APRIL 2019 | BENEFITS AND PENSIONS MONITOR
In the exchange traded fund (ETF) world, Canada has a distinction for firsts. The world's first ETF ‒ the S&P SPDR ‒ was created in Canada in 1990, transforming the investment landscape and offering the advantages of pooled investing and trading flexibility.
Then, in 2000, the first bond ETF ‒ the iShares Canadian Universe Bond Index ETF ‒ was launched here.
Combining the features of mutual funds with individual stocks, an ETF holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occasionally occur. Most ETFs track an index, such as a stock index or bond index.
In their early days, ETFs were used primarily by institutional investors to execute sophisticated trading strategies. However, it wasn't long before individual investors and financial advisors embraced ETFs because of their low costs (especially in today’s low return environment), tax efficiency, stock-like features, and access and diversification in asset classes such as real estate and infrastructure which are typically beyond the reach of smaller institutional investors and individuals.
Since their introduction, they have grown to become one of the most popular products in the global investment industry. Today, ETF assets in Canada total more than $158 billion, invested in more than 600 ETFs. Globally, assets in ETFs and other exchange-traded products (ETPs) total more than $6.5 trillion, invested in more than 7,430 products.
This growth is also due, in part, to a change in 2009 from commission-based financial advice to fee-based structures. This helped drive the global ETF market past the $1 trillion mark.
The Canadian industry now has 33 providers and could grow to $400 billion by 2024.
In the pages that follow, Joe Hornyak, Executive Editor of Benefits and Pensions Monitor, leads a roundtable discussion of ETFs with Justin Oliver, Director of Institutional ETFs for BMO; Guy Lamontagne, Vice-president and Chief Investment Strategist at Desjardins Global Asset Management; and Jaime Purvis, Executive Vice-President at Horizons ETFs.
How long have you been in the ETF space?
Jaime Purvis: Horizons launched its first ETFs on January 9, 2007, so that puts us at 12 plus years. Our entry into the ETF industry was our BetaPro suite of leveraged ETFs. From there, that product line grew very quickly and we then realized that the ETF was really an efficient delivery vehicle for all kinds of investing strategies.
In 2009, we really started doing actively managed ETFs and there were a few missteps in as we tried to create it looking like a mutual fund lineup. Then we realized that we’re better off partnering with really strong partners as sub-advisors to run product lines in specific spaces ‒ dividends or fixed income ‒ where we thought the indexes were inefficient.
Today, we have nearly 90 ETFs covering the gamut from active, passive, strategic beta and our BetaPro line-up. We’re the fourth-largest provider of ETFs in Canada with over $10 billion in assets under management.
Justin Oliver: BMO really got started in ETFs nine years ago.
We are almost at $53 billion now and we’ve done it through establishing four simple pillars ‒ one, broad beta; two, smart beta, which is getting into factors and deviations from indexes, tilts, and so on; three, innovative solutions, which are advanced, interesting plays, providing downside protection; and four, comprehensive fixed income.
Guy Lamontagne: Desjardins Global Asset Management (DGAM) first entered the ETF space in 2017 with the goal of positioning its offering in the context of the evolution of global investment solutions. The first suite of Desjardins ETFs included four fixed income ETFs, one preferred share ETF, and four innovative, multi-jurisdictions, multi-factor ETFs using six academically accepted risk factors and constructed to maintain a level of control on the portfolio volatility.
In 2018, DGAM innovated once again by creating a unique range of eight responsible investment ETFs designed with strict ESG criteria and constructed to address climate change concerns. These ETFs are based on companies selected through a rigorous process and whose practices clearly demonstrate their sense of social responsibility and respect for the environment.
