The ETF sector has been growing at a breakneck pace. This rapid growth can be seen both in the level of assets under management and in the number of firms offering ETFs.
Passively managed ETFs have exploded in popularity over the last decade in no small part due to their low management fees. In fact, you can now find ETFs with management fees close to zero. To learn more about this and other developments in the ETF space, we met with Erika Toth, director, institutional and advisory ETF sales for Eastern Canada at BMO Global Asset Management.
We first asked whether ETFs with extremely low management fees might result in lower-quality products for investors. On the contrary, Toth said; lower fees are a significant benefit for investors, contributing to a marked increase in long-term returns. Toth added that firms offering ETFs with very low fees are able to do so due to the economies of scale from their considerable assets under management.
Broadly, there are two types of ETFs: passive (or index-tracking) ETFs, and actively managed ETFs. Given investors’ increasing adoption of ETFs, will actively managed ETFs eventually replace traditional mutual funds?
Toth said she does not believe ETFs will completely replace mutual funds. Currently, not all financial planners and investment advisors are licensed to sell ETFs, and not all wealth management firms have the infrastructure required to sell them. However, these planners and firms can offer ETF-based mutual funds to their clients.
Toth also noted that mutual funds offer certain benefits not offered by ETFs, such as zero trading fees and the ability to implement systematic contributions or withdrawals at no cost, as well as the corporate class structure available in certain mutual funds, which can be very tax-efficient for non-registered accounts. The majority of investors, she noted, use a combination of ETFs, mutual funds and individual stocks.
The Covid-19 crisis has raised certain questions regarding ETFs. As a case in point, certain bond ETFs traded at steep discounts to their net asset value (NAV) during the market volatility of last year. For example, the iShares iboxx Investment Grade Corporate Bond ETF traded at 3.3% below its NAV, and the VanEck Vectors High Yield Municipal Index ETF traded at an 8.3% discount. Some investors considered this a weakness of bond ETFs.
But Toth said she saw this as proof of the strength of the ETF structure, rather than a weakness. In her opinion, bond ETFs allowed their holders to access liquidity precisely at a time when the underlying assets were hard (if not impossible) to trade. The market valuations reflected a more realistic view of the true value of the underlying bonds with respect to their overall NAV.
Since the entire corporate bond market essentially froze up and ceased to trade for a few days last March, NAVs were based on data from several days earlier. Thus, it was bond ETF prices (and not NAVs) that provided price transparency and were a better gauge of the market value of the underlying bonds during this time. Toth added that the structure of bond ETFs is designed to make bonds more transparent, liquid and tradeable.
With the Covid-19 crisis, some investors have turned to ESG ETFs, which take environmental, social and governance issues into account. Toth pointed out two factors that may explain the recent growth of ESG ETFs.
First, investors are seeking quality companies with more prudent management teams that are better equipped to face crises such as the one we have experienced recently. Second, by emphasizing ESG issues, these companies are less likely to be embroiled in various scandals, which can trigger adverse financial consequences at the company level. Moreover, the risks related to global warming have become increasingly clear. A growing number of investors are trying to make a difference by investing in companies with good environmental practices.
Toth noted that research tends to show that investing with ESG factors does not mean sacrificing performance. When comparing the cumulative return of the MSCI World ESG Leaders index to that of the MSCI World index from October 2007 to December 2020 (since common inception), the performance is nearly identical, with the overall risk level slightly lower on the ESG index, resulting in stronger risk-adjusted returns.
What can we expect with respect to the future of ETFs? Toth said she believes the main issue for most investors will be selecting the right ETFs for their needs. Given the vast and ever-growing number of ETFs available, this may prove more challenging than in the past. It will be important for investors to consider the ETF provider and the suite they offer; the companies, countries, and sectors one is exposed to within an ETF; and an ETF’s total costs and liquidity. Naturally, it is important for investors to consider ETF investment in the context of their overall portfolio, rather than evaluate ETF features on an individual basis.
In the future, Toth said she sees many mutual fund firms launching ETF offerings. Moreover, we will continue to see a growing number of new offerings of actively managed ETFs. Finally, Toth said she believes major established ETF providers will continue to increase their offerings of low-cost, passively managed ETFs, given the consistent demand for these products.