Top Canadian ETF Trends for This Year: Vanguard

Ruth Saldanha: Vanguard recently put together five top ETF trends that they see for this year. These include the increased popularity of ETFs with Canadian investors, increased fixed income and multi-asset flows and interest in specific themes and sectors. What do some of these mean for you? Sal D'Angelo is the head of product for Vanguard Canada, and he is here today to talk about these trends.

Sal, thanks so much for being here today.

Sal D'Angelo: Thank you so much for having me. Great to be here.

Why do Canadian ETF Investors Like Fixed Income, and Will This Trend Continue?

Saldanha: So, let's start by talking about the fixed income inflows. Now, some of the reason is probably the high interest rate, but do you expect this to continue? And also, what risks should investors be aware of going ahead?

D'Angelo: Yeah, it's a great question, Ruth. Thank you for the question. So, yeah, we definitely expect the popularity to continue. I mean, this year, through end of August of 2023 year-to-date, we've seen a huge uptick in fixed income ETF flows and that's evident through the data. If we look at Canada, over 60% of year-to-date flows have been actually in fixed income ETFs and that compares to 35% of total year-to-date flows in 2022. So, a pretty large uptick. What does remain consistent, however, is that through the first eight months of the year, half of the fixed income flows have actually been in ultra-short or money market ETFs. What we do see is advisors continue to see the very strong benefits of fixed income ETFs as they provide strong liquidity and diversification benefits for their portfolios.

We've actually been speaking to clients since Q4 in 2022 about the opportunity in bonds offering long-term investors opportunities to make money with yields well above inflation. We also believe that bonds will reassert its role as a stable hedge in the portfolio to equities after spending most of last year in negative territory due to the rapid tightening cycle.

So, about risk – what do we see as the risk? We actually believe a key risk investors should watch is for overconcentrating their fixed income in short duration exposure such as these same money market or ultra-short ETFs. While the short end of the curve does look very attractive from a risk-reward perspective, this year could actually be a great time to average in to more durable, longer-dated maturities. So, today's higher yields provide a cushion for market volatility and bonds have traditionally done well after the Fed stops raising rates or nears the end of its hiking cycle. Inflation will dictate when that date comes. We believe the Fed or the Bank of Canada will keep rates on hold as long as possible. So, if a recession does come, rising credit spreads could dampen returns. But then, at some point, falling rates would actually be a strong tailwind for fixed income portfolio with duration exposure.

Why do Canadian ETF Investors Like Both Fixed Income and Equity Simultaneously

Saldanha: On the other hand, in the multi-asset section, you've seen a lot of inflows into all equity and growth. So, how do you explain this preference that investors have both for all equity on the one hand, as well as fixed income on the other?

D'Angelo: Yeah. So, on that side, we do believe the strong relative demand relative to the more conservative profiles, the relative demand for growth in all equity multi-asset ETFs is due actually to two main factors. First, fixed income suffered heavily in 2022 and we believe investors are avoiding fixed income heavy portfolios due to recency bias. Second, we continue to see strong demand for multi-asset ETFs from discount brokerage channel, which tend to have a stronger adoption rate from younger investors. And we do know that growth in all equity multi-asset ETFs are a great solution for younger investors who have the ability and willingness to take on more risk and have the patience to weather any short-term market turbulence. So, while the balance of 60-40 portfolios took a hit in 2022, they've actually rebounded quite nicely already in 2023 with year-to-date returns on the 60-40 or balanced multi-asset ETF of about 8%. I think that underscores the importance of discipline, diversification and staying the course. And last, I'd say, we're more optimistic about the outlook going forward for the balanced portfolio, given much higher yields from the fixed income portion of the portfolio, coupled with more modest equity returns. So, we actually expect on a forward-looking basis in Canadian dollar terms the balanced portfolio to deliver about 5% to 7% annualized over the next 10 years, which is more in line with historical norms.

Canadian ETF Investors Like Non-U.S. Equities

Saldanha: On the equity side, what are some sectors and themes that investors like right now?

D'Angelo: Yeah, a great question. So, we actually see strong interest in Canada and ex-U.S. equities, so ex-U.S. market equities. So, U.S. equity ETFs in Canada – in the Canadian ETF market, U.S. equity ETFs have actually lost about $1.8 billion in year-to-date flows through the end of August, which is a sign of investor sentiment towards the region. And we concur with that view and believe that the last decade of U.S. outperformance in U.S. equities is likely sowing the seeds for the next decade of underperformance. The valuation-driven outperformance in the U.S. is unsustainable and ex-U.S. stocks actually offer favorable valuations with attractive dividend yields. And then, if we look within Canada, we see strong flows in dividend stocks including financials, either as part of a dividend ETF mandate or within other income-focused ETFs.

ETF Trends for the Rest of the Year

Saldanha: What are some portfolio construction preferences that you're looking at? And as we move towards the end of the year, do you see this shifting at all?

D'Angelo: Yeah. So, as previously mentioned on the fixed income side, we continue to see investors with this high allocation to ultra-short or money market ETFs. On the equity side, as I just mentioned as well, so these valuation-sensitive investors are increasingly allocating to the ex-U.S. stocks. However, within the U.S. equities, we continue to see a preference for growth style, despite their rich valuation. And then, lastly, just from a portfolio construction perspective, what we're seeing in the Canadian market with advisors and investors alike is continued allocation increases to low-cost passive ETFs. We've seen investors and advisors increasingly use a core satellite approach with using low-cost index ETFs as a core and pairing these with their highest-conviction active managers or individual stock picks. We do expect this trend towards lower-cost core ETFs and lower-cost active management to continue in the decades to come. I would say just last, as always, what we tell investors that in more volatile market conditions, focus on what you can control. You can't control the markets, but you can control the cost of your investment portfolio and your asset allocation. So, stay focused on your long-term investing goals, properly manage your investing costs and stay diversified. It's definitely an all-weather enduring investment strategy.

Saldanha: Pretty much the same advice we give. Thanks so much for being here today, Sal.

D'Angelo: Thank you so much, Ruth. Have a good day.

Saldanha: For Morningstar, I'm Ruth Saldanha.