Above the fray

A: ETFs now are viewed as a solution, not as the enemy or something to be frowned upon, as they may have been in the past. Investors want to invest in more asset classes and more markets, so there’s a move toward index products such as ETFs because people find that it’s difficult to generate alpha or outperformance relative to benchmark indices by themselves. It’s also hard to find mutual funds that deliver alpha consistently.

We also see that hedge funds, on average, are not beating the S&P 500 composite index – and that’s been the case for the past seven years. [Assets under management (AUM)] in ETFs, globally, surpassed hedge funds in June 2015 – which is impressive, given that the first ETFs were launched in Canada in March of 1990 and hedge funds have existed for more than double that number of years. At the end of 2017, the AUM in hedge funds was less than global ETF AUM by US$1.6 trillion.

Q: Has the long-running bull market led people to believe the best solution is to “buy an index” and not to pick individual securities?

A: It’s difficult for anyone to pick stocks that will do better than the market consistently, or to pick a mutual fund that’s going to do better than the market all the time. And cost weighs in on this. ETFs are more cost-efficient for an individual than buying all the underlying securities. Today, you can buy ETFs that allow you to choose other investment strategies besides just buying the whole market. Although, when we looked at which ETFs brought in the greatest amount of net new AUM last year, they tended to be broad-market, core, low-cost ETFs based on market cap-weighted indices rather than strategic beta or actively managed ETFs.

Q: What do you foresee being the most popular types of ETFs?

A: Many investors still go for the plain, old building blocks – and that’s best represented by SPY [SPDR S&P 500 ETF] in the U.S., which just celebrated its 25th birthday. That product is now the world’s largest ETF with more than US$300 billion in AUM, and it’s the most actively traded ETF. I think the trend will continue toward core building blocks, driven by the fact these plain-vanilla products are not complicated. They’re also cost-efficient, relative to futures contracts, for large institutional investors that want to obtain particular exposures.

Q: Where’s the ETF industry heading with new product innovations?

A: Smart beta and factor-based ETFs will be popular, but we’re also seeing a real pickup in [environmental, social and governance (ESG)] factors in the construction of specialized ETFs. People are looking for ethical, sustainable governance because what you’re finding today is that companies focused on these issues actually demonstrate better results, which in turn leads to better stock market performance. And so, we’re seeing people look at ESG and impact investing, green bonds and clean energy. Themes also will be important, but it’s a matter of the right product at the right time. Things such as cybersecurity and other niche exposures resonate with some people.

Q: What is the potential of actively managed ETFs vs passive ETFs?

A: We’re seeing robo-advisors in Canada offer both active and index-based ETFs, whereas, typically, in other parts of the world, robo-advisors are embracing only low-cost, passive ETFs. In Canada, regulations require that ETFs, like mutual funds, need only disclose their holdings quarterly. This makes it easier for ETFs [in Canada] to use active strategies than in the U.S., where the rules require more transparency. Canada is a bit different. You also have marijuana ETFs in Canada, which are not allowed anywhere else. You have to remember that Canada was first in the world to launch ETFs when TIPs [Toronto 35 Index Participation units] were introduced in March 1990. SPY came out three years later. So, Canada has had a number of firsts [in the ETF space].

Q: What about demand for fixed-income ETFs?

A: Individuals and robo-advisors are using ETFs to build diversified asset allocation. So, being able to access different fixed-income exposures easily has been useful and popular for investors. We’ve seen some investors are a little bit skeptical and have needed a bit of convincing about liquidity, as fixed income is not priced and traded on an exchange in the way equities are.

There are fewer fixed- income index providers and indices than on the equities side, but we’re starting to see more. Some investment fund companies, including [California-based] Pacific Investment Management Company LLC, have spawned some active fixed-income ETF products. Compared with equity fund [portfolio] managers, fixed-income [portfolio] managers probably are more comfortable providing regular disclosure on their holdings in active ETFs.

Q: With the evolution beyond passive strategies, are ETFs becoming too complex and do investors understand what they’re buying?

A: I do think it’s getting more complicated. It’s easy for people to see that an S&P 500 ETF gives exposure to 500 large U.S. stocks. But when it comes to factor-based and multi-factor ETFs, you find that even the index providers have different ways of defining and calculating things such as momentum and low volatility. So, yes, it takes more work to understand some of the new products that are coming to market. That creates a bit of an educational challenge for the index providers that are trying to convince product developers to use their indices, and also for the advisors who need to help clients understand what they’re buying.

Q: Do you have any predictions for the growth of global ETF AUM within the next five years? Although we’ve just come off a record-breaking year of global inflows, what inning are we in as far as global growth of the ETF industry?

A: We’re going to see stronger growth for ETFs relative to most other financial products. ETFs make it easy for people to invest: they’re simple and cost-efficient, and investors can trade in small or large amounts. ETFs are uniquely democratic in that institutions, financial advisors and retail investors are able to use the same toolbox at the same low cost, even for small investments. People understand that other things being equal, products with lower costs tend to perform better over time.

With [the introduction of the second phase of the client relationship model] in Canada and the increased transparency on fees and performance, we’re seeing the adoption of ETFs increasing among retail investors. ETF usage is increasing relative to picking individual securities, relative to active mutual funds and to the use of futures. The beauty of ETFs is that they can be used by so many different types of investors and for many different strategies.

We’re still in the early stages of growth for the ETF industry, especially globally. The first ETF in Kenya was just launched this past year. But even in the U.S., there’s still a lot of room to grow, as ETFs are being used for different kinds of exposure. Investors are learning that it’s increasingly difficult to find active funds that can deliver alpha consistently, and that you also can generate alpha through asset-allocation strategies. ETFs also are being used more for fixed-income and alternative strategies.

Q: We enjoyed a bull market for stocks for several years. In more bearish conditions, are ETFs vulnerable?

A: Sometimes with volatility, you find that ETF trading increases. The value of AUM might go down in a correction – if there’s a 10% correction in equities markets, the value of market-linked equity ETFs goes down 10%. And ETFs would also be impacted by asset flows. But I don’t think a correction is going to cause people to not want to use ETFs. They showed resilience during the 2008-09 global financial crisis.

Q: Is the market becoming saturated with new products and players?

A: Providers are trying to differentiate with the new products they offer. Many of the newer issuers are trying to wrap ETFs into portfolio solutions, so they’re packaging them in different ways. Smart beta has become more prevalent, along with different themes and factors. So, providers aren’t just coming out with “me too” products; they’re coming out with different things.

Q: What are the key risks in the ETF market?

A: Many people are not doing their homework on some of the ETFs that deviate from the plain-vanilla, market-cap ETFs. They don’t necessarily understand the factors behind portfolio construction or realize that they’re not going to get outperformance every day of the week or month. Some factor-based products have academic research that says the product has outperformed market cap in the past over long periods of time. But there can be multiple years of underperformance. So, people need to have the right expectations. There’s also concern about some of the newer things, such as bitcoin. And it’s important that people have realistic expectations around volatility.