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Fixed-Income ETF Momentum Set to Continue

August 21, 2023 11 min 15 sec
David Stephenson
CIBC Asset Management
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Welcome to Advisor ToGo, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

David Stephenson, director of ETF strategy for CIBC Asset Management.

Recently, investors have been turning to the safety of fixed income ETFs versus equity. Do I see this continuing? Why or why not?

So this is an interesting question, which I would look at through two different perspectives: one, over the short term and another over the long term. First of all, fixed income ETFs have dominated the Canadian ETF market so far this year, accounting for just under 60% of flows. The reason for this is pretty clear. After 10 Bank of Canada rate increases since March 2022, yields are the highest we have seen in decades. For example, conservative fixed income exposures now provide compelling yields. It’s not that hard to find 4% plus yields in Canadian short-term fixed income. So in the short-term, with interest rates remaining high and economic risks still lurking, fixed income ETFs are likely to remain popular.

Interestingly, when you scratch under the surface of where investors have been turning to, it’s been largely in money market, cash and ultra short-term ETFs, over 50% of the fixed income flows. This suggests more defensive positioning by investors, but makes sense given a deeply inverted yield curve, and you can get 5% plus yield taking on little to no risk with high interest savings account ETFs. Going forward, this could be at play, as the economy moves to a firmer footing and the interest rate environment becomes clearer. Canadians are sitting on significant cash levels. We are close to the end of the tightening cycle, where investors may look to extend duration and/or credit in their portfolio or add to equities. Some investors are already positioning for this, as long-term bonds have seen over 2 billion in flows year to date through July 31st. The good thing for ETF investors is there is a very broad and diverse fixed income ETF offering in Canada to express any view in their portfolios.

The second perspective is I think fixed income will continue to grow over the longer term. Fixed income is approximately 30% of total ETF AUM today. It has doubled over the last five years from 52 billion to 110 billion today. Investor usage will continue to deepen, both retail and institutional. Active fixed income looks well positioned to grow, where managers can be dynamic in duration or credit positioning as opportunities arise. One-stop fixed income portfolio solutions are also convenient and are a single ticket core solution that can help lower volatility, enhance income, and tactically adjust based on the market environment. The industry has grown to a point where fixed income ETFs allow for increasing precision in exposures whether you are targeting a specific region, sector, credit, yield, or maturity. Fixed income ETFs have also become a portfolio tool for customization, hedging risk, capturing opportunities in corporate credit, for example, or emerging market debt. The convenience of ETFs and different portfolio applications bode well for future growth. Fixed income innovation will continue to evolve and grow as well. For example, strategies such as sustainability, factors and defined outcomes.

How is the current economy impacting ETF flows? Ongoing investor and market uncertainty has been the norm this year, prolonging volatility while equities continue their strong rally from bear market lows in late 2022.

It’s been a tale of two markets, as investors grapple between fears of recession and hope for recovery. Investors are trying to assess the impact of central bank tightening on the economy and whether it will cause a recession. The other question is when central banks end the tightening cycle and perhaps start easing.

Year to date, equity markets and credit markets have been resilient. Technology and growth stocks have experienced significant gains this year on excitement over artificial intelligence. The NASDAQ index had its best first half in 40 years. Only 1975 and 1983 outperformed the first half of 2023. ETFs have continued to bring in flows over the last few years, despite volatility, and 2023 has been no different, with approximately 23 billion year to date through July 31st.

In terms of how flows have been impacted, I think cash money market has been the key story in the Canadian market. Equity flows have been quite bifurcated. Yield oriented strategies such as dividend and covered call strategies have done well this year, which I expect to continue. Another interesting development so far in 2023 has been investors diversifying into global and international equities. International markets offer attractive relative valuations, in some cases are trading at significant discounts to the North American market, specifically the U.S. Furthermore, valuations for individual Asian and European markets are well below their mean and at the bottom of the range seen over the last 15 to 20 years. So international companies offer diversification and are much further behind the interest rate and inflation cycle, which present opportunities for investors.

In terms of trends, from a big picture perspective, it’s been interesting to see the way how investors use ETFs is evolving and growing. ETFs provide liquid access to virtually every corner of the financial markets, and as product choice has grown, investors use ETFs to pivot portfolios, add exposures, or shift sensitivities in only one or two trades. I think the use, ease and simplicity, convenience of ETFs will continue to grow. If you think of just the last few years, ETFs have helped investor portfolios reposition around the issues most top of mind: higher interest rates, inflation and market uncertainty. So I think that trend will continue in both good and bad markets and whether investors use them for strategic asset allocation or tactical adjustments. Investors are poised to increase their use of ETF strategies as tools to potentially beat the market in the years ahead.

Another trend to watch is continued growth in active ETFs as the ETF industry grows. Canada has been a leader in active ETFs. The first one launched over 15 years ago, and active ETFs are now approximately 30% of ETF assets under management. What is interesting, however, is to see how growth is unfolding in the US, leading to the next stage of growth in that market. Active mutual fund providers have entered the ETF market by converting or cloning existing mutual funds or adding new strategies. In Canada, ETF share classes of active mutual funds has been growing and is now a significant part of the market. Companies are leveraging existing mutual funds and putting them in an ETF wrapper to appeal to advisors and investors. I expect this to continue to grow going forward as well.

So what types of products are being released this year and how will markets in the economy shape upcoming releases?

So far this year through July 31st, we have seen 112 new ETF launches in Canada. We now have over 1300 ETFs, so there is a lot of choices for investors. Interestingly, there has also been 77 ETFs that were terminated or announced they will be terminated. The launches have been well diversified among exposures, as well as active and index, but two big themes stand out.

It’s really been about money market cash ETFs and yield oriented products, specifically enhanced yield and covered calls. Yield has been a long-term secular theme in the Canadian market, and there are plenty of options now given the repricing in the bond market, dividend yields on equities in general, as well as enhanced yield covered call ETFs that can be in the low double-digit range.

For investors in the decumulation stage and looking for cashflow, these ETFs have been prime beneficiaries. ETF share classes of mutual funds has also been growing year to date. Almost 20% of new launches have been ETF share classes. Manufacturers have become structure agnostic, leveraging existing mutual funds that work well in an ETF wrapper to appeal to investors. There’s still room for product innovation though, and ETFs will continue to democratize investing and disrupt other asset classes like they did for fixed income, commodities and niche specialized exposure in thematics, for example.

One interesting area to keep an eye on is outcome oriented products, such as buffer ETFs, as an alternative to structured products and products that also focus on downside protection, volatility reduction, as well as yield enhancement.

So what risks should investors be wary of? Looking ahead, we continue to see rising recession risk, consistent with both the US and Canadian yield curves being deeply inverted. The other risk is although inflation has been coming down, the Bank of Canada expects it to decline to 2% by the middle of 2025, which is longer than originally thought. The risk is it could still stall, jeopardizing the return to price stability. Those are the two risks that I’d be wary of, but the central banks in both Canada and the U.S. have definitely moved from catching up, to fine-tuning rates. And for now, higher yields mean investors are paid to wait.

The implication to investors is to remain diversified and stick to your long-term strategic asset allocation plan. This is the best way to deliver on financial goals and is a time-tested strategy.

The last thing I would say is to think in probabilities and the opportunity cost of cash. In the short term, the opportunity cost of being in cash is very little, but increases over time. If the reasons for holding cash is market timing or worrying about short-term events or uncertainty, when you have a long-term time horizon, history shows it’s best to stay invested.