Exchange traded funds fueled by volatility

par Alain Thériault | October 19 2012 03:21PM

Fears sparked by volatility and the quest for lower management fees are driving investors toward exchange traded funds (ETFs). ETF mutual funds are also gaining some ground.

The first exchange-traded funds surfaced in Canada in the early 2000s. These funds are securities that can be traded on the stock market throughout the day. Their return is aligned with an index or a basket of stocks. The latest ETFs use sophisticated calculations to reduce volatility and maximize returns.

ETFs stand out from mutual funds because of their lower MER. For example, BMO Financial Group’s Aggregate Bond Index ETF (ZAG) has a management expense ratio of 0.32%. The BMO Guardian Security ETF Portfolio Class, whose main investment is the ZAG, charges a 1.65% fee. This fund invests in 11 vehicles, including 7 BMO ETFs, and allocates almost 75% of the portfolio to fixed income securities.

Mutual fund companies are eager to harness the strength of ETFs. By creating ETF portfolios, or mutual funds, which can be sold by their representatives, fund distributors can get around the rule that ETFs can be distributed only by full-service brokers.

Back in 2009, Invesco’s mutual fund ETF PowerShares emerged (with 14 ETFs). BMO Guardian Funds and niche player PIE Funds were introduced the following year. In terms of assets, ETF mutual funds lag far behind other funds.

Best growth in five years
For pure ETFs, the wave has been building since the crisis began. Produced by ETF specialist Pat Chiefalo, National Bank Financial’s monthly bulletin highlights ETFs’ advantage as a value haven. ETFs garnered $784 million in August, most of which went toward fixed-income funds. Seven of the top 10 ETFs in terms of net inflows in August are bond funds, the newsletter points out. Preferred share ETFs are also very popular, unlike growth ETFs.

Total net inflows in August were relatively modest: this year, ETF sales peaked in March, as net inflows approached $1.8 billion.

ETFs had $51.55 billion in assets under management in Canada in August. Of the 261 ETFs listed on the Canadian stock market in August, the biggest winner was BlackRock’s iShares S&P/TSX 60 (XIU), with $158.7 million in net sales. Since the start of the year, however, BMO total bond ETF has reigned, with inflows of $486 million.

A pioneer on the Canadian ETF market, BlackRock (formerly Barclay’s Global Investors) leads the pack with assets under management of $39.42 billion at Aug. 31, 2012. Launched in 2010, BMO ETFs rank second, with assets of $7.21 billion. Horizons comes third, with assets of $3.41 billion. BMO ETFs grew the most in August, with $450 million in inflows, versus $176 million for BlackRock. Trailing behind, in descending order, are PowerShares, Vanguard, RBC Royal Bank and First Asset.

BMO Asset Management posted robust results. Its exchange traded funds broke the $7 billion mark in assets under management in late August. Assets thus increased by $1 billion in July and August, for growth of 16%.
A report on the 2012 Outlook published in September by BMO Global Asset Management says that at Aug. 31, 2012, ETF assets under management rose by 15.9% year to date. “In only eight months, the growth rate in 2012 [so] far is already close to the Canadian ETF industry’s compound annual growth rate (CAGR) of 18.5% over the last five years,” BMO confirms.

ETFs should continue to grow until late 2012 despite the unfavorable economic environment, the report adds. BMO also foresees ETF market growth for the next 5 to 10 years, says Alain Desbiens, vice-president, regional sales for BMO ETF. In an interview with The Insurance and Investment Journal, he points out that the market’s robustness will hinge on innovation and the development of new distribution networks.

Just before the interview, BMO launched a new ETF in response to the current environment: Low Volatility Canadian Equity (ZLB). “Individual investors are increasingly seeking shelter from volatility. ZLB is a fund that participates less in bull markets but cushions the impact of bear markets. In fact, this type of solution used to only exist in the United States and at institutional investors,” Mr. Desbiens explains.

Another innovation may soon hit the Canadian ETF market. The success of actively managed ETF in the United States may spawn emulators in Canada, the BMO report predicts. For now, most ETF have passive mandates.

