Disclosure form

Whenever a new investment idea or ETF offering becomes available, my reaction is always to wait and see how things go before investing.

Over the years, I have seen many mutual funds and ETFs merge with other products due to lack of interest from investors. I have also seen many smaller companies bought up by larger firms after launching a suite of investments that were unable to attract enough assets to remain viable.

Although these situations can leave unitholders confused and financial advisors scrambling to either sell or explain the changes to their clients, there is not necessarily any money lost. Also, the reality of investing means any product can turn out to be a bad investment, regardless of the size of the issuer.

Last month, Emerge Canada Inc.’s 11 ETFs were put under an unprecedented cease-trade order (CTO) for missing a regulatory deadline on fund reporting. This means that while Emerge is still actively managing the ETFs’ strategies, there cannot be any trading, creations or redemptions until the regulators lift the CTO.

I found it encouraging that the Ontario Securities Commission stepped forward to respond to a situation that had become non-compliant. Although necessary, it was highly unusual.

This situation highlights the necessity of doing proper due diligence on both a security itself and its manufacturer.

The exponential growth of ETFs over the past decade has led to the creation of countless new products, several of which do not pass the test of time. I underscored the consequences of this in my recent article on thematic investing.

I wrote: “As with all ETF investing, investors should take a good look under the hood to make sure they understand what they are buying. Detractors say these ETFs come to market just when the underlying trend is topping and are usually money-losing propositions after launch.”

Experts estimate that a new ETF needs roughly $100 million in assets under management (AUM) to remain viable. At present, roughly one quarter of the ETF providers in Canada do not meet this AUM threshold, according to data from National Bank Financial.

The viability of the ETF’s issuer also is important to consider.  Established providers might have a better chance of sustaining a market for new investments they bring to market and provide better support concerning the use of the products (e.g., overall portfolio risk management criteria) and tax information.

BMO has created a useful advisor checklist that outlines key questions and considerations when choosing an ETF provider. Here are some questions that are pertinent in the case of smaller issuers:

  • What is the firm’s total AUM and total ETF AUM?
  • How experienced is the firm in managing and launching ETFs?
  • Does the firm provide local support and ongoing education?
  • Is the provider a leader in the industry? What ETFs does the product shelf include: broad based, smart beta, fixed income, innovative solutions?
  • When does the provider post tax parameters? Monthly and year-end distributions?

Lessons going forward

Getting into an investment early can be tempting, as doing so can come with the lure of enhanced returns down the road and the satisfaction of being able to say that you identified a trend or an opportunity first.

But this decision can be costly if it coincides with not checking off all the due-diligence boxes on our list. As fiduciaries of our client’s wealth, we need to be able to explain how and why we choose our investments and, if applicable, why an investment decision has not worked out over time. Problems with an issuer can be complex and hard to explain, since they may be unrelated to market returns and the economic environment.

I do not think the Emerge situation will penalize the ETF industry as a whole going forward. Nor do I think the situation will force product creation into the hands of the larger providers. I consider this to be a one-off event that has little to do with the size of Emerge ETFs. But it is a cautionary tale for advisors.

As I say to my team: we can’t control the markets, so let’s do our best to control the things we can, like doing our homework on the investments we choose, looking under the hood and checking off our due diligence list.