The ETF at 25

by Lori Bamber

It’s been a quarter-century since the Toronto 35 Index Participation Fund – the first North American ETF – was listed on the Toronto Stock Exchange, launching a global industry that has grown to more than $2.79-trillion US in assets under administration.

By the end of 2014, the Canadian ETF sector had expanded to include more than
300 funds, nine fund issuers and assets of nearly $80-billion. Along the way, exchange-traded funds have changed the Canadian investment landscape and influenced the way advice is delivered.

To mark this important milestone, we asked leading portfolio managers, academics and other industry experts to share their insights on the trajectory of this made-in-Canada investment innovation – and what it means for investors.

Shifting perceptions
It all began in March 1990 with the launch of TIPS 35, a product that enabled invest-ors to gain exposure to the Toronto Stock Exchange 35 Composite Index without purchasing each constituent company’s shares. And so the ETF was born.

Looking back, Warren Collier, head of iShares Canada, BlackRock, calls the moment “one of the biggest pivot points in investing. It brought investors a simpler, more transparent, more cost-effective way of investing that has had so many spinoff benefits.”

Collier should know. As part of the TSE’s restructuring in the late 1990s, the TIPS 35 and TIPS 100 merged into iShares S&P/TSX 60 Index (TSE: XIU), still Canada’s largest ETF.

Professor Eric Kirzner, the John H. Watson chair in value investing at the Rotman School of Management, University of Toronto, calls today’s ETF investment products “highly competitive” and notes, “Canada was at the forefront of ETF de-velopment for many years.”

The retail investment world initially viewed ETFs as an alternative to mutual funds and believed that growth in the sector would happen at the expense of mutual funds, says Earl Bederman, president of Investor Economics. But as Canadian households shifted toward more investment-oriented behaviour overall, the mutual fund and ETF sectors have grown together, with ETFs growing faster from a smaller base.

A major factor in that growth is the “ubiquitous nature” of ETFs, says Bederman. Unlike mutual funds, designed primarily for retail investors with advisors, ETFs “appeal to self-reliant, do-it-yourself investors who are looking for a low-cost solution; to advisors, brokers and financial planners who use ETFs in advice-based solutions; to asset managers who use ETFs to strengthen their asset management; and to institutional firms that want a low-cost substitute for active management or as a component of active management solutions.”

Mark Yamada, president of PÜR Investing Inc. and an columnist, stresses that institutional rather than retail investors were the principal force behind the sector’s early growth.

“If you have large sums of money to move around, a very liquid, diverse and transparent vehicle like ETFs will help you in your tactical movement into and out of the market,” he says. “If you look back around the time of the financial crisis, for example, the use of leveraged ETFs in Canada exploded as a percentage of total volume. It was clearly professionals hedging positions, manoeuvring into and out of the market, using the liquidity provided by these vehicles.”

Overcoming gaps in investor understanding
 In 1997, Kirzner and Richard Croft developed the National Post FPX indexes, which still appear each day. “We built them around ETFs,” says Kirzner. “My aim was to help investors understand that the key for them is asset allocation: getting an appropriate mix of safety, income and growth in the portfolio. I believed – and still do – that one of the best ways to do that is through an ETF portfolio.”

But among retail investors, the benefits of ETFs are still not well understood, says Kirzner. “When I wrote columns for the National Post about ETFs, I’d get all these letters afterwards from people saying, ‘I don’t really understand what they are.’ That still seems to be true – I gave a talk just last week and got a lot of questions about ETFs.”

The value of ETF transparency also tends to be overlooked by Canadian investors, says Yves Rebetez, managing director of online magazine “If I buy the iShares S&P/TSX 60, I know exactly what it’s composed of at any point in time through the week, through the month, through the day. And I know at any point in time what it’s worth in the marketplace, in terms of not only the ETF itself, but of the 60 large-cap companies embedded within it.”

Knowing exactly what you own is essential, he points out. “When you contrast this with a lot of other investment vehicles, you could think you’re buying one thing and end up with something entirely different. You might look at the top 10 holdings of a mutual fund, for example, and invest thinking you’re adding to your exposure to these names, when at the same time the manager could be selling those holdings.”

Investors also tend to overlook the value of fixed income ETFs, says Jeff Black, pres-ident and CIO of Crestridge Asset Management. “Since the financial crisis, the whole bond-trading world has changed. Many dealers don’t have the capital for bond inventory they once did, and it’s never been a transparent marketplace. It’s very tough to build an individual bond portfolio – and yet the ease in targeting a sector that can be achieved through ETFs is often overlooked.”

The ultimate advantage of ETFs is the fact that they offer these benefits and solutions – and many more – at the lowest possible cost, a factor that can be discounted even by market professionals. “If there is one thing even I haven’t fully appreciated until recently but am now keenly aware of, it’s the importance of the compounding effect, and the decay that even half a percentage point a year can translate into in terms of your longer-term portfolio size,” says Rebetez. “When people are looking at saving a per cent here, a per cent there, nobody cares. It seems so mundane and trivial. But in the world of investing, it’s absolutely critical.

“If you were to tell me that you’re delivering an investment solution to me that is superior and costs more, I’d say no problem. But if those solutions are less effective and cost more, I’d be paying attention.”

The advisor link
 In certain jurisdictions, regulatory change has led to greater retail market penetration for ETFs, says Yamada. “But it’s been a long, long road in Canada. [In many cases] the only thing standing between a superior investment vehicle like an ETF and the end client is the advisor. The challenge for the industry has been to educate the advisor.”