ETF mutual funds
Mr. Desbiens thinks the distribution networks will diversify, spurred by the advent of ETF mutual funds. Only investment advisors who hold full-service securities brokerage licenses can distribute an ETF. Mutual fund representatives can access this market via ETF portfolios.

“We are seeing a growing number of independent advisors amalgamate traditional mutual funds with ETF mutual funds in their clients’ portfolios. BMO Life Insurance is integrating more and more ETFs in its universal life insurance products and its segregated funds,” Mr. Desbiens says.

Mutual fund companies are seizing the opportunity. According to the BMO report, the number of investment funds or funds of funds that take ETF positions is growing steadily.

Invesco mirrors this trend. “We continue to see strong demand for our PowerShares Funds and Invesco Intactive Allocation portfolios. We did create a new yield-focused mandate, Invesco Intactive Strategic Yield Portfolio and Invesco Intactive Strategic Capital Yield Portfolio Class, in April,” Oricia Smith, vice-president, Product Development at Invesco says. She describes the launch as extremely successful.

Michael Cooke, head of distribution at PowerShares, says that these funds racked up total assets of $1.5 billion in August. Launched in 2009, the line now boasts 21 funds. The five most popular PowerShares funds – PowerShares 1-5 Year Laddered Corporate Bond Index Fund, PowerShares Canadian Dividend Index Class, PowerShares Tactical Bond Fund/Capital Yield Class, PowerShares Real Return Bond Fund and PowerShares Preferred Shares Index Class – each have about $200 million in assets under management.

Released in September 2010, Intactive ETF portfolios have also prospered. “Flows have been very strong, reflecting the demand for solutions that manage risk in today’s environment,” Mr. Cooke explains. Assets under management in Intactive portfolios stood at $2.7 billion on Aug. 13. Mr. Cooke adds that the two new Intactive portfolios rolled out in late April had amassed $67 million in assets by August.

Invesco bucked the trend by introducing its ETF mutual funds before the actual ETFs. In 2011, Invesco brought its American ETF to Canada, also called PowerShares. “We felt it wasn’t the right time to launch ETFs in 2008-2009, and we decided to bring it through our funds. Then the demand (in Canada) for ETFs increased and big banks provided liquidity for them so we decided to launch the PowerShares in Canada in June 2011,” Mr. Cooke explains.

Leon Garneau Jackson, vice-president, business development, at BMO Guardian Funds, calls the $1.86 billion accumulated in ETF Guardian from its 2010 inception until July 31, 2012 a huge success. The independent network of mutual fund representatives generated $450 million, versus $1.41 billion for branches.

“Demand took off in Eastern Canada and spread to other regions. Sales are now steady, and, if we include recent weeks, I think we have reached $2 billion,” he said in an interview on Aug. 15.

Guardian Funds also brought out two new ETF funds, in mid-June: LifeStage Plus Advisor Series and Target Enhanced Yield ETF Portfolio. The two new portfolios focus on trust investments, Mr. Jackson adds.

The line, initially four funds strong, added two strategic portfolios, plus the two latest products. The vast majority of ETF mutual fund sales are generated by the bank branch network and its financial services directors and financial planners.

“Their portion is greater than that of the independent network (mutual fund and full-service representatives) because the two networks are different,” Mr. Jackson explains. The Bank’s network is extensive across Canada, with 2166 financial services directors and 692 financial planners.”

Mr. Jackson knows that the high fees may rile investors who prefer to buy ETFs directly on the stock market. However, he says he has found his target clientele. “ETF portfolios are aimed at investors who want a turnkey solution. Yes, the fees are higher, but their portfolio offers more tools: daily rebalancing, risk profiling, tax efficiency (Category funds)...ETFs are fine for people who do not need these three characteristics,” he explains.

Historic opportunity
At Invesco, Michael Cooke sees ETF funds and tactical portfolios as the trendiest integrated solution in Canada because they offer a combination between active and passive management. “It’s closer to the institutional investment process used by some of the world largest investors, like leading pension funds. They attract the attention of the aging population. Older investors are risk averse and cash flow dependent,” he says.

Boomer investors want portfolios that offer interesting income and risk management combined with an attractive return, Mr. Cooke continues. Yet it is difficult for even the best fund managers to generate income for investors in a volatile environment compounded by low long-term interest rates.