Where to Expect ETF Growth

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Text transcript

David Stephenson, Director of ETF Strategy and Development, CIBC Asset Management.

2020 has been an interesting year, to say the least. The world has experienced the greatest pandemic in 100 years, and the worst economic contraction since the Great Depression, as economies effectively shut down. For example, the Canadian economy contracted at an annualized rate of almost 39% in the second quarter before bouncing back fairly quickly over the summer months. But it’s still down from pre-Covid levels. In the U.S. investors experienced the fastest bear market ever recorded, as the S&P 500 index shed over 30% in just 22 trading days before bottoming in late March. It was also the shortest bear market as well, as by the middle of August the S&P 500 was trading at record highs again. In fact, the S&P 500 had returns in the first two quarters of this year that would have ranked in the top 10 for the best and worst quarters ever since 1926.

2020 can be best summarized as a tug of war between the opposing effects of the coronavirus and economic stimulus by world governments and its impact on economic fundamentals. So how did ETFs fair so far in 2020?

Against this backdrop, investor demand for ETFs remains stronger than ever. In fact, early here in the fourth quarter, ETFs are on track for their best year ever in Canada, bringing in just over 32 billion. Barring a major reversal over the last two and a half months of 2020, this would eclipse the record of 28 billion set last year. Even more impressive is that ETF flows remained positive in each month so far in 2020, despite some volatility in fixed income ETFs back in March. Overall, both equity and fixed income flows have been strong. An interesting development we expect to continue going forward is investors are diversifying outside Canada, in both equities and fixed income, likely as a result of attractive valuations and higher yields.

So what type of products do I expect to thrive in the current and future environment? ETFs are a very flexible wrapper and can serve many purposes in investors’ portfolios. They can be used as core long-term strategic holdings, or investors can use them tactically to express a view on a specific theme or sector. ETF flows have been very broad based in 2020, but investors have used them to also take advantage of the market environment and ensuing volatility. For example, gold and gold equity-related ETFs have seen strong interest for most of this year. There also continues to be a strong interest in active fixed income where managers can take advantage of market opportunities to potentially add value. With the proliferation of new ETFs here in Canada, there are plenty of exposures and solutions for investors to choose from. Looking into the future, I expect ESG will to attract investor interest. There’s been quite a few products launched this year, as Covid-19 has awakened investors to the occurrence of a low-probability, high-impact risk which could include climate change — and will also lead investors to look for companies with sustainable business practices.

Another interesting area to watch evolve will be ETFs that use derivatives to increase yields and lower volatility or, more precisely, shape the pattern of returns over a defined period. Option writing ETFs have been around in Canada for a while, but products that shape the pattern of returns and risk markets, or offer a tail-hedge, have been a major development in the U.S. And we are starting to see this in Canada as well.

Index investing has been the origin of the ETF industry and will always be a significant part of the ecosystem. In fact, today about 70% of total industry assets are in ETFs that track an index such as the S&P/TSX Composite Index. Investors also use low-cost market cap ETFs to make active decisions within their portfolios. Having said this, I expect active ETF to continue to grow in Canada. We’ve had active ETFs in Canada for over 12 years now and today they account for about 22% of industry assets, doubling in the last five years. Active ETFs also account for just under 40% of all listed ETFs in Canada.

The U.S. Also launched active non-transparent ETFs earlier this year and large U.S. mutual fund companies are launching active ETFs, which will lead to further growth and awareness in the market. In particular, fixed income, and I also think global and international equities, will benefit from active strategies. Active ETFs can respond to rapidly changing markets like we’ve seen in 2020 and a well-designed strategy that delivers good risk adjusted returns and downside protection and a differentiated exposure can be core holdings or compliment index ETFs.

Another trend to benefit active ETFs is the evolution of ETFs themselves from exposure and trading vehicles to now core investment solutions for investor portfolios. You can now get a well diversified portfolio in one ticker, or a portfolio solution to address fixed income in one trade.

The outlook for balanced funds is a top of mind issue today for many investors, but it’s really about low yields on the fixed income side, especially for Canadian government issues. To be clear, bonds are still an important component of a well diversified portfolio, as they can hope cushion equity volatility. But the question looking ahead is what to do when 40% of your portfolio is yielding 1.3%, which is the current yield to maturity on the universe bond index. The yield on the 10-year Canadian Government Bond is around 60 basis points after declining 110 basis points so far this year, and another 26 basis points in 2019. This has resulted in solid returns for bonds, but the best predictor of future bond returns is the starting yield. So at 1.3% it is clear bond return in the years ahead will be more difficult to achieve than in years past. As well, low rates are likely here to stay. Back in September, the U.S. Federal Reserve Board recently indicated that they would keep rates near zero throughout at least 2023.

So aside from reducing expectation, what are investors to do? Well, this could create an environment for active managers and so-called go-anywhere active fixed income, and fixed income portfolio solutions. For example, active managers can achieve a more efficient yield from layering in opportunities from a wide investment opportunity set. The global fixed income universe is over $100 trillion. So being responsive to opportunities as they unfold across different markets — like U.S. High yield, emerging market debt and mortgage-backed securities, for example — can add value for investors. I also think portfolio solutions on the fixed income side will resonate with investors to help them navigate markets, which can be complex. A one ticket fixed income solution can help lower volatility and potentially enhance income and return potential, while tactically adjusting the portfolio based on the market environment. Much like asset-allocation ETFs have resonated with investors since 2013 and are well-diversified between equity and fixed income, an investor is able to do that specifically for the fixed income component of their portfolio, giving them options and portfolio construction.

To summarize, developments and flows for the ETF industry in 2020 bode well for continued growth in the years ahead.