BY MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS
May 17, 2018
Canadians appear to like actively managed exchange traded funds (“ETFs”).
Actively managed ETFs represent approximately 18% of the total assets invested in Canadian-listed ETFs, which accounts for approximately $26 billion in assets under management (“AUM”).
ETFs are designed to combine the best features of mutual fund and stock investing. Like a mutual fund, ETFs are open-ended, meaning that new units of the fund can be created or redeemed at a price per unit that reflects the market value of the underlying securities the fund holds. Like a stock, ETFs trade on an exchange with a ticker symbol and can be purchased or sold at any time during the trading day.
The first ETFs launched were designed to aim to replicate a broad index of securities, such as the S&P/TSX 60™ Index or the S&P 500® Index, just to name two well-known examples. Since there is no expectation of trying to outperform these asset class benchmarks, these ETFs are referred to as “passively managed”.
Cost is a key component of passive index investing – it needs to be as low as possible since there is no expectation of achieving additional returns beyond the benchmark index. Since ETFs are a low-cost1 and flexible way to offer index exposure, the rise in the use of indexing amongst the investing public coincided with the rise of ETF usage.
ETFs then are simply a type of investment technology. They have the flexibility to hold really any type of liquid investment strategy. Currently in Canada, about 70% of those strategies are passive index strategies. This has led many investors to assume that all ETFs follow a passive investment strategy. This is not true, as passive management and active management are not mutually exclusive.
ETF Asset Growth in Canada
It’s important to note that actively managed ETFs do not trade any differently than passive ETFs. Just like a traditional ETF, an actively managed ETF can be purchased anytime during the trading day. For the most part, the underlying liquidity of an actively managed ETF is not any different than a passive strategy.
The Active Approach
Horizons ETFs Management (Canada) Inc. has long been the leader of actively managed ETFs in Canada, launching our first actively managed ETFs in 2009. Since then, our actively managed ETF business has grown to represent approximately $4.4 billion in AUM. It’s the largest family of ETFs in Canada that uses discretionary active management.
A central appeal of ETFs is their low management fees. Fees can have a significant impact on investment performance, since they create an additional hurdle for the investment to overcome in order to be profitable. Simply put, the higher the fee on an investment fund, the better the fund needs to perform in order to generate a competitive return. This fee hurdle has been a big reason that more investors have opted to invest in index strategies, which, after fees, tend to have a superior track-record in aggregate versus actively managed mutual funds in Canada.
According to the S&P Index versus Active Scorecard (SPIVA), about 75% of Canadian equity managers underperform the S&P Composite Index, and less than 10% beat the S&P 500® Index on a five-year basis. When we look at fixed income, these statistics get turned on their heads –with the majority of active managers outperforming due to market inefficiencies in fixed income.
There’s a strong case to be made that an active approach has a better track-record in fixed income management, particularly if its fees are not substantially higher than an index strategy.
PIMCO conducted an important investment study in 2017 which showed that historically, actively managed fixed income funds had statistically superior return distributions versus index strategies.
Source: PIMCO, as at April 30, 2017.
Bonds do not trade on an exchange like an equity, which makes their pricing less transparent. In addition, inventories for bonds are heavily reliant on either dealers or, increasingly, ETFs as a source of liquidity.
This liquidity can be constrained in areas such as preferred shares and high yield bonds, which makes indexing difficult. Index ETFs with very large amounts of assets can sometimes be their own worst enemy, particularly when they rebalance their exposure which can cause price disruptions.
Consider a market like Canadian preferred shares, for example. It has approximately a $70 billion market-capitalization and has an index ETF representing more than $2 billion in assets under management – that becomes a huge source of pricing power. Except, in this case, that pricing power is passive; there is no consideration for things like credit quality or the fair value price of the underlying constituents. The ETF is simply required to buy any issues that meet the methodology requirements of the index the ETF seeks to track.
Given that the market depth of liquidity of preferred shares is somewhat limited, this can work against the ETF which could be forced to overpay for new additions to the ETF and forced to sell other issues at a discount.
The performance of the Horizons Active Preferred Share ETF (HPR), one of our largest actively managed ETF, highlights how having an active approach can reduce the impact of this pricing dislocation.
HPR is not forced to buy or sell any issuances in its portfolio. Instead, it uses the investment expertise of Fiera Capital Corporation (“Fiera Capital”), one of the largest fixed income managers in Canada, to actively select the underlying preferred shares.
