Investing in exchange-traded funds, commonly known as ETFs, has become a more taxing exercise as the long bull market in North American stocks shows signs of losing its fizz.
ETFs typically track a market index, which means that picking winners has not exactly been rocket science since the current upswing in equities began in March 2009. The S&P500 index had trebled by late October. Even the more volatile S&P/TSX Composite index was up more than 80 per cent from its low.
Bond markets have also enjoyed an unexpectedly long run as the Federal Reserve and the Bank of Canada have held interest rates down in order to keep the economic recovery on track.
But investors – and their financial advisers – now confront a more turbulent climate. A combination of the slowdown in the Chinese economy, the UK’s vote in June to leave the European Union, weak U.S. earnings and signs that the Fed is set to become more aggressive in raising interest rates, have pushed markets into a state of limbo that some pundits describe as a “no man’s land.”
ETF assets under management in Canada have doubled in the past four years, reaching $107.9-billion in August, or about 7 per cent of total investment fund assets, the Canadian ETF Association reported.
But, in a sign of investor nervousness, the industry saw an outflow in September, with assets slipping to $107.2-billion, even as the number of ETFs continued to grow to 442, from 429 a month earlier.
The reversal was almost entirely due to redemptions of the iShares S&P/TSX 60 Index ETF, which makes up more than 10 per cent of all Canadian ETF assets. Many other funds reported continued inflows, led by a BMO MSCI fund focused on high-quality European stocks hedged to the Canadian dollar, and two short-term corporate bond funds.
“We’re definitely into a capital preservation mode at the moment,” says Deborah Frame, president of Toronto-based Frame Global Asset Management, which specializes in ETF portfolios.
Frame recently eliminated its entire exposure to the S&P500, hedged its exposure to the
Canadian dollar, shortened maturities in its bond index holdings, and pushed up the cash holdings in its conservative and moderate growth model portfolios from 2 per cent to 15 per cent – a sure sign of caution.
Despite uncertainties on the future direction of the markets, the ETF industry as a whole remains in robust health, says Yves Rebetez, managing director of ETF Insight, which specializes in ETF research and analysis. He predicts record inflows for the year as a whole and continued growth in 2017 and beyond.
Vanguard Investments Canada, the third biggest ETF provider, sees growing interest in ETFs, especially fixed-income funds, among small and mid-sized institutional investors, such as portfolio managers, many of which lack the resources for in-depth market analysis.
“We’re still very early in the ballgame in terms of where ETFs are compared with mutual funds,” says Mario Cianfarani, Vanguard Canada’s head of capital markets.
“We have seen a rising trend in usage and take-up and inflows when it comes to ETFs, particularly over the past few years. If you look over the long term, the trend is certainly very positive.”
Mr. Rebetez adds that “the increasing reach of what ETFs provide and the diversity of methodologies further their potential for additional penetration.”
ETFs’ low management fees and their liquidity are especially powerful selling points as investment returns flatten out or even turn negative. Vanguard Canada has lowered the average asset-weighted management fee on its funds from 0.27 per cent in 2012 to 0.15 per cent.
As for flexibility, “the beauty of an ETF is that you can quickly go in and out of asset classes,” says Ms. Frame. By contrast, mutual funds are normally required to hold a minimum number of securities.
“The managers of a mutual fund are not focusing on the broader economy,” she adds. “They have to be fully invested. They’re paid to pick stocks, so their focus is on the things that are impacting individual members of the asset class. They’re too focused on the trees and not on the forest.”
An ETF Primer
Exchange-traded funds, or ETFs, are part of “a broad secular move towards lower-cost investing that we see around the world,” says Todd Schlanger, senior investments strategist at Vanguard Investments Canada.
An ETF 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.
The largest ETF providers in Canada are Blackrock (with 107 funds and a 48 per cent market share at the end of September 2016), BMO Asset Management, Vanguard, Horizons ETFs and Invesco Powershares.
Besides simplicity, ETFs owe their popularity to lower fees and higher liquidity than many mutual funds, making them easier to buy and sell.
According to Morningstar, the average management fee on ETFs offered in Canada is 0.645 per cent, about one-third of the expense ratio charged by the average mutual fund. Horizons ETFs Management charges an annual management fee of just 0.03 per cent on its S&P/TSX 60 Index ETF, which it claims is the lowest-cost investment fund in Canada.
Yves Rebetez, managing director of ETF Insight, adds that ETFs “trade during market hours, which is an advantage for people who think: ‘Gee, I’m a little nervous about everything. I want to have investments, but I want to be able to get out.’”
ETF fund managers typically have 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 distinction is becoming more blurred as mutual funds lower their fees to remain competitive, and ETFs broaden their horizons with more actively managed offerings.
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