Growing ETF market offers new opportunities for investors
Demand for exchange-traded funds is surging in spite of lacklustre equity, bond and commodity markets. istockphoto.com
If proof was needed of the burgeoning popularity of exchange traded funds (ETFs), consider the prospectuses filed in recent months by two of Canada’s top money managers.
Mackenzie Investments and TD Asset Management have built their business largely on mutual funds. But their prospectuses suggest that both are now on the verge of launching their own stable of ETFs.
“ETFs are the more effective, more efficient delivery mechanism for [mutual-fund companies’] products. Over time there will be a blurring of the lines between mutual funds and ETFs.”
Announcing its move, Mackenzie said: “Active ETFs are an important investment alternative for investors and are playing a larger role in financial and retirement planning as a complement to mutual funds.”
The value of Canadian-listed ETFs, measured by net assets, ballooned by 16.7 per cent last year to a record $89.5-billion, despite the generally lacklustre performance of equity, bond and commodity markets.
ETF sales also reached new highs, totalling $16.5-billion, according to Canadian ETF Association. Although they still make up only about 7 per cent of investment fund assets, Canadian-listed ETFs contributed 20 per cent of all investment fund inflows.
The moves by Mackenzie and TD are not the only signs of ETFs’ advance. Two other big mutual-fund distributors, CI Investments and AGF, have acquired ETF managers during the past year.
“The mutual-fund companies recognize that they’re fighting a rearguard action,” says Mark Yamada, chief executive of PUR Investing, which designs ETF portfolio software for investors and their advisers. Mr. Yamada adds that “ETFs are the more effective, more efficient delivery mechanism for their products. Over time there will be a blurring of the lines between mutual funds and ETFs.”
Deborah Frame, president of Frame Global Asset Management, which specializes in ETF portfolios, says her firm’s model typically contains eight to 12 ETFs.
“The cost of creating a portfolio such as ours is quite a bit less than an active stock-picking manager,” she says, noting that ETFs also trade at lower commissions than stocks.
The ETF market has received another shot in the arm from new regulations, known as Client Relationship Model Phase 2 or CRM2, which will require financial advisers to disclose more details of portfolio performance and service costs. The new rules are due to be fully implemented later this year.
“CRM2 is causing advisers to take a second look at the kind of things that are offered to clients,” Ms. Frame says. “Not all advisers are defensive about the fees they’re charging. But rather than having that difficult discussion with their clients, some are looking at going to a fee-based model and moving away from a commission-based model. And ETF strategies are often offered on a fee-based model.”
The surge of interest in ETFs has also created challenges. Howard Atkinson, retired president of Horizons ETFs Management and now an independent corporate director, notes that the market “is getting a lot more crowded, and there’s a lot more competition. You either need to have scale or to carve out a niche for yourself.”
Many ETF providers are trying to stand out by adding value to their products in the form of actively managed funds and ETF-managed portfolios.
Actively managed funds, also known as smart beta or alternative beta ETFs, are rebalanced periodically to take into account of factors such as growth, value or momentum.
Such products are further blurring the lines between ETFs and mutual funds. Even so, Mr. Yamada says, “these ETFs are more disciplined. They’re more transparent because you know what the rules are, and they have to deliver against those rules.”
ETF-managed portfolios typically have at least half of their assets invested in ETFs. Mr. Atkinson notes that “there’s quite a few discretionary portfolio managers that either use ETFs exclusively or use them in conjunction with other vehicles, but they make up a big percentage of the client’s portfolio.”
Ms. Frame estimates that Canada is five to six years behind the U.S. in the market penetration of ETF-managed portfolios, setting the stage for more growth ahead.
What are ETFs?
An exchange-traded fund typically tracks an equity, bond or commodity index and, unlike a mutual fund, is itself listed on the stock market. It thus offers investors the advantages of a diverse portfolio in a single traded security. An ETF can be held as a long-term investment, bought on margin, or sold short.
ETFs do not aim to beat the underlying index on which they are based; rather, they seek to replicate the index’s performance. Unlike index mutual funds, which are priced at the end of each trading day, ETFs are traded throughout the day.
Besides simplicity, ETFs owe their popularity mostly to low fees. According to Morningstar, Canadian management expenses average 0.61 per cent of net asset value for ETFs versus 1.86 per cent for active mutual funds, among the highest in the world.
ETFs have other advantages too. Being linked to a specified index provides transparency to investors. ETFs also offer higher liquidity than many mutual funds, making them easier to buy and sell.
ETF fund managers have typically had less discretion than their mutual fund counterparts. They make minor, periodic adjustments to keep the fund in line with its index, rather than actively buying and selling individual stocks or bonds. Even so, the line between ETFs and mutual funds is becoming fuzzier.
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