The Canadian ETF market, once a pioneer in the exchange-traded fund space, has evolved into a complex and crowded landscape. This article delves into the lessons learned from the 'graveyard' of Canadian ETFs, where 654 funds have closed over the past two decades, shedding light on the challenges investors face in this dynamic environment.
The Small Asset Trap
One of the most striking findings is the prevalence of small asset-sized ETFs. Eighty percent of closed funds had less than $10 million in assets, with only 1% surpassing $100 million. This makes sense, as the revenue generated from a small ETF's management fees is insufficient to cover expenses, especially when considering the costs of portfolio management, compliance, custody, and exchange listing. The pressure to siphon support from other products further exacerbates the challenge.
Commentary: Investors should scrutinize the assets under management (AUM) of ETFs, as displayed in the ETF Facts document. While small ETFs aren't inherently flawed, their struggle to reach the critical mass required for long-term sustainability is a significant concern in a crowded market.
The Low Fee Paradox
Despite the emphasis on low fees as a key factor in long-term wealth accumulation, the data reveals a paradox. Thirty percent of the closed ETFs had low fees, indicating that low-cost funds alone are not a guarantee of success. The challenge lies in the thin margins of low-cost ETFs with mediocre asset growth, which can lead to financial losses for ETF providers.
Analysis: Low fees are essential, but they must be complemented by strong asset growth and consistent trading volume. Investors should seek funds that demonstrate a healthy balance between cost and performance.
The Five-Year Litmus Test
The closure data highlights the critical importance of the first five years of an ETF's life. Only 29% of the closed funds survived beyond five years, with 12% closing within two to five years. This suggests that the initial years are crucial for an ETF's success, and investors should exercise caution when considering new launches.
Reflection: New ETF launches carry statistical risks. While innovation and lower costs may be appealing, investors should wait for funds to establish a track record before investing, ensuring they have proven their ability to withstand market challenges.
Passive Strategies Don't Always Fare Better
The rise of 'smart beta' ETFs, which combine passive and active management, has been notable. However, these strategies have been overrepresented in the graveyard, with 19% of closures attributed to this category. The challenge lies in the consistent exposure to a single factor, which can be detrimental when market conditions shift.
Opinion: Passive strategies, while efficient, are not immune to market dynamics. Investors should carefully assess the competition within each fund category and the potential risks associated with 'smart beta' approaches.
The Final Takeaway
In the ETF market, longevity is a critical factor. Investors should prioritize funds with a proven track record of endurance, focusing on scale, time, and competition. While low fees and passive labels are beneficial, they are not sufficient guarantees of survival. The market's crowded nature demands a discerning approach, backing strategies that have already demonstrated their ability to go the distance.
Conclusion: In the world of investing, as in running, success is rarely accidental. Investors must be selective, backing funds that have proven their mettle over time, rather than chasing shiny new entrants.