Most recently, in January 2019, changes in mutual fund regulation enabled DGAM to allow investors to more easily invest in liquid alternative solutions. Structured as an ETF product, the Desjardins Canadian equity market neutral fund is a strategy that aims to offer absolute and uncorrelated returns in all market conditions. The strategy seeks to achieve net market and beta neutrality with no directional or sector biases, resulting in a minimized volatility profile relative to comparable strategies and to traditional benchmarks. The stability of the fund’s return profile and its consistent absolute return objective make it particularly conducive to a portable alpha strategy.
What are the primary attractions of ETFs for institutional investors?
Justin: Before we go any further, we should probably talk about the definition of an institution. When you’re talking about institutions, they can be sub-categorized into defined benefit and defined contribution pension plans, asset managers, endowments, foundations, and insurance companies. There’s a different message and a different primary attraction for each one of those groups.
We have simplified these main attractions into five categories ‒ liquidity, cost, transparency, confidentiality, and diversification. Were institutional investors early to the game or late?
Justin: I started doing this 6½ to seven years ago now. There was a group of early adopters then, but typically most investors were not comfortable or educated on the reasons and attractions of using ETFs for their portfolios. Many wondered how their clients would perceive them if they used ETFs when their job is to manage equities or fixed income actively themselves. Over time, that myth is being alleviated and all are recognizing the efficiencies that can be garnered with ETF use.
The latest adopters in the whole spectrum have been pension plans. Many don’t have the structure to support ETFs yet. Let’s hope that changes in time and turnkey technologies can be put in place to help infrastructures because they will see the efficiencies as well.
Jaime: One of our calling cards is that we go out and talk to institutions about something like preferred shares. We’re able to talk to them and they say: “We like the active approach in preferred shares. We think it’s a good trade right now, but we want to do it ourselves.”
Then, they come to the reckoning point where there are four different types of prefs and they have to figure out what is working and which lines they’ll need to take from individual issuers.
They realize that to run an active segment of the book can be more expensive than the fees on the ETF. Plus, if they ever want to exit the preferred share trade, it’s really easy to do with an ETF. If you hired someone to do that job, you now have an incumbent in the seat who’s costing you.
What are some of the unappreciated benefits of ETFs for institutional investors?
Justin: Everything is an unappreciated benefit by the institutions because we don’t have enough of a voice yet and awareness continues to be narrated. This is going a lot slower than I would have expected but as institutions see the ease in single trade geographical or sector diversification, the benefits of liquidity, and the ease of use, the pace is accelerating.
We’re starting to see some significant shifts over the last two to three years and adoption of certain brands. I really think that comes down to scale. Only in the last two or three years have so many of ETFs achieved a level where they would be deemed an institutional- level unit or product. These have over $1 billion, trade like water, and have an active option market. That’s when you start to really see institutions come in.
Jaime: The other thing is institutions may be constrained by the percentage of assets they’re allowed to hold in any sector. So if you’re trying to provide a product for someone who wants it, what they can actually initially invest may be much lower than what the target is.
You’ve mentioned that you've been doing active ETF investing since virtually the beginning. Yet, the perception is that active ETFs are a relatively recent phenomena. Can you clarify?
Jaime: One of the things that Horizons has always prided itself on is innovation, but I think at times we’ve been beyond the cutting-edge of innovation. Certainly in the early days we had a lot of revenue because BetaPro was so successful which gave us the financial freedom to try things out.
The longest-serving actively managed ETF in Canada today is our Seasonal Rotation ETF (HAC) which we launched in 2009. It turns over 1,500 to 2,000 of its holdings each year.
When you’re looking for active, you have to be validated by performance. Some of the other ETF hypotheses that are put in place for some of the active managers don’t work, so you’re always looking for things that you think are different, that add value, and that you can price reasonably. You’re not always right in the active space.
Are fees still the primary attraction?
Jaime: Flows in the U.S. would certainly indicate that fees really matter. There, 80 per cent of assets are in the five per cent of the lowest-fee ETFs.
Last year, 97 per cent of fees went to ETFs that charged 20 basis points or less. So fees have a huge impact, especially when you’re looking for basic beta.
