Exchange-traded funds are gaining ground. According to the London, England-based research and consultancy firm ETFGI LLP, assets invested in ETFs and exchange-traded products listed globally reached about US$3.1 trillion at the end of May 2016. Greenwich Associates’ 2015 study of Canadian institutional ETFs showed institutional users of ETFs had invested an average 21 per cent of total assets in them.
So as ETFs make headway in the Canadian institutional investor space, what trends are industry experts seeing?
Bond ETFs
Bond ETFs have seen an increase in usage among institutional investors in the past few years. According to the Greenwich Associates study, almost 70 per cent of Canadian institutional users now use bond ETFs, with 95 per cent using them for at least two years. The top three reasons cited for using bond ETFs are ease of use, quick access and liquidity.
“Liquidity has been a big theme,” says Alan Green, director and head of the iShares capital markets Canada team at BlackRock. According to Green, there are two reasons why investors are looking more at bond ETFs. One is monetary policy in the current environment of very low interest rates. “Every basis point counts when you’re looking at trading commissions and trading costs,” he says. “ETFs can be very compelling just from a pure cost sense.”
The other reason is the global reform that followed the 2008-09 financial crisis. “Every stat you look at points to that being impacted in terms of the bond market, in terms of how much liquidity there is around at one time,” says Green.
Read: How Canada is leading the way in bond ETFs
For institutional investors such as pension plans, bond ETFs serve as a liquidity sleeve, according to Yves Rebetez, managing director and editor of news website etfinsight.ca. “That means there’s no selling of the bonds comprising the ETFs; there’s merely a switch in terms of ownership [of the ETF].” As a result, institutional investors can get in and out of those ETFs on short notice without worrying if the underlying bonds are trading every second of every day, says Rebetez.
Rebetez notes any large institutional investor has cash flow-related needs, such as funding short-term liabilities. “When that happens, they’re looking for quick implementation tools and quick ways to gain access to either the liquidity when they need to get out or access to products when they need to get in.” ETFs introduce the flexibility institutions like to have, he adds.
With bond ETFs, what the active management tilt brings to the table — apart from credit risk analysis — is the ability to essentially source bonds, says Rebetez. “It’s not that obvious to source bonds for the average investor and to obtain proper execution and proper pricing.”
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Bobby Eng, vice-president and head of SPDR ETF business development at State Street Global Advisors in Canada, agrees. Bonds are more and more difficult to trade, he says, and investors are turning to ETFs as a tool to compensate for that challenge. Institutional investors are using them to manage their credit or their duration or as core holdings, he says. “Others are using them as rebalancing tools, for hedging purposes or as a liquidity enhancement.”
Since 2011, fixed-income usage has increased by about 60 per cent, says Eng. The Greenwich Associates survey indicates 29 per cent of respondents foresee an increase in their fixed-income usage over the next 12 months.
Actively managed ETFs
The term active management in the ETF space “can be a broad swath,” according to Jaime Purvis, executive vice-president of Horizons ETFs Management (Canada) Inc. “You can have managers who deviate greatly from an index, since they have more discretion, or you can have managers who manage around the benchmark. For example, they own 50 names that make up the TSE 60 but might overweight their top 10 favourites and short the stocks they like the least.”
Purvis says Horizons ETFs has designed its ETFs to be active only in places where it thinks the index has flaws or weaknesses. “We don’t have active management in large cap equities because, historically, cap-weighted indexes have been very efficient and have low turnover, and they tend to be an effective benchmark for the market as a whole.”
In June, Vanguard Investments Canada Inc. launched its first actively managed ETFs in Canada. Managed by its quantitative equities group, the four ETFs provide an option for investors to boost their performance based on factors such as minimum volatility, value, momentum and liquidity.
Read: ETF industry made gains in January
“Factors are the DNA of an investment portfolio,” says Tim Huver, head of product for Vanguard Investments Canada. The idea, he adds, is to compete with a traditional active manager at a lower cost.
At a management fee of 0.35 per cent, the cost is a bit higher than for a traditional passive ETF, says Huver. But among the advantages of a low-volatility option, he says, is protection against downside risk without sacrificing the upside capture.
In Canada, there has been some success in the area of actively managed ETFs in regards to preferred shares and fixed income, says Rebetez.
Noting it’s difficult for most market participants to consistently beat their benchmarks, Rebetez says evidence suggests many of them fail, particularly when they take cost into account. As a result, actively managed ETFs may be a good option.
“There are specific areas of the market where you may be better off getting somebody who has the requisite market access and connections that help them relative to you as an individual investor and help address some potential shortcomings of a purely passive approach,” he says.
“In the preferred-shares space . . . liquidity consideration, credit-quality issues and the respective structural attributes of the various issues that are brought to market are important from an asset management perspective to understand in order to be able to navigate more effectively . . . than a pure passive [perspective].”
Read: How institutional investors use ETFs
While the past two years have been challenging for the preferred-shares market because of interest rate resets, the active management approach has been worthwhile, says Rebetez. In fact, there has been a proliferation of actively managed or targeted ETF solutions that are essentially looking to mitigate the interest rate risk, he says. “[This is] simply because the risk/ reward is tilted to the negative relative to what it had been historically.”
In other words, it takes longer to recover from market setbacks if yields start to rise than it used to because investors used to make more yield.
And investors that don’t have the scale can use a structured solution that “provides more yield or attempts to squeeze a little more yield out of the overall bond market, without requiring investors to go all in high yield,” says Rebetez.
Robo advisors and ETFs
Robo advisors (providers of online portfolio management services) use ETFs in their portfolios. While these automated advisors are still predominantly in the retail space, they have dipped a toe into institutional waters.
David Nugent, portfolio manager and chief compliance officer at Wealthsimple Financial Inc., says the investing service currently has five companies (ranging from 20 to 300 employees) with a group registered retirement savings plan.
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Nugent says the big takeaway he has seen, particularly in the group market, is personalization. “It’s ironic they’d come to an automated service for the personalization because that’s simply not what we’d be known for,” he says. “[Employees] want the client service. They still want the advice. When they need help, they want to be able to speak to someone who’s not sitting in a call centre, someone who can’t provide advice. We have registered portfolio managers they can speak to at any point.”
While it may take some time for more institutional investors to embrace robo advisors, Nugent notes there are some companies — technology startups, for example — that have never been in the pension space that are now beginning to look at it. “We see it as a huge market, especially as retirement continues to come into vogue.”
Predictions for continued growth
Given the trends and the growth in the ETF space, it’s difficult to predict where ETFs will be five years from now. Pat Dunwoody, executive director of the Canadian ETF Association, says bond ETFs, in particular, have “opened the door to the rest of the ETF world just because it was something [institutional investors] needed and then they’re being introduced to the other products available.”
By U.S. standards, the Canadian ETF industry is small. While Dunwoody says it recently exceeded $100 billion, she definitely sees the growth continuing.
“We’re growing at about 18 per cent to 20 per cent a year,” she says. “I think that will continue to increase as we become more known as an option.”
Read: Institutions get better at sizing up ETFs
Brooke Smith is a freelance editor and writer based in Toronto.
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