Product innovation fuels growth in ETFs

Although the first generation of ETFs were based on broad stock market indices, the product is becoming significantly more varied, allowing clients to access a wide variety of asset classes and niches, as well as pre-packaged balanced portfolios. ETFs can be used to focus on investment styles such as growth or value, or on fixed income products.

Among the latest industry developments are ETFs designed to protect against interest rate increases, such as those with underlying exposure to short term bonds, laddered portfolios of bonds or preferred shares, and floating rate loans.

Recently, interest has been growing in ETFs offering international and U.S. equity exposure, as investors reduce some of their Canadian holdings due to the lackluster performance of the resource-dominated market. Investors have also been turning to unhedged products to achieve diversification away from the Canadian dollar.

“There are more tools in the box than ever before,” says Kevin Gopaul, chief investment officer at Toronto-based BMO Exchange Traded Funds, part of Bank of Montreal. “For example, previously it was difficult for investors to access emerging market debt and equity. Now, ETFs provide this exposure in a low-cost, transparent manner.”

At BMO ETFs, the top seller this year has been the BMO S&P/TSX laddered preferred share index ETF, which has led all ETFs in the country with net sales of more than $800 million in the year to July 31.

“The product is designed to address concerns about a rising interest rate environment, and the underlying portfolio contains only rate-reset preferreds,” says Gopaul.

Since BMO ETFs were introduced in mid-2009, AUM has soared to $12 billion and the firm has zoomed to second place in the industry with a 20% market share, compared to the 68% market share for iShares Funds Canada ($41 billion in AUM), a division of BlackRock Asset Management Canada Ltd., with in its family of 93 ETFs.

The industry’s second most popular product this year has been BMO S&P 500 index ETF, which represents the broad U.S. stock market and is unhedged in terms of currency exposure.

In terms of outflows, investors have been selling ETFs investing in Canadian equities, resources, and interest rate-sensitive securities such as real estate investment trusts (REITs) and bonds.

“A recent trend has been demand for non-Canadian assets, especially U.S. equities,” Gopaul says. “There’s been more flow into non-Canadian fixed income as well, including U.S. investment grade and high yield bonds. There’s also a lot of demand for unhedged product. Canadians want currency exposure to the U.S. dollar, whereas previously they did not. “

Figures from National Bank Financial show that AUM in Canadian ETFs stood at $60 billion as of July 31, up 20% from $50 billion a year earlier. The number of ETFs listed in Canada jumped to 281 from 252 a year earlier and ETF trading has mushroomed to account for 8% of all equity trading in Canada. Nonetheless, ETFs are still dwarfed by the massive mutual fund industry, which has AUM of about $907 billion.

In addition to BMO and BlackRock, other significant players in the Canadian ETF marketplace include Horizons Exchange Traded Funds Inc. ($4 billion in AUM), PowerShares Canada ($1.7 billion) and Vanguard Investments Canada Inc. ($1.2 billion).

A big actor in the U.S. ETF market, Vanguard opened its doors in the Canadian marketplace just 18 months ago. “As we build our brand and more people become aware of ETFs, our asset growth rate is accelerating,” says Atul Tiwari, Vanguard Investments Canada’s managing director.

This is the first article in a three-part series on exchange-traded funds.

On Tuesday: Protect against rising interest rates with ETFs.