Canadian-listed ETFs generated $5.1-billion in new investment in the third quarter of 2018, shattering the $3.4-billion record set in Q3 2015. It’s part of a longer, larger trend. The number of ETF providers has climbed from five in 2012 to 31 today, up 600 per cent in just six years. The first ETF in the world was launched on the Toronto Stock Exchange in 1990. Today, there are more than 600 trading in Canada alone.
What is driving this tremendous growth? Investors.
Providers are responding to market demand, says Pat Dunwoody, executive director of the Canadian Exchange Traded Fund Association (CETFA). “Investors are now more attuned to the impact of fees on their portfolios. With lower returns, everyone is taking that extra look to understand what they’re paying for the services they’re receiving. ETFs allow for more visibility, so for advisers, it means it’s easier to point to a line item on a statement and say, ‘this is what you pay me, and these are the services I provide.’”
The cost-value proposition for many ETF products is also compelling, providing access to broad diversification with management costs just fractions of a percentage point above zero. “Investors and advisers can use these funds as the anchor of the investment plan and then add mutual funds or other investments around that low-cost core,” says Ms. Dunwoody.
ETFs also often provide a greater level of transparency in terms of daily holdings, making it easier to know exactly what’s in a portfolio and to align with asset allocation targets. “Investors often think they have a full, wide-ranging portfolio of mutual funds, but when they actually look at the top 10 holdings of each fund, too often they are very similar,” says Ms. Dunwoody. “With ETFs, it’s easier to do that deeper dive to ensure you have full diversification.”
Another primary factor driving the expansion of the ETF market is their global reach, says Tyler Mordy, president and CIO of Forstrong Global Asset Management. “I think one of the lesser-known facts about the world of ETFs is that it’s dominated by active investors. ETFs have historically been associated with passive investing, but for us, the driving force is that ETFs have colonized the world’s asset classes. Done properly, ETF investing means that Canadians can now build more diversified, more globalized and ultimately more robust portfolios.”
“Factor” ETF investing has also been a magnet for new investment, especially over the past 18 months, says Christopher Doll, the vice-president of ETF Sales & Strategy at Invesco Canada, and a CETFA board member. “This is investing based on tried-and-true factors that have shown persistence over time, such as classic value versus growth or momentum, dividend investing, low-volatility investing and quality investing. These factors have started to capture the attention of investors and have been a big driver of flows into ETFs in recent years.”
A lot of the expansion in the market over the last decade has been about giving investors access to options that weren’t previously available to them, says Mr. Doll. “For example, we were the first to launch senior secured loans in an ETF – basically a high-yield, floating-rate loan investment product – back in 2011 in the US and 2012 in Canada. It’s the sort of investment traditionally only available to institutional investors. ETFs have democratized the investment landscape, giving investors greater access to asset classes like bank loans or investment factors like dividend, low volatility, value, momentum or quality.”
Investors have also changed, says Michael Cooke, the head of Exchange Traded Funds at Mackenzie Financial and a CETFA board member. “We see multiple generations in the marketplace, from baby boomers to Gen Xers to millennials, and they all have different types of investment objectives. Investor needs are becoming more discrete, and the marketplace is responding by offering more options.”
ETFs are efficient building blocks with which to build customized portfolios, and by extension, customized outcomes, he explains. “If you want to go active or passive, if you want to manage the total cost of your investment portfolio or the overall risk within your portfolio, ETFs have emerged as an effective tool. Cost is part of the narrative, but I think it’s the efficiency and precision with which you can achieve a certain investment exposure that has been the critical driving force of the popularity of ETFs,” says Mr. Cooke.
In part due to these characteristics, ETF market growth is also being driven by institutional investors that include pension funds, sovereign wealth funds and central banks, he adds.
ETFs and mutual funds are simply containers that hold a variety of different investment strategies, both active and passive, says Mr. Mordy. “The conversation is no longer about products, but about process and solutions. What is the appropriate solution for the investor, and what vehicle – either ETF or mutual fund – best accomplishes it?”
“As of 10 years ago or so, ETFs and mutual funds were discussed as an either/or,” says Ms. Dunwoody. “Today, many advisers view a combination of both as the most appropriate way to build a portfolio.”
What is smart beta?
In the investing world, “beta” is used to describe the risk/return potential of a particular security or portfolio compared to the broader market. “Smart beta” is a term that describes a strategy that tweaks portfolios that reflect the broader market – applying transparent rules to increase or decrease asset positions in the aim of achieving higher returns. Asset holdings are weighted (increased or decreased) based on their likelihood of performing better under various market conditions. These characteristics are known as “factors;” factor-based investment is the core of most smart beta ETFs.
These are the most commonly applied factors:
Value: Managers seek to identify stocks that are underpriced relative to their true value.
Size: Smaller companies have higher risk/return potential than larger companies.
Momentum: Stocks that are currently in investor favour tend to stay that way for a while.
Quality: Companies with low debt, stable earnings, consistent growth and sound management tend to do better over the long term.
Low volatility: Stocks that exhibit low volatility have the potential to achieve stronger risk-adjusted returns.
Source: CETFA; see CETFA.ca for more information.
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