We are also starting to see fee revisement. This takes place when you get to a certain asset level and you can start reducing your fees and still retain profitability.
As ETFs get more successful, are you able to charge for overperformance?
Jaime: The OSC won’t let you do that anymore. Our seasonal rotation ETF is, as far as I know, the only ETF in Canada that still has a performance fee. It’s grandfathered because we launched it in 2009. It has had an incentive fee in place since its inception.
Justin: It’s so unusual because before the rules the adoption of performance fees through funds was actually increasing for DB plans.
If you’re an active manager, you’re paid to perform; therefore, you should be paid on your performance and, therefore, performance fees make a lot of sense in my opinion.
Jaime: What you might see is a range of potential fees based on performance versus a flat fee, and then an additive fee based upon performance. That’s where you might see some wiggle room going forward.
Turning to performance, a recent report from Europe said investors are starting to attach greater importance to past performance when choosing which ETFs to invest in? Are we seeing this in Canada as well? Is this a good or a bad thing?
Justin: It’s definitely happening and it’s just that there are more ETFs out there that have three years of past performance and now a lot more that have more than five years. Typically, institutions want three or five years of performance before investing (or allocating) and can’t have a fund that doesn’t have that. It’s nice to see they’re graduating into understanding ETFs from that perspective as well and putting them in the same basket as a fund.
Jaime: The point I’d make here is institutions are supposedly looking for these long track records, but the big institutions in Canada ‒ CPPIB, OMERS, Ontario Teachers’ ‒ are buying private asset products that have zero track records. They’re giving up liquidity and track record for having a massive upside and a long runway. It’s interesting to see.
You basically have polar opposites: “I’ll take a long runway on something that has very low liquidity, and I don’t know if it’s going to work although I think it’s good.” However, institutions also do a lot research, saying: “I want to see track record, track record, track record,” which, as a provider of active ETFs, we welcome because if you’re managing actively, you’re doing it, ostensibly, to beat the benchmark or deliver benchmark with less volatility. If you’re achieving that, then you want to be valued for achieving what your original investment and hypothesis was.
How does factor investing fit into ETFs?
Guy: Factor investing is positioned at the crossroads between passive and active management. Essentially, these types of strategies seek to capture value add from persistent and broad market biases. Factorbased investing, or the act of identifying and isolating specific risk factors, essentially attempts to capture these biases in a systematic approach from a broad universe of securities. Because of their structure and liquidity, ETFs are probably one of the most conducive vehicles to implement factor-based investments.
Justin: Ultimately there’s broad beta, and then you get tilts on that broad beta. There is a lot of new theory over the last five years by index providers who have a long legacy of dealing with academics looking at this and how it all plays out. It’s a second layer for managers to mitigate market risks and diversify more fully.
Depending on which index provider you’re talking to, they all have their own different ways and names. MSCI, for instance, is dividends, small cap, low volatility, quality, momentum, and value with 20 per cent left for alpha (stock picking and timing).
Factor investing allows you to take your broad beta and then add another level to deal with downside risk and to make sure you are not only diversified globally, but you’re diversified through factors.
So in a value-driven market, which maybe it is now, you can get exposure to that by buying that particular skew. You can go overweight in that specific area very quickly using ETFs then move into the underlying equities you feel fit your mandate more over time while transitioning out of the ETF.
The investment management industry is moving to responsible investing. Are we seeing ETFs following suit? Have any ETF providers signed the UNPRI?
Justin: We are a signatory to the UNPRI and one ETF that we’ve launched recently ‒ The BMO Women in Leadership Fund, or WOMN ‒ is based on a minimum of 25 per cent board-level participation or a female chief executive officer.
We’re a big believer in socially responsible investing (SRI). F&C Asset Management, which we purchased five years ago, is the largest SRI and environmental, social, and governance (ESG) provider in Europe. We’re learning more about its brand leading products and bringing that into our practices more every day.
