked by volume because we still see very sophisticated investors still getting spooked by looking at volume and freaking out, thinking that they can't get out when they need to because somehow they think they're stuck in this position. Think about the timing you want to get in and make sure that you trade at the right time, so that you don't unfortunately get hosed with a larger bid-ask spread that could eat into your returns at the end of the day. And these days as every basis point counts, that becomes that much more important.
So just do your homework, get familiar with the way you trade an ETF. And many banks, all the brokerage firms have ETF desks. Many times they're more than happy to help an advisor if they have specific questions on how to access an ETF, what's a good time? Provide some color around the market. They can speak to the strategy, but they can speak the market itself, the trading volumes and so on and so forth. So leverage them, and if worse comes to worst, by all means speak to your sales representative as well, who can then provide some guidance as well.

Michael Hainsworth:
And when it comes to ETF investing, it's a lot like barbecuing. You got to keep an eye on it.

Warren Steinwall:
Exactly. There is no, I guess autopilot mode unfortunately. So once you buy it, you got to keep an eye on it. And if you're trying to time it where you need to get out at a certain point, then yes, keep a close eye and know when to get out. Also, be careful, when you put trades on, one of the things they always say is do not put market orders in, because a lot of the algorithmic trades could unfortunately hose you. So it's always important to put a limit order, and that way one of those algos can pick you up and take you for a ride, unfortunately. So we've seen people who got burnt by putting in market orders, so always avoid that. Go with the limit order, which is much safer.