snakes and ladders

As the ETF industry burgeons, the original premises of indexing are in danger of being swamped. What were those original premises? Simplicity was one, and so were cost-effectiveness and tax-efficiency. The idea was to track as broad an equity index as possible.

In a sense, this is Modern Portfolio Theory, as articulated by nobelist William Sharpe. The market portfolio was efficient—it couldn't be bettered, at least not easily. Best to buy the whole stock market cheaply and let the random walks for individual stocks cancel each other out. All that mattered was for the investor to express a risk appetite, by allocating money away from the market portfolio to a risk-free asset (cash) or a comparatively risk-free asset (bonds). Hence the efficient frontier: so much risk buys so much return.

But academic theory doesn't always describe investor practice. The key point is risk. Stung by two bear markets, investors now seek better beta and less risky beta (perhaps both at the same time). That is, if they are still in equities.

The problem is the complexity this brings to ETF investing. The product market is running ahead of investors' capacity to understand it.

Evidence? Even so-called do-it-yourselfers are finding it hard to know where to begin with ETFs. Advisory services are springing up to aid them in finding the right asset allocation. That idea must also be behind the Canadian Securities Institute's launch of a new program for advisors, Certificate in Advanced Mutual Funds Advice, for those who are licensed only for mutual fund sales.

As indexed products, ETFs are still cheap compared to their mutual fund competitors. But they may not be as simple as they once were. Buying better beta, or less risky beta, is an attractive concept in the abstract.

But this may be putting the cart before the horse. The fundamental question posed by Sharpe still applies: what is the client's risk tolerance?

Scot Blythe is a Toronto-based financial writer.
Originally published on Advisor.ca