Guy: Desjardins Global Asset Management (DGAM) is a signatory of the Principles for Responsible Investment. As part of this engagement, we integrate ESG considerations into our investment process and are proud to be the first Canadian ETF provider to offer a suite of responsible investment ETF solutions. Our approach to constructing our ETFs are in accordance with the United Nations Global Compact agreement and adheres to international treaties signed by Canada.
As such, we exclude issuers associated with critical controversies or who are involved in the production of tobacco and controversial weapons. In addition to norms-based exclusions, our ETF solutions are designed to meet non-financial performance targets relative to specific sustainable development goals.
The first iteration of this approach, inspired by the objectives of the Paris Agreement and the Task Force on Climate-related Financial Disclosure (TCFD) recommendations, are ETFs specifically developed to address the issue of climate change which are designed to reduce the portfolio’s carbon footprint by a minimum of 25 per cent relative to traditional industry benchmarks. Importantly, this threshold aligns directly with the Desjardins Group pledge to ensure the carbon footprint of its own assets invested in the markets are 25 per cent less than the average greenhouse gas emissions of the companies that make up the stock and bond market indices.
Jaime: Horizons is a member of Canada’s Responsible Investment Association, which supports the adoption, education, and proliferation of responsible investing principles and products in Canada’s investing ecosystem.
Back in 2018, we launched our first ETF geared toward this space ‒ our Global Sustainability Leaders Index ETF – ETHI, which provides exposure to ethical largecap companies leading the fight against climate change through sustainable practices.
What you see is different approaches to this space – specific mandates that can be geared individually toward the environment, social progress, human rights, governance, and more. A lot of this has been driven in Canada from growing awareness of self-directed investors, but you’re starting to see more institutional uptake.
The ESG movement is actually a little stealthier than investors are typically aware of. It has far more impact. The universe is growing. If you look at how wealth transfer is shaping up in North America and how that thought process is going to be driven, millennials and women are going to drive an accelerated change and they are keenly interested in RI (responsible investing) and ESG issues.
We keep hearing rumblings of a recession sometime in the near future. How have ETFs fared in past financial downturns like, for example, 2008/2009? What can ETF investors do to protect their portfolios if a recession does indeed start?
Justin: ETFs in those types of markets are the market. They’re the only products that are defining what the actual net asset value is, real time, of that particular market segment. The age-old example is high yield. The only thing trading in the market downturn in 2007/2008 were ETFs. If you wanted to get in or out at any level, you had to buy the ETF.
It goes to the fact that ETFs now are trading more every year than the U.S. GDP. People are viewing these as liquidity vehicles and that is the only way to access the market in times of pain or if the market is moving really fast on the upside.
I’m not an economist, but whether or not a recession is inevitable or we are going into a fifth wave, investors don’t want to be caught in illiquid products going the wrong way. You want to be liquid enough as an institution, retail investor, or advisor, to make sure you can change your portfolio and ETFs are the best way to do that.
Jaime: There are some opponents to ETFs out there still who say when the markets go, ETFs are the reason or they’re going to really get hurt.
The point is, everything gets hurt in a recession. ETFs historically have become the market. The expectation is that if we get another recession, that will continue. So what’s your liquidity in that space?
It goes back to why are institutional investors starting to use these. It’s because if they own an ETF, they can get off a couple of $100 million trades very quickly, whereas if they’re trying to sell the names themselves, it’s piecemeal and a much longer trading process since they have to find partners.
Guy: While ETFs have not truly been tested in the context of a global recession, we remain advocates of the liquidity benefits they provide to the market. Furthermore, the DGAM solutions have been explicitly constructed to address these concerns. Over the past 10 years, since the Great Financial Crisis, we have witnessed the proliferation of innovative and sophisticated ETF solutions such as volatility-controlled strategies and, most recently, liquid alternatives.
