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HBG And The Rise Of Human Managed ETFs In Canada

October 31st, 2016

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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As I was perusing the list of ETFs listed in Canada, I noticed that there was a new ETF provider called Hamilton Capital (to learn what ETFs are, please read my free book). Hamilton Capital currently has only one ETF on offer, called the Hamilton Capital Global Bank ETF (Ticker: HBG). Note that I will refer to the ETF by its ticker HBG going forward.

The ETF invests in about 50 bank stocks across the globe, both in developed and developing countries. But thats not what piqued my interest in the ETF. Rather, what interested me was the ETFs investment strategy.

Most ETFs offered today follow a rule based strategy. The first ETFs that were introduced usually followed very simple rules. For example, the SPDR S&P 500 ETF Trust (Ticker: SPY), simply holds every single stock that belongs to the S&P 500 index, which is made up of the 500 largest U.S. stocks.

As time went by, however, new ETFs emerged that followed more complicated rules. The new ETFs sought to generate higher returns through the use of more sophisticated investment strategies.

However, the use of strategies came at a cost. Since the algorithms were often costly to research and develop, the ETFs that employed those strategies often carried higher annual fees known as Management Expense Ratios (MERs). For example, an ETF called QVAL, which forms part of MoneyGeeks regular portfolios, charges an MER of 0.79%, which is higher than average. By comparison, partly because of the simplicity of its strategy, SPY charges a mere 0.1% per year in fees.

An ETF provider doesnt charge the holder of an ETF directly. Rather, the effect of the MER shows up in the ETFs performance. If the investments that QVAL holds go up by 5%, then the ETF will see a gain of 4.21%. Therefore, its important to carefully analyze a sophisticated ETFs strategy to see whether it would justify the higher costs. But because the sophisticated ETFs are still based on rules, they dont need to pay for human analysts, and can afford to keep costs reasonably low.

Now, you might wonder what this has to do with HBG, Hamilton Capitals new ETF. As far as I know, HBG is the first Canadian ETF that doesnt follow any published set of rules. Rather, the contents of the ETF are determined through continuous human analysis. In other words, a human manager will use his/her knowledge and intuition to assess economic conditions, as well as the attractiveness of each stock.

HBGs reliance on human analysis marks a big departure from other ETFs, and makes HBG more akin to traditional mutual funds, which I recommended against in my free book. However, I wouldnt rush to pass judgment on the ETF because of that. Rather, I think its worth considering the pros and cons below, and then decide if you like the approach.

Lets start with the pros. Perhaps the biggest benefit of using human analysis is that humans can incorporate information that rule based strategies have trouble incorporating.

For example, lets say that company XYZ had a stellar record of consistently growing earnings, but recently, the company had been found out to be a ponzi scheme and the regulators shut it down. Lets say that XYZs shares crashed from $50/share to just $0.05/share practically overnight.

If a human analyst looked at the company, he/she would rule out investing in the company, even though the stock is extremely cheap. However, a rule based ETF that tries to buy cheap stocks may have a different response.

When the stock price declines, popular valuation metrics like Price to Earnings Ratios and Dividend Yields will skyrocket, at least until the companys next earnings report. This could cause such ETFs to invest in the fraudulent company. This is partly why Im careful not to recommend just any value investing ETF, even though I believe in value investing.

The benefit of human analysis extends beyond such simple examples. This especially applies to hard to analyze industries such as banks and other financial services firms, which are the companies that HBG focuses on. Banks are tough to analyze because theres a lot of uncertainty around the value of their assets, as the financial crisis of 2008 has shown. Incorporating human analysis therefore could improve the performance of the fund.

But unfortunately, there is no guarantee that human analysis will lead to better performance. The main reason is that investing is a zero sum game. If an investor outperforms the rest of the market, that means some other investor underperformed the market by the same amount. Therefore, its important to discern whether the human manager responsible for analysis is better than average.

Unfortunately, assessing whether the human manager is good is very difficult, and this constitutes the first major downside to investing in an ETF like HBG.

With ETFs that follow rule based strategies, we know exactly how the strategies work, what the results would have looked like if they had been applied in the past, and we can expect to see a predictable application of the rule going forward. This allows us to analyze the strategy more easily.

With a human manager, however, none of this applies. We dont know which stocks the manager would have chosen in the past, so we dont have a lot of data to help us analyze the managers performance. We also dont know which criteria he/she uses to select stocks today, and we dont know whether the manager will change his/her methodology in the future.

Furthermore, there is no guarantee that the same manager will be in charge of the ETF for a long time. If the performance of the ETF is great, the manager may feel tempted to transition to another job that pays more.

The temptation may especially be great for managers of HBG, because they charge less than the average mutual fund. While the stock market mutual funds tend to charge a 2% MER, HBG charges 0.85%. The lower fees mean that HBGs managers are likely paid less than their mutual fund colleagues.

The fact that HBG charges less than mutual funds, however, doesnt mean that the fees are low in absolute terms. HBGs MER of 0.85% is still 0.55% higher than Horizons S&P/TSX Capped Financials ETF (Ticker: HXF) which follows a simple rule based strategy. This means that to make the up for the higher fees, HBGs manager will have to outperform HXF by 0.55% every year before fees in order to at least equal HXFs performance. 0.5% per year doesnt sound like a lot, but its still a significant hurdle.

Though I mentioned some drawbacks to investing in HBG or similarly structured ETFs, this doesnt mean I think theyre bad investments necessarily. Its possible that HBG is managed by a team of above average analysts who will generate great returns for its investors.

Rather, the point I want to emphasize is that its hard to know whether HBGs management is any good, and whether it will stay good. That means there are risks involved with investing your money with a human managed ETF like HBG, and you would be wise to tread carefully.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.