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ETF Investors Seek Yield Amid Uncertainty

February 27, 2023 09 min 05 sec
David Stephenson
CIBC Asset Management
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David Stephenson, director, ETF strategy, CIBC Asset Management.

2022 was a huge year for ETFs compared to mutual funds, which saw outflows. Why was this the case? Despite a volatile year, the Canadian ETF industry had over $38 billion in flows in 2022, which was the third-best year on record. I would also add, 2022 also saw record ETF trading volumes in Canada, almost $680 billion traded.

And it’s not just here in Canada, the U.S. market had its second-best year ever with over $600 billion in flows, and global ETF trading volumes reached record levels as well in 2022. The great thing about the ETF wrapper is by listing on an exchange, is that you can open up access to different distribution channels in a diverse investor base. Retail, family offices, institutional hedge funds, for example, converging into one investment vehicle.

So I think what is driving inflows is investors are using ETFs not only as core holdings, but also as tactical vehicles to express a view on the market. And the product choice available makes that easier, whether the concern is higher interest rates and inflation, positioning one’s portfolio in a risk-off environment, or trying to benefit from a theme or specific exposure. For example, last year, the need to preserve capital informed many investor decisions, judging by record-high interest savings account ETFs or flows in the cash alternative products.

Overall, I think the use cases for ETFs has expanded significantly over the last five years, and even since the pandemic, devolving beyond asset allocation. Wealth managers use ETFs to package their investment beliefs into outcome-oriented products for their clients, and there is also a growing trend to personalize portfolios. So having more control and greater ability to customize the diversity of product choice and thematic ETFs, or ESG for example, allow investors to do that. So at the end of the day, ETFs are easy to use, convenient solutions investors use to pivot portfolios, and take advantage of market opportunities.

How will higher interest rates affect investor preferences in new products? We have seen one of the fastest tightening cycles in history, with the Bank of Canada raising rates from 0.25% in March 2022 to 4.5% today, so 425 basis points in total. Couple that with a largely risk-off environment in 2022, the Canadian bond market was down almost 12%, one of the worst years ever. Investors used to talk about 1994, but bonds were only down 4.6% that year. The S&P was down about 13% in 2022, as were Canadian equities, although much less so, at negative 6%. Balanced portfolios also had a challenging year, and bonds provided no diversification. So if you add all that up, it’s no surprise investor preferences were focused in cash, ultra-short and short- duration, as well as defensive equity, such as dividend funds and covered calls.

High interest savings account and covered call ETFs definitely benefited from the overall market environment last year, as approximately 60% of flows were just in those two categories. Covered call ETFs have been around since 2010, and have done well attracting AUM, but flows really accelerated last year. Investors are looking for yield and cash flow, so think the accumulation portfolios, and covered calls are among the highest yielding ETFs in the industry, generally 68% that can be higher for sector covered calls. High interest savings account ETFs doubled their AUM as well last year, and approximately 15 billion in AUM today. When you look back to December 31st, 2021, the yield on HISAs were 72 basis points compared to 5% today. So big picture, given there are still uncertainties lurking in the market, and there’s an ongoing debate whether higher interest rates will lead to a so-called hard versus soft landing, I do expect these products to continue to attract investor interest. And as of mid-February 2023, that has been the case.

Having said that, I think fixed income will continue to do well and attract flows. The silver lining here is yields have really come up across the curve, where you can now get 4% on Canadian aggregate fixed income and Canadian short-term bonds, 6% on investment grade corporate bonds, 7 to 8% on emerging market debt, U.S. High Yield, and even global bonds, where active managers can positions to take advantage of current opportunities with flexible mandates and wide investment opportunity sets. So investors can actually get income now from fixed income without having to go too far up the risk spectrum. These are yields we haven’t seen in 15 years, or before the great financial crisis in 2008. On the equity side, I see flows continuing into low cost beta, as well as dividend ETFs for yield. At current valuation levels, there are also opportunities for investors to diversify outside North America, with China reopening, and valuations in Europe and Asia relative to the U.S., active managers can take advantage from a shift away from a momentum market to find opportunities.

So what trends do I expect to see in terms of product launches this year? I think income-focused strategies will continue to grow, and so far in 2023, many new covered call and fixed income ETFs have launched.

Another interesting area is ESG. There’s about $8 billion in ETFs today, which is about 2% of the total ETF AUM. I would expect that to be significantly higher going forward. There’s been an explosion of product launches in the last three years. There was about 20 ESG ETFs in 2018 compared to 140 today, so growth in the number of ESG products by a factor of seven. There is a lot of products compared to today’s asset base, but I think manufacturers are taking a long-term view here, and the market will ultimately decide who the winners are. There are broad-based ESG exposures for core portfolio holdings, but I think investors want exposures that align with their personal values.

So I also see future opportunities when you drill into the E, S, or G, so think clean energy, or green bonds and fixed income. They’re also direct and transparent ESG exposures, they’re hard to argue their place within the category. The last point I would say here is ESG really appeals to Generation Z and Millennials, and there has been some interesting flows within the robo platforms.

I also expect to see continued growth in active ETFs. Canada has actually had active ETFs since 2008, but it’s interesting that we have more active ETFs today in Canada than passive, which is the historical roots of the industry. 30% of the AUM in the industry is in active ETFs, it has grown from about $20 billion in 2017 to approximately $90 billion today. Many investors use a combination of indexing and active strategies to build resilient portfolios. Fixed income, for example, is unique with opportunities as the bond market is opaque and managers can position for trends in rates and credit.

On the equity side, active managers that focus on risk adjusted returns can complement passive strategies and make a difference in markets that are shifting from momentum and have a wide dispersion of returns. Active ETFs are also growing significantly in the U.S., now representing about 5% of ETF assets. Although Canada has been further ahead, it’s been interesting to see developments in the U.S. as it’s the fastest growing part of the market, which should still raise visibility here in Canada.

Finally, I would say demographics and evolving distribution channels will have an impact on future product launches. Full service brokerages and discount brokers are significant ETF channels, but I expect institutional and robo channels to grow significantly as well. The robo channel has effectively doubled market share over the last few years, and many companies are working on digital strategies which are conducive to ETFs.

Generation Z and Millennials will continue to grow their wealth, and they’re comfortable with technology, mobile apps, for example, and have specific investment preferences and exposures they are looking for, for example, thematic ETFs.