Volatility-controlled portfolios are designed to reduce down-market capture in a bear market, while commensurately seeking to achieve outperformance in a rising market. Designed in this fashion, the DGAM multi-factor volatility-controlled ETFs combine factor-based alpha generation with volatility target reduction to optimize the portfolio risk return equation, with the ultimate goal of exceeding long-term traditional benchmark returns.
With the new regulations contained in National Instrument 81-102, facilitating investor access to liquid alternatives through ETF vehicles, we can expect more sophisticated and targeted solutions to help investors weather various market conditions, such as downturns. A liquid alternative strategy, such as our Canadian equity market neutral ETF, can easily be deployed in an institutional or private client asset allocation to achieve a specific outcome. In our case, the low correlation of the Desjardins Canadian equity market neutral ETF offers strong diversification benefits, limited volatility associated with the broader market, and an opportunity to limit downside capture during market corrections.
It strikes me that ETFs would be a wonderful vehicle for DC plans. Yet, the uptake has been slow. What are some of the obstacles?
Justin: I don’t think any DC plans have yet to adopt ETFs directly and it just really comes down to record-keeping and how they cannot value the various products during the day. The infrastructure is changing and they should soon be able to do this, which I think is definitely a future trend and a huge opportunity for exchange traded funds. At the end of the day, DC plans should have the ability to access everything to provide the best possible outcomes for their clients.
Jaime: The record-keeping is the biggest issue, but the second issue would be transaction cost. If you’re taking regular daily flows, rather than bulking your purchases, there is additional cost. It’s that repetitive cost per transaction which you don’t see when you buy a mutual fund or a pool.
One of the big criticisms on the DC side is that when employees enter the decumulation phase, their basic option is to move their assets into high cost mutual funds. Are advisors telling their retiring clients with DC plans that this is a less expensive alternative?
Justin: It’s definitely something that we’re starting to work on with our capital markets groups to create and increase awareness for that particular market. The decumulation phase is very personal to each client and bespoke products need to be built in many cases.
Jaime: We don’t have the same built-in capital market relationships with the DC plans that the big banks have, so we have to work a little harder for it. But I would echo what Justin said: We want to be one of those five providers and, since we don’t have the size of a bank, Vanguard, or iShares behind us, that enables us to do things that they can’t, so we can fit in that grouping very well.
Emerging Markets are cited as a growth areas for markets. Is there interest in EM ETFs?
Justin: Going back to factors, factors also represent fund flow. One of the best things about ETFs is you can track fund flow in sectors, geographies, or niches. Something that an institution that is actively managing their funds can do is look at what’s happening with ETFs to find out where the funds are going. The short answer is we have seen inflows into EM over the past few months and expect that demand to continue.
Jaime: What we’re hearing from our conversations with institutions is that passively, emerging markets are doing very well right now. For active management in this space; in the equity side, we’re using a dividend focus, which is interesting because you’re beginning to see more of these emerging markets developing stronger middle classes – a strong sign of growing economic stability. With that, there’s the development of their pension systems, and in turn, you start seeing robust companies able to pay dividends.
On the fixed income side – and this is where the transparency of an ETF comes in – the institutions we’re talking to are looking at our holdings and want to discuss the rationale for those holdings with the portfolio manager. For example, we’re holding Argentina bonds and they want to know why. They’re looking at Turkey – how are you positioned on Turkey? There are all of these different emerging market considerations, so it gets very granular there in a way that it doesn’t get on the equity side. Our emerging markets ETF within the fixed income space is sub-advised by Fiera Capital, which has been able to bring its deep fixed income experience to bear to manage the ETF and to explain the reasoning behind its investments.
Justin: I wouldn’t mind taking this back and reconciling it to the asset allocation question. PIAC came out with its survey in 2017 that went over 240 institutions, representing about $2.1 trillion. The subset, the DB plan asset allocation, shows: home bias on Canadian equities in 2017 was 23.48 per cent. Canadian bonds long were 9.7, Canadian bonds universe were 11, so between the fixed income and the Canadian equity piece, you’re well over 40 per cent in Canada so the natural flow will be global over the years to come.
