ETFs push ahead

And ETF manufacturers are moving to address this demand, offering a choice of income-producing products investing in a range of securities, including government and corporate bonds, preferred shares and dividend-paying common shares.

A key theme cited in the BMO report is investors’ preference so far this year for bond ETFs, despite the fact that the yield on 10-year Government of Canada bonds is at a record low. For the first eight months of this year, assets under management (AUM) in bond ETFs had increased by 38% to $17.8 billion. According to the report, with the broad choice of offerings, investors are becoming more tactical in their fixed-income strategies, targeting various parts of the yield curve or credit spectrum to maximize return or reduce volatility.

Demand also is increasing for non-Canadian bond ETFs, such as U. S. high-yield bonds and emerging-markets debt. And dividend-based ETFs are growing in popularity as investors at or nearing retirement search for an elusive income stream in today’s low interest rate environment.

One ETF manufacturer aiming to exploit the growing interest in fixed-income strategies is Vanguard Investments Canada Inc. of Toronto, a relative newcomer to the Canadian ETF marketplace. Vanguard Canada is launching five new funds _ three of which are aimed at income generation. A preliminary prospectus has been filed and the funds should be available by yearend, bringing Vanguard’s Canadian products’ stable to 11 ETFs.

The new income funds include Vanguard FTSE Canadian High Dividend Yield Index ETF, Vanguard FTSE Canadian Capped REIT Index ETF and Vanguard Canadian Short-Term Corporate Bond Index ETF. The product launch also includes Vanguard S&P 500 Index Fund and a currency-hedged version of that fund.

“The new products will round out the first tranche of Vanguard ETFs, which were designed to be core building blocks for any investment portfolio,” says Atul Tiwari, managing director of Vanguard Canada. “If you look at the [sector’s] trends year-to-date, income and equities-income products are the drivers.”

Vanguard Canada, a wholly owned subsidiary of U. S.-based investment-management behemoth Vanguard Group Inc., opened its doors in Canada last December, bringing its parent’s low-cost, index-based investment approach to Canadians. The Canadian subsidiary so far has garnered $316 million in AUM.

Although Vanguard Group is a whale in the U. S. ETF marketplace with 64 ETFs housing US$220 billion in AUM, Vanguard Canada is a minnow here. The biggest player in the $50-billion Canadian ETF sector is iShares Funds Canada Ltd., a division of BlackRock Asset Management Canada Ltd., with 76% of the market and $39.4 billion in AUM; followed by Bank of Montreal, which has a 14% market share and $7.2 billion in AUM.

Vanguard Canada’s most popular product is Vanguard MSCI Canada Index ETF, with a rock-bottom management fee of nine basis points (bps), which has brought in $76 million in AUM. The second-most popular fund is Vanguard MSCI Emerging Markets Index ETF, with a management fee of 49 bps and AUM of $70 million.

The popularity of the Vanguard Emerging Markets ETF, Tiwari says, is “a bit of a surprise,” given that the sector is generally experiencing outflows in the emerging-markets equities category.

“The category has seen outflows, and we’re seeing inflows, which is a testament to our low-cost approach,” Tiwari says. “Many of those who follow a disciplined asset-allocation and rebalancing approach are looking to Vanguard to fulfil that proxy.”

The average management fee on Vanguard Canada’s existing ETFs is 24 bps, while the sector’s average is almost four times higher at 88 bps. According to Toronto-based Morningstar Canada, the average management expense ratio for a Canadian equities fund is 2.8%. This means Canadian equities fund portfolio managers who take an active approach must consistently outperform the benchmark by about 2% just to match market returns. Given the low returns of the past five years, cost savings on management fees make a bigger impact.

Rising awareness of the cost of fees has spurred the growth of ETFs in Canada. As of Aug. 31, the value of ETF AUM in Canada stood at $50 billion, an increase of about 16% year-to-date. According to the BMO report, the Canadian sector has seen an average annual growth rate of 18.5% during the past five years as investors ranging from institutional managers to individuals increasingly employ ETFs as part of their portfolios’ construction.

“ETFs have become a popular solution for investors looking to reduce costs while also attaining market exposure,” the report says. “This is especially true, given that similar plain-vanilla ETF products are becoming less expensive due to pricing competition from various providers.”

Although the year has seen some brief rallies in Canadian equities, the BMO report adds, it is clear that the appetite for risk among Canadian investors continues at a low level.

AUM in dividend-based ETFs, which tend to be defensively oriented in established, blue-chip companies, grew by 45.2% for the first eight months of the year. Several ETF providers have gone beyonnd plain-vanilla products, developing ETFs to help reduce volatility. Some of the more sophisticated ETFs use hedging and long/short strategies or covered-call options to enhance yield.

© 2012 Investment Executive. All rights reserved.