Exchange-traded funds are roaring ahead, as new innovations, such as actively managed ETFs and fund-of-funds products, expand the potential client base.

Assets in Canadian ETFs hit $34.7 billion at the end of January, up by almost 60% from $21.9 billion a year earlier, according to figures from TMX Group Inc. The number of ETFs listed in Canada jumped to 137 from 85 a year earlier, with January 2010 showing a frenetic pace as 16 new ETF listings joined the fray in a single month. ETF trading has mushroomed to account for 16% of all equities trading in Canada.

“The level of activity has been dizzying,” says Dan Hallett, director of asset management with Oakville, Ont.-based HighView Asset Management Inc. “There’s been a huge proliferation of product, both within Canada and globally. There are a lot of interesting things and good offerings, but investors must sift through the junk to get the good stuff. Advisors can play an important role in helping clients make choices and incorporate ETFs into their portfolios in a complementary manner.”

Canadian ETF assets have grown at an average annual compound rate of 30% during the past five years, which indicates their appeal to investors through both bull and bear market conditions. Regular mutual fund assets grew by 5.6% annually during the same period. However, ETFs are still dwarfed by the massive mutual fund business, which has assets under management of $585 billion.

There are only a small handful of ETF players in Canada, the largest being iShares Funds Canada, a division of BlackRock Asset Management Canada Ltd., with $25 billion in AUM in its family of 37 ETFs. Others include Claymore Investments Inc., and BetaPro Manage-ment Inc. and its affiliate AlphaPro Management Inc. (All companies are based in Toronto).

A relative newcomer is Bank of Montreal, which has expanded its ETF product line to 22 funds since it entered the market last summer. With an experienced team under the leadership of Rajiv Silgardo, formerly the head of iShares, combined with the bank’s powerful brand image and extensive branch network, BMO could help make ETFs a household name in the Canadian marketplace in the same way that the big banks brought mutual funds to the masses.

BMO ETFs include fixed-income funds as well as country- and industry-specific niche funds that provide exposure to such areas as China, India, junior gold companies, global infrastructure and utilities.

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

In one of the latest ETF industry developments, AlphaPro has introduced a line of Horizons AlphaPro ETFs offering the active management skills of specific investment fund managers within an ETF structure. (See story on page 28.)

“We’re starting to see some high-calibre managers running actively managed funds within the lower-cost ETF structure,” Hallett says. “If successful, those products will exert more fee pressure on the mutual fund industry.”

AlphaPro has started with only a handful of high-profile money managers, including Frank Mersch, Vito Maida and Dennis Gartman. But, Hallett says, there are many more high-profile managers who have left large fund-industry complexes in recent years to manage their own boutique firms, and these managers could surface in ETF products as they seek to expand their distribution.

“The ETF industry is evolving in the same way the mutual fund industry evolved,” says Hallett. “If you want to gather more assets, you introduce new products that are dressed up differently. There’s a lot more slicing and dicing going on. In addition to an international or emerging-market ETF, you can now buy a single-country ETF. And fixed-income ETFs are being sliced and diced into narrower ETFs specializing in government bonds, provincials, corporates, short-term and long-term bonds. Buyers can target a specific segment or take a diversified approach.”

Fixed-income ETFs have been particularly popular this past RRSP season, as investors are seeking to attain yield in these times of low interest rates, says Heather Pelant, managing director at iShares.

“The desire for yield is intersecting with a lower appetite for risk,” she says. “Investors are becoming more savvy about different ways to achieve yield. As demographics shift and more people retire, there’s going to be a 20-year conversation about yield and building a reliable income flow.”

@page_break@The focus in launching new products at Claymore has recently been on the fixed-income side, says Claymore president Som Seif. Claymore’s government-bond ETF has a management expense ratio of only 15 basis points and its corporate-bond ETF charges 25 bps, compared with an MER of 1.7% for the average Canadian bond fund. For investors looking to save taxes and who are willing to pay 30 bps, there is also Claymore Advantaged Canadian Bond ETF, a blend of government and corporate bonds that converts interest income into tax-advantaged capital gains.

“Investors have a broad choice of different fixed-income assets within ETFs,” Seif says, “including high-yield and real-return bonds.”

Some innovations, such as the introduction of active management, are bringing ETFs closer to mutual funds. But there are some significant differences. ETFs have MERs that are typically below those of both actively managed and index-based mutual funds. For example, iShares ETFs carry MERs ranging from 17 bps on Canadian LargeCap 60 Index ETF to 98 bps on iShares CNC Nifty India Index EFT. According to Morningstar Canada, the average Canadian equities fund currently has an MER of 2.4%, while the average foreign equities fund has an MER of 2.5%.

“Lower fees are a big reason behind the growth of ETFs,” says Esko Mickels, a fund analyst with Morningstar. “There’s no question that’s the primary advantage.”

ETFs are particularly suited to fee-based financial advisors, who can add their own advisory fee to the MER charged by ETFs and still offer clients an overall cost that’s less than the clients would pay on mutual funds. Advisors who are not fee-based need to consider the effect of commissions charged on both the purchase and sale of ETF units in calculating the cost advantage of ETFs to their clients.

Claymore is the only ETF provider that offers a class of ETFs that pays a trailer fee to advisors, and this 75-bps fee is added to the MER. These “advisor class” ETFs currently account for about 10% of Claymore’s AUM of $4.5 billion. Although the trailer fee erodes the cost advantage for the ETF client, says Seif, the MER is still significantly less than a typical mutual fund.

“The Advisor Class has opened up the market,” he adds, “and encouraged commissions-based advisors to use ETFs.”

In yet another industry innovation, mutual fund giant Invesco Trimark Ltd. has introduced a family of 17 PowerShares funds that are actually ETFs in disguise. The company’s U.S.-based parent acquired the PowerShares ETF group in 2006 and has been incorporating ETFs in a variety of packaged products.

These new Trimark mutual funds are essentially holding vehicles for selected PowerShares ETFs that trade on U.S. stock exchanges. They enable advisors at Mutual Fund Dealers Association of Canada-licensed firms, who are not registered to trade on stock exchanges, to offer ETFs to their clients. Originally introduced last November, Power-Shares funds have garnered more than $100 million in AUM.

The PowerShares funds cover a variety of geographical areas, including Chinese and Indian equities, as well as narrow niches, such as global water and agriculture, in which it would be difficult for investors to acquire international knowledge, trade on foreign exchanges and diversify adequately on their own.

The PowerShares funds also appeal to advisors at securities dealers, due to the construction of the indices on which the underlying ETFs are based, says John Ciampaglia, head of product development at Trimark in Toronto. Rather than being based on traditional indices weighted by the market capitalization of stocks, the PowerShares ETFs are based on “intelligent indexing,” whereby the selection of securities in the basket or index that underlies each ETF is based on fundamental characteristics tied to dividends, cash flow and book value. IE