Pandemic Put More Money Into ETFs

But do we need so many options? We discuss what's next with Mark Noble from Horizons ETFs

Ruth Saldanha 3 June, 2020 | 1:39AM

 

 

Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

Ruth Saldanha: In the COVID-19 panic selling and subsequent recovery, one trend has become increasingly clear. Canadian investors are putting more money into exchange-traded funds or ETFs than mutual funds. Morningstar has long held the view that in most cases the ETF model with its low cost, passive investment strategy serves individual investors well. However, Canadian investors have almost 1,000 ETFs from which to choose. Do they really need that many? And what's likely to happen next for Canadian ETFs? Mark Noble, Executive Vice President of ETF Strategy at Horizons ETFs, is here today to talk about this.

Mark, thank you so much for being here today.

Mark Noble: Always a pleasure.

Saldanha: Let's start with the volatility over the past couple of months. Investors saw a sharp fall followed by a relatively quick recovery and now they seem to be headed more into fixed income. Why is this? And going ahead, in what areas of fixed income do you see having the most value?

Noble: Well, I think, we need a little bit of context on what's happened. Fixed income has really been one of the huge inflow areas for ETFs for quite some time over the last few years. In fact, it's Canada – and I've been on here a number of times saying this – Canada has the highest proportion of fixed income ETF assets of any developed market in the world. It's roughly 30% of the asset flow which is huge. Globally, it's about 16%.

What we saw really for the first time in March and globally across North America was huge outflows actually of fixed income ETFs because the corporate fixed income market was hammered. From peak to trough in March fixed income declined by almost 14% which is huge – and this is investment-grade fixed income; I'm not even talking about high yield – but I think that investors might be missing an opportunity here because if you look at what's happened on the government bond side, like a five-year Canadian government bond is yielding less than 50 basis points and even 10-year bonds are yielding sort of in the 50 to 60 basis point range. Rates have really never been this low in our lifetime in terms of funding a portfolio. And retail investors – and not even just retail investors, pensions, whoever it may be, there's a real need for income. And finding income at 50 basis points, which is still below the level of what inflation is supposed to be, is likely not going to cut it.

So, I think that in the latter end of the year, the asset class people are selling, might likely be the asset class they might return, to which are investment-grade bonds, corporate bonds. And the reason for that is simply because those are yielding 200, 300 basis points above those government benchmarks. And that's sort of the funding level that investors are going to need. Plus, and this is really specific to ETFs, you know how the U.S. Fed directly buying ETFs to backstop the corporate bond market which has never happened before in North America. So, they are buying ETFs, so buying ETFs to get their bond exposure because ETFs make up the bulk of inventory for bonds. So, you basically have the government implicitly backing corporate bonds, but you're getting yields that's 200 to 300 basis points more. At a certain point, I think investors will start to gravitate towards that asset class simply for a need to find the income portion of their portfolio.

Saldanha: Let's talk about the industry now. In general, Canadian ETFs seem to have weathered the storm relatively well. However, there are still close to 1,000 ETFs in Canada. Do you see some ETF closures on the cards for the rest of the year?

Noble: Yeah, certainly. And the reason – I thought there were going to be closures even before we saw this market downturn. But when you have a significant pullback in the equity market, you see the assets under management in ETFs decline. And quite simply, I mean, it's hard to give a figure, but generally, ETF profitability occurs somewhere around $30 million to $40 million in assets under management I would argue on average. If you have an ETF for sort of $30 million to $40 million, I would say there's a profitability, there's a reason for the ETF provider to offer that.

Now, most ETF providers put out ETFs with a goal of keeping them open and trying to attract investment dollars and they make an honest effort to do. They'll probably run an ETF for one to three years, one year at a minimum, usually around three years to gather those assets. But when you have a pullback like this, it takes the assets under management away from the ETF providers and there was already a number of ETF providers that I think were struggling to raise assets. So, you mentioned the 1,000 ETF figure. You have to figure that about 15% of those are probably not profitable ETFs. So, at a certain point, ETF providers have to make a tough call and yes, I do think it will result in closures over the next 12 to 18 months as those ETFs simply aren't sustainable to manage from an AUM. Performance-wise they can do fine, but the ETF providers themselves need to raise assets and see momentum for them to make it viable from a business perspective.

Saldanha: So, what are the kinds of funds that are most at risk of closures?

Noble: I think it's really me-too ETFs, like so me-too ETFs on the equity side. Why you see is there's a 1,000 ETFs in Canada but of the ETFs I'd say really investable ETF universe is more like 300 or 400 ETFs in terms of providing broad asset class exposure. If I look at some of the S&P 500, you're probably looking at close 20 ETFs that offer some iteration via the S&P 500 or broad U.S. equity. I mean, how many large broad U.S. equity ETFs do Canadian investors need? Not that many.

So, I think the ETFs you actually start to see closed are iterations of like large-cap equity strategies and strategies that investors have an abundance of choice in. Simply, when you have a multitude of choice, they are not going to buy everything. Now, certainly, those are popular asset classes, which is why there's so many ETFs in them. But those would be the first areas that I would see.

And then, the next area would be very nichey ETFs, so ETFs that invest in like broad small sub-sectors. So, when you launch a niche ETF, you are sort of looking for an ETF that would provide exposure hoping to hit kind of what I would call it a home run, like an asset capture lightning in a bottle. For our firm, for example, we had the Marijuana ETF which is really a small niche sub-sector of the Canadian equity market, but it was extraordinarily popular for a long period of time over the last three years and still doing relatively well. That's a home run. But for every HMMJ, there's a whole bunch of other ETFs that are invested in like technology sub-sectors, biotechnology, slicing and dicing things like healthcare where there's just no interest. So, the other second area where I would see there to be a fair amount of closures would be any of these very small thematic ETFs that again haven't attracted assets.

Saldanha: Thank you so much for joining us today, Mark.

Noble: My pleasure.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Horizons Marijuana Life Sciences ETF6.78 CAD-1.17
Horizons Marijuana Life Sciences ETF USD5.10 USD0.59

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Ruth Saldanha

Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca

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