Jaime: Remember, the registered plan maximum for foreign investment 20 years ago was 20 per cent. This prompted institutions to invent futures-based structures that allowed them to hold 80 per cent cash in Canada and the 20 per cent would go to a futures margin which then gave them S&P 500 exposure and there are all sorts of workarounds created. It was massive.
Justin: Now, you start thinking about ETFs as a substitute for futures contracts. It’s definitely starting to occur in the U.S. and it’s starting to come up here. The cost and operational necessities of rolling futures is quite high and always has an element of human error. ETFs could be another way to achieve these goals. Using ETFs may not provide the same notional at the same cost, but they definitely allow institutions to get there.
What are some of the significant innovations we have seen in ETFs in recent years and what kinds of innovation do you see on the horizon?
Justin: There are so many product innovations coming out quarterly driving asset flows at an accelerated pace into ETFs. We just launched three one-stop multi-asset, asset allocation portfolios – ZGRO, ZCON, ZBAL – for 18 basis points. Its definitely more retail focused, but I wouldn’t be surprised to see institutions on the smaller side start to pick them up and look at them as an option if they perform well over time. Further we are starting to see innovations coming to the surface that may update antiquated processes, whether portfolio or advice related. Robo-advisors, such as our own Smartfolio or Advice Direct, give a variety of clients different options to easily access ETFs and various levels of advice. We are going through a major structural change in asset management with ETFs leading the charge. It will be interesting to see what is to come.
Jaime: We are seen as a proliferator of ETFs that’s been driven by bringing firstof- their-kind, innovative, and in-demand products to market. That includes expanding on themes that are working, so adding additional active fixed income managers.
Emerging markets is one that we launched last year. We’ll keep expanding our low-cost indexing suite and we’ll compete with our competitors here on adding some value which may result in a fee reduction.
Another area where we’ve done some work is in early-stage themes that we believe will mature and ultimately drive future investing. Cannabis is a big one and it continues to capture a lot of the market’s attention.
There are also the ‘future’ technology themes, like robotics and automation, artificial intelligence, and the blockchain, which are also all captured in broader exposure through our Industry 4.0 fund. These are things that are typically longerterm investments that we think are going to become increasingly important investing spaces in the future.
What’s the future? Do thematics matter? I wasn’t sure when we launched them, whether they mattered to institutions. The institutions were all interested because they were a little different than what they’ve done all day long for 20, 30, 40 years.
Guy: In our opinion, we see innovation taking hold in the ETF markets on several fronts. Firstly, the complexity of the capital markets and the availability of new analytical tools, will be conducive to the implementation of new smart beta strategies. We believe we are at the forefront of this movement.
Next, will be the continued evolution of actively managed ETFs. There has been a paradigm shift in favour of active ETF solutions over the past several years and we are beginning to see the next generation of these types of strategies as traditional financial models are combined alongside non-financial criteria. We see evidence already, not only for equity ETFs, but also in the fixed income world where ESG integration has evolved beyond the addition of just green bonds to portfolios. As an example, DGAM launched its actively managed Canadian bond universe ETF that incorporates leading ESG practices with a climate change lens.
The third innovative trend we see is aligned with investor desires to use their investments as vehicles for driving change, such as ESG focused changes. This has sparked interest in developing investment products increasingly aligned with sustainable development goals and we expect this to drive the growth in thematic and specialized strategies that seek to exploit key factors and ESG opportunities for specific investment outcomes.
Lastly, the recent regulatory changes simplifying the inclusion of liquid alternative strategies in mutual funds and ETFs is expected to drive innovation as experienced managers in this space once reserved for institutional investors bring their non-traditional strategies to market and democratize specific solutions for investors.
The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.
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