While ETFs took longer to develop in Canada than south of the border, Canada can lay claim to having launched the first exchange-traded fund in 1990, a security that has evolved into today’s iShares S&P/TSX 60 Index ETF (XIU) on the Toronto Stock Exchange. And now, their popularity is now rapidly.
Last year, the ETF market had C$365 billion under management, and with the Canadian ETF Association (CETFA) marking its tenth anniversary earlier this year, issuers and investors alike are bullish on an asset class that has come of age.
We’ve done a stock take of the market to identify the characteristics and trends in this growing space.
North or South?
As the Canadian ETF market has matured, the relative appeal of its larger southern cousin has waned. Fees in the north have moderated and are aligning with those in the US. Plus, additional liquidity has been brought to long-standing ETFs, in turn luring capital to more thinly traded funds.
This has given local investors greater confidence to look first at their home market where there are better cost-management opportunities associated with trading in the domestic currency, and which is exempt from tax penalties that apply to some US trades.
“Your starting point should be to look at Canadian products when you’re a Canadian investor,” said Mark Raes, Managing Director at BMO Global Asset Management, told a Bloomberg webinar on the subject.
Cash is king – for now
Cash is a safe-haven at times of economic volatility and that’s reflected in the Canadian ETF market, where cash-based funds are outperforming much of the rest of ETF sector. Around C$21bn is invested in cash-linked ETFs, which offer investors an easy-to-enter, low-risk destination for their capital.
These assets have benefited from rising interest rates, which have led banks to offer returns on the cash deposits into which ETF money is being invested.
Cash ETFs also have better yields than many other “safe” investments. The Evolve High Interest Savings Account (HISA) yields around 5% and the Horizons High Interest Savings ETF (CASH) offers a little more.
That compares with cashable guaranteed investment certificates (GICs), such as the one-year security offered by Scotiabank, which are offering around 10-15 basis points less.
However, doubts about the longevity of this strategy deepen as they offer low fees and will lose appeal as rates stabilize. Alan Green, Vice President, ETFs at Scotiabank, also warns that the notion that “safe” brick-and-mortar investors back these products may be wrong.
“A lot of financial advisors, some portfolio managers, and even some institutional money,” is behind them, he said.
Inflation busters
ETFs have built-in inflation-friendly characteristics – such as low fees – that bring down the cost of holding them, helping to offset the real-rate losses that are common when the cost-of-living climbs.
Now, a plethora of funds linked to inflation-protected assets or built on strategies with a track record of performing better during inflationary periods, are offering comparable and often higher returns than their cash alternatives.
Among them are funds built on Treasury Inflation-Protected Securities, long equities funds, discount bond funds, such as BMO Discount Bond Index ETF (ZDB), and those with an options overlay that’s structured to profit from volatility.
“Not only are you getting great yield from fixed income, but when you get the yield to maturity, you’re getting an extra alpha kick,” said Naseem Husain, Vice President at Mackenzie Investments.
ESG rethink
As the meteoric rise of ESG and green markets wanes, so too does the appeal and structure of sustainability-linked ETFs. Canada, which has a complicated relationship with ESG thanks to the size of its fossil fuel and refinery industries, has not been immune to this upheaval.
Increased scrutiny by regulators intent on stamping out greenwashing are placing burdens on issuers, and the declines in the once-potent iShares ESG Aware MSCI USA ETF (ESGU) in the US, though not replicated in Canada, have given issuers and investors north of the border pause for thought.
There is a sense that ESG-focused ETFs have not prospered in Canada because they have been wrongly placed within passive structures.
“It’s an active strategy, just like smart beta,” said Eric Balchunas, Senior ETF Analyst at Bloomberg.
Active is back
In the US active ETFs are breaking through. According to Bloomberg figures, they account for just 4% of assets but last year claimed 14% of flows. This year they already account for 30% of flows. That trend is reflected in Canada as issuers look for the higher returns of an actively managed vehicle with the convenience of an ETF.
The maturity of Canada’s market has made life easier for investors seeking the potential alpha offered by active funds. With some ETFs touching the two-decade mark, there is enough performance history out there for portfolio managers to use their asset-picking skills within ETFs.
And with some participants reporting pent-up demand for actively managed instruments, it’s apparent that there is a greater willingness on the part of issuers and investors to accept the higher costs that come with such ETFs.