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ETF outlook: Trending in 2016

First Trust's Karl Cheong shares his recap of 2015 and his expectations for 2016 in the Canadian ETF market.

Jess Morgan 13 January, 2016 | 6:00PM
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Karl Cheong: It was another record breaking year for Canadian ETFs. We saw about $16 billion of flows into Canadian ETFs. That surpasses the previous record of about $12 billion in 2012. We also saw about $400 billion of flows globally. So we saw investors focusing on low-cost international and fixed-income ETFs, especially amid the carnage we've seen here in our Canadian equity markets. So it was really a good time to be in the ETF business despite the tumultuous year we had in 2015.

Driving ETF flows: Investment innovation

When you take a look at ETFs, they are really just a new technology. An analogy I tend to use is that ETFs are to mutual funds what the Internet was to newspapers. It's really just a newer and better technology. In financial services, we haven’t seen a tremendous amount of innovation or breakthroughs, but in every other industry, every single time there is a breakthrough or new innovation, everyone goes and competes or executes that gets the best and the newest. Think about like an iPhone for example.

Driving ETF flows: Underperforming active managers

It's hard to pick stocks. It's always been hard, it's never been harder. Think about investors that invested in Valeant last year. So take a look at the data from Morningstar as well, that 80% of large-cap equity managers are underperforming the S&P/TSX. So in that environment, investors are gravitating to low cost ETFs because they are fundamentally cheaper, they are fundamentally more transparent and they are easier to trade than mutual funds. So I really think that $16 billion we saw flow into Canadian ETFs will continue to grow.

Trending in 2016: Fund providers in the ETF space

We are going to see these large traditional mutual fund players dive into the ETF pool, similar to what we've seen in the U.S. So why that’s significant are two reasons. One: It's the latest gust of wind pushing the ETF growth story along. We're going to have all these large firms out there talking to investors and advisors about the value of ETFs and the commitment to that value. It's also going to be great. Number two: It's going to provide a lot more choice for investors. Of course the challenge is, it's going to be a lot of choice. One of the biggest questions I have in my mind is how committed these traditional mutual fund companies will be in terms of selling ETFs on a standalone basis, because you know what it actually does: it could potentially cannibalize existing offerings.

Trending in 2016: The growth of smart/strategic beta

I like Morningstar's definition, because smart beta has really become a catch all term for alternative weighting. For First Trust it could mean you weight an index by fundamentals, or you hedge out your duration risk within your fixed income. The point is, it's really just key differentiated exposures.

Now what we've seen recently is most of the fund companies or ETF companies that have come into the market are either launching these smart beta ETFs or fixed income ETFs because they are looking for a place to hide from the fee war that’s taking place for traditional market cap exposure. I think as an investor, there are two things you need to be thinking about. One: Don't overpay, like everything else, when you look at these strategies. And two: Don’t chase performance. We've seen in the data that investors pile into these funds when they start to outperform and pile out of them when they underperform.

Just like any type of factor bet that you see out there, there are going to be periods of outperformance and underperformance in the strategy. And if you could hold on to it, over five to 10 years you should be rewarded. Now if you can’t overcome that behavioural bias, then it might make sense to hold the broad market. But, really, the strategy is a real inherent benefit because what you have is an alpha-seeking strategy that’s really a mechanical part of what the index is about. So it's really contrarian investing made easy, and I think this inherent benefit is great.

Trending in 2016: Currency hedging

The currency is going to be again one of the biggest decisions investors face this year. You are going to have currency exposures, and I think every investor should be thinking about how to manage that within their portfolio. Because it's really the difference between a good couple of years and okay ones. The S&P 500, in local currency terms, returned about 1.4% in U.S. dollars. But if you are going to invest in the S&P 500 in CAD dollars, that’s a spread of about 20%. So the beauty of it is that there are options to play the dollar via hedged or unhedged ETFs from ETF providers like First Trust, because then you can get that 20% return.

Now one of the strategies and themes we've been seeing from our client base is hedging, or hedging half their exposure as opposed to full, because it kind of eliminates that problem of market timing, because you are going to be right sometimes but you won't be right all the time in that space. But the conclusion is that you are going to have to focus on currency because it's going to be one of the biggest decisions or factors affecting returns this year.

Trending in 2016: Lower fees, higher transparency

Overall, we've seen ETFs get better over the last few years. We've seen fees come down across major investment categories. You can now get the S&P/TSX 60 Index for 3 basis points or $0.03 for every $100 invested. It's actually become even less expensive to buy corporate bond ETFs for an institution than to go out there and place $100 million to $200 million directly into the individual bonds.

I think what you are seeing as well is that mutual fund companies are starting to reduce the amount of fees at an increasing rate within their own products, only because some of the transparency rules that will come into effect will require these firms to clearly disclose fees on investor statements going forward. But I think all of this is important because, one, fees matter when it comes to performance, and, two, Canada has always been criticized for having the highest fees. One thing I want to mention, though, is that fee is very important, but it's not the only decision-making factor you should look at when investing in an ETF. You have to look at the strategy. Because if fees were the only determinant of a successful product, then you'd see a one-to-one correlation between fees and the most successful products in the marketplace. But that’s not always the case.

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About Author

Jess Morgan

Jess Morgan  Jess Morgan is the associate editor of Morningstar Canada’s website. She began her career as a television producer and freelance writer, often making appearances on TV and radio as a commentator on politics and culture. She holds a BA in communications from the University of Winnipeg and a diploma in Creative Communications from Red River College.

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