Some of the key advantages of active management in this example include:
Active Management/Credit Analysis: Fiera Capital undertakes independent credit analysis on every issue it selects. Index strategies do not.
Interest Rate Outlook: If the team at Fiera Capital thinks rates could continue to increase, they will add discounted fixed reset or floating issues to the portfolio. Conversely, if they think rates could decrease, they will buy a fixed rate perpetual.
Rebalancing: HPR is not tied to fixed date rebalancing. The Canadian preferred share market remains relatively shallow in terms of liquidity. HPR is not forced to buy or sell any issues on a fixed date and in some cases it can also take advantage of the price dislocation that occurs when index ETFs rebalance.
Here’s the proof of the effectiveness of this approach. Both of Horizons ETFs’ active preferred share ETFs – the Horizons Active Preferred Share ETF (HPR) and the Horizons Active Floating Rate Preferred Share ETF (HFP) have outperformed index ETF strategies since their respective inceptions.
* Source: Morningstar Direct, as at April 30, 2018.
The indicated rates of return are the historical annual compounded total returns including changes in per unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The rates of return shown in the table are not intended to reflect future values of the ETFs or returns on investment in the ETFs. Only the returns for periods of one year or greater are annualized returns. The index is not directly investable.
Active ETF Mechanics
In Canada, the disclosure for ETFs and mutual funds is generally the same. In the case of Horizons ETFs for example, the ETF’s top 10 holdings are disclosed publicly on a monthly basis. We view this as a suitable level of transparency, particularly since most investors in actively managed ETFs are usually seeking longer-term holding periods than index strategies, which can be (and often are) used for trading purposes.
A key feature of ETFs compared to mutual funds is their liquidity – units can be bought and sold throughout the business day on an exchange. In order to ensure that the units trade at or very near their current net asset value (“NAV”) throughout the day, an institutional capital markets trader, known as the designated broker, creates and redeems units of the ETF with both the ETF provider and the secondary market.
This process has worked well for actively managed ETFs, many of which now trade at bid/ask spreads equivalent to spreads observed on comparable index ETFs.
We are moving beyond the ‘Passive vs. Active’ debate. What we are finding is more investors are asking, ‘What is the best way to get exposure to a target asset class?’. ETF investors are not limited to indexing strategies and can build portfolios that mix both active and passive strategies in areas where each respective type of strategy may make sense for their personal goals and objectives.
The Active Advantage
Low-cost1, liquid and professionally managed – that’s the active advantage!
HPR: The Horizons Active Preferred Share ETF seeks to provide dividend income while preserving capital by investing primarily in preferred shares of Canadian companies. The ETF may also invest in preferred shares of companies located in the United States, fixed income securities of Canadian and U.S. issuers, including other income generating securities, as well as Canadian equity securities and exchange traded funds that issue index participation units. The ETF, to the best of its ability, seeks to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.
HFP: The Horizons Active Floating Rate Preferred Share ETF seeks to generate income consistent with prevailing short-term preferred share yields while stabilizing the market value of the ETF from the effects of interest rate fluctuations. Horizons HFP invests primarily in preferred shares of Canadian companies and may also invest in preferred shares of companies located in the United States, fixed-income securities of Canadian and U.S. issuers, including other income generating securities and listed funds. Horizons HFP will generally maintain a portfolio duration of less than 2 years. Horizons HFP may use derivatives, including interest rate swaps and futures contracts, to contribute to the ability of the ETF to seek to deliver a floating rate of income. Horizons HFP, to the best of its ability, seeks to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.
CPD: The iShares S&P/TSX Canadian Preferred Share Index ETF seeks to replicate the S&P/TSX Preferred Share Index, net of expenses.
ZPR: The BMO Laddered Preferred Share Index ETF seeks to replicate, to the extent possible, the performance of the Solactive Laddered Canadian Preferred Share Index, net of expenses. The fund invests in and holds the Constituent Securities of the Index in the same proportion as they are reflected in the Index.
1 Relative to the typical MER of comparable, regular mutual funds.
Certain statements may constitute forward looking information within the meaning of Canadian securities laws. Forward-looking information may relate to a future outlook and anticipated distributions, events or results and may include statements regarding future financial performance. In some cases, forward-looking information can be identified by terms such as “may”, “will”, “should”, “expect”, “anticipate”, “believe”, “intend” or other similar expressions concerning matters that are not historical facts. Actual results may vary from such forward-looking information. Horizons ETFs undertakes no obligation to update publicly or otherwise revise any forward-looking statement whether as a result of new information, future events or other such factors which affect this information, except as required by law.