Under the law of unintended consequences, there are two developments that may actually doom the exchange traded fund market to mutual fund-itis. As reported by Preet previously, regulators in various jurisdictions are proposing to eliminate mutual fund companies from paying commission to investment advisors to secure sales or to accept trailers.

More locally, as of Monday, National Instrument 31-103 (NI 31-103) will be in force across Canada.  NI 31-103 harmonizes the byzantine Canadian securities regulatory when it comes to registering market participants by  requiring anyone who is in the “business” of securities (a wide regulatory net than merely selling securities) to register in one of five classes of registrations.

In particular, those who administer mutual funds will be required to register for the first time ever in a newly created “investment fund manager”  registration class. The compliance requirements will be quite costly as it requires the hiring of compliance officers, registration and policies and procedures (both new and updating of old ones) to be implemented.

Both the move to disclose or limit mutual fund commissions and trailers and to require greater registration commenced in 2006. The results, as a whole, can be seen as a pincer movement on the mutual fund industry. On the one hand, regulators are  trying to slow revenue growth by  limiting enticements to push product and, on the other hand, increasing expenses through more compliance measures (undoubtedly, NI 31-103 has cousins in other countries).

Regulation alone has never stopped the financial services industry; history shows that as soon as the regulators close down one loophole, the player move to a greenfield product that has little to no regulation and it takes the regulators years to create another regulatory framework. If not for the credit crisis, Congress would still be talking about how to regulate hedge funds.  More to the point, while regulators are adding regulation to mutual funds, lawmakers are scratching their head over how to limit commodity ETF that may be distorting market prices.

Thus, the fact you have the regulators protecting the public interest in product that is most likely on a downward side of a product life cycle  (although very slow decline) while Congress scratches its heads about the public policy consequences of  ETFs  (“….Mr.  Speaker, I thought ETF was a branch of the Department of Homeland Security…),  means that the industry may move away from the regulators to something they don’t quite understand yet and has legs. This is the ETF market.

I do not think regulatory pressure on the mutual fund industry alone will cause a wholesale shift to the ETF market. But it will be a factor (the degree of influence is up for debate). If this happens, history indicates that the financial industry will basically ruin ETFs with excess and sell the sizzle and forget the steak.

Sadly, excess is already here. As Larry MacDonald reported, there are now actively traded, non-benchmarked, high MER ETFs on the market based on demographic trending (the 1.96% annual operating expense seems low given the prospectus states underlying ETF fees and expense are 0.17%; if turn-over is high, this seems like a low estimate). Given 1 million units were traded in the first 4 days of trading- a relatively modest volume given that Vanguard Total Stock ETF traded almost 1.9 million shares yesterday-it seems to prove the theory people will buy anything if packaged right.

As a smart investor, if poorly designed EFTs becomes the rule rather than the exception, please remember why you would invest in these products to begin with, mainly:

1. You have no intention to beat the market which, statistically speaking, will not happen to most investors but matching the market will put you in a better position than most active investors;
2. Broad exposure to markets; and
3. Low fees.

If a new mutual fund, dressed up in ETF clothing for sales and regulatory purposes, is pitched to you, please review the above list and see if it passes the test.