ETFs and Risk – What Clients Are Asking Us

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James E. Houston, CIM, FCSI

June 4, 2014


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ETFs and Risk – What Clients Are Asking Us

Whenever we host client events, like the annual event at the National Club or our regular pooled fund lunches in the office, it gives us a good opportunity to hear what is on our clients’ minds and to answer questions at the end of our presentations. In this case ETFs and risk.

Below, we highlight two questions which we feel may be of interest to our readers that came up in our annual client presentation in November.

1. Are passive index funds and ETFs risky for investors?

Passive index funds and exchange-traded funds (ETFs) are designed to perform in-line with a particular index or sector or specialty theme. They allow investors the opportunity to get broad market exposure through a single investment vehicle. There are billions of dollars invested in the hundreds of ETFs available to investors in Canada; they offer exposure to everything from the TSX 60 Index to global infrastructure stocks to an index of Canadian junior oil stocks. While these investment vehicles may appear attractive on the surface, we suggest that they are not suitable for all investors. Embedded fees and expenses can be quite high, particularly for smaller ETFs with specialty and/or global exposure. In addition, the “passive” nature of the funds means that investors get exposure to equities that are included for quantitative rather than qualitative reasons. This resulted in Nortel’s stock making up more than one-third of the value of the TSE ETF in August 2000, and mining scam Bre-X Minerals being included in the TSE index before it vaporised in 1997.

We see the proliferation of these passive investment vehicles as an advantage to Nexus and our clients. We find that there is less fundamental research being done on companies and that passive fund re-balancing, by its nature, causes passive fund managers to buy high and sell low. This creates advantages for us and allows us the opportunity to add value.

As an active manager, Nexus believes that our investment decision-making will meaningfully improve investment outcomes. In fact, as we demonstrated in this year’s presentation, Nexus’s “active share” at September 30, 2013 was 73%. That means that 73% of the holdings in the Nexus Equity Fund differed from its benchmark. ETFs can be useful in certain circumstances, but we think that emphasizing them too much risks creating unwelcome consequences.

2. What is our most aggressive holding?

In terms of the stock in our portfolios with the highest price-earnings multiple, it is likely Gilead Sciences. Gilead is a biotechnology company that researches, develops and commercializes pharmaceuticals primarily focusing on HIV/AIDS, liver diseases such as hepatitis B and C, and cardiovascular and respiratory conditions. One of the more recognizable products developed by Gilead is Tamiflu, which was widely used (as well as stockpiled by various governments) during the global outbreak of H5N1 avian flu in 2005.

While the stock trades at a P-E multiple in excess of 30 times, versus the S&P 500 at approximately 17 times, we feel that it is justified based on the company’s strong record of growth and the pending launch of highly profitable new drug therapies. We are particularly enthusiastic about two drug compounds which have shown well in late stage clinical trials addressing hepatitis C and leukemia.

On its own, Gilead appears “aggressive”, but because its business is so different from our other holdings it actually helps to diversify the portfolio. However, simply being different is insufficient justification for purchase.  In fact, Gilead has a future earnings profit that we believe will justify today’s valuation.

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