The global trend towards fee-based advice may provide a glimpse into Canada’s future, he suggests. The U.K. and Australia have banned trailing commissions, essentially mandating a fee-based compensation model. “In Australia, they went even further – every advisor is now a fiduciary, which means they must offer only the best possible products to their clients,” says Yamada. “Within 12 months of that law change in Australia, the volume of ETFs doubled – their adoption really comes hand-in-hand with advisors seeking out the best possible low-cost solutions for their clients.”

In the U.S., he adds, the absolute number of advisors is declining, and the average North American advisor is now over the age of 55. “They’re retiring at a hell of a rate – some estimates put it at 10 per cent per year. Only a single category of U.S. advisor is growing – the registered investment advisors, or RIAs, who have a fiduciary responsibility to their clients.”

Robo-advisors (organizations that provide financial advice online with limited human interaction) are all registered as RIAs, so they have a fiduciary responsibility, Yamada notes. “They’re effectively growing at a rate of 100 per cent every six months, albeit from a small base, using only exchange-traded funds.”

Bederman expects regulatory shifts to enhance the future growth of the industry in Canada as well. “There are already the beginnings of an opening for mutual fund dealers and financial advisors who are not registered with IIROC [Investment Industry Regulatory Organization of Canada] to begin to use them, and that is going to be a key factor in the marketplace.

“The advisor increasingly has a role to play in bringing the value and benefits of ETFs to the attention of investors,” he says.  

Delivering on strategic portfolio management
ETFs have made it possible for portfolio managers to “construct a $100,000 portfolio with an embedded breadth of holdings that 20 years ago might have taken a minimum of $1-million,” says Rebetez.

He points to international markets as an example. “When you would otherwise be dealing with all the challenges associated with trading individual securities in foreign markets – different regulatory backgrounds, tax considerations, time zones, etc. – it’s clear that what ETFs have added to the toolkit is very meaningful.”

At the most basic level, ETFs can help shift the client focus to the all-important asset mix decision, says Black. “It takes the emphasis off of security selection. And particularly if you take a core approach with some basic ETFs, investors can accept a passive approach to those exposures and benefit over the longer term.

“Numerous studies show that a preponderance of investors in actively managed mutual funds don’t get the benefit of longer-term returns because they get impatient and trade in and out. The core ETF approach instills a little more patience.”

ETFs provide an opportunity to change asset mix exposures in a tactical manner, says Black. “There may be instances where we are lowering or increasing exposures in a particular sector, for example. Until we get the individual securities changed, an ETF allows us to get the exposures we want.”

He also uses ETFs to achieve tactical geographic diversification. “Canadians typically have a domestic bias, but the reality of our equity marketplace is that there are 10 global investment classification sectors, and we’ve really only got representation in our market to three: financials, energy and materials.”

Many ETFs allow Canadian investors to get broad U.S. market exposure (hedged or unhedged against currency fluctuations), and others make it possible to focus in on sectors such as health care and tech. “It’s a great approach, because if you look at Canadian financials, they’ve certainly done better post-crash than the U.S. financials. Sector-focused ETFs can really add opportunity,” says Black.

The future?
 According to ETFGI, a U.K.-based in-dependent global research firm, the ETF industry in Canada gathered a record $2.7-billion US net new assets in December, with net inflows for the year totalling $9.2-billion US. “Canada has been an innovator when it comes to ETFs, and I expect that to continue,” says Deborah Fuhr, managing partner.

Bederman also predicts that innovation will continue to drive the sector. “What we are likely to see, as we’ve seen in the past, is a greater degree of convergence between ETFs and other investment vehicles.”

The differences are narrowing now, he says. “For example, actively managed ETFs haven’t gained a tremendous amount of traction in the advisor or investor world yet, but our expectation is they will as the distinctions between the various product types change.”

He expects a “different class of investor” to emerge over the next 20 to 25 years, broadening the market. “Younger individ-uals are more inclined to self-reliance and technology, and ETFs are well positioned for that segment of the marketplace.

“There will be all kinds of changes ahead that we cannot presently foresee, but we believe the overarching trend is one of growth, competition and change.”

Recently back in Canada after stints in the U.S. and Latin America, Collier says, “The ETF industry kind of grew up in the equity marketplace. But the challenges of the fixed income marketplace today make it compelling to think about how ETFs could drive change, and here Canada is quietly leading the way.”

At about $100-trillion globally and $1.5-trillion in Canada, the fixed income market dwarfs all others, he stresses. “It’s a market where it’s getting more and more expensive for investors of all sorts, not just retail investors, but institutional investors, to get exposure. The spreads on bonds, particularly investment grade corporate bonds, are widening – the spread for a simple basket of Canadian corporate bonds is three or four times the spread for the corresponding iShares fixed income ETF.

“Looking out, I see ETFs fundamentally changing the way the fixed income market works, bringing transparent, low-cost exposure.”

“Innovation, in my mind, is undeniably going to be a continuing feature,” says Rebetez. “Mutual funds won’t be sitting still – we’re going to see costs coming down there. In the U.S., there is a movement afoot to have exchange-traded mutual funds. In my mind, that is in no small part an attempt to seek to access the higher tax efficiency found within the ETF mechanism.”

Whatever happens, he adds, advisors will have a critical role to play. “It’s a fluid world that we’re looking at going forward, and ultimately, investors will still be overwhelmed by the wealth of choices and opportunities.”

Former Chatelaine Magazine Money Expert and radio host Lori Bamber has authored seven
books on personal finance and investment. Her work has appeared in The Globe and Mail,
BCBusiness, Alberta Venture and other publications.

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