How risk-off mentality affected ETF industry in 2022

Will disruptive change continue into the new year? CI GAM's head of ETF strategy looks at what's in store

How risk-off mentality affected ETF industry in 2022

As the challenges of inflation, rising interest rates, and volatility transformed the behaviours of investors, this year has also brought disruptive change to the Canadian ETF landscape, according to one industry expert.

“2021 was a strong year for ETF and mutual fund sales with mutual funds outselling ETFs for the first time in several years,” says Nirujan Kanagasingam, VP and head of ETF Strategy at CI Global Asset Management. “Canadian-listed ETFs generated approximately $53 billion in flows in 2021, which was a record.”

Canada’s ETF space has cooled considerably in 2022, Kanagasingam says; ETF net flows are on pace for just north of $30 billion for the year, though that’s still relatively strong considering the current market environment of volatility and economic challenges.

ETFs also regained their dominance over mutual fund flows, with the Investment Funds Institute of Canada (IFIC) reporting more than $26 billion in net redemptions from mutual funds for the year up to October 31, 2022.

“It should come as no surprise that we have seen a risk-off sentiment from investors in 2022,” Kanagasingam says. “Nearly 50% of all ETF flows have gone into fixed-income ETFs, and in particular cash alternative ETFs.”

While they posted net outflows in 2021, cash alternative ETFs have attracted $7 billion in net inflows this year, representing nearly 25% of all ETF flows year-to-date. Among those, Kanagasingam says the best-seller has been the CI High Interest Savings ETF (TSX: CSAV), which invests primarily in high-interest deposit accounts at Schedule 1 Canadian banks.

The risk-off attitude among investors has also led to a reversal of fortunes for thematic ETFs and crypto ETFs. After robust flows in 2021, these categories have struggled to replicate the success due to the heightened market volatility that’s taken hold this year.

Volatility has been an opportunity for some defensive ETF categories. Kanagasingam pointed to covered-call ETFs, which have generated strong flows in 2022 as investors seek to capitalize on higher volatility with higher option premiums. More covered-call ETFs have come to market off the back of that demand, providing investors targeted access to specific themes and sectors with the added benefit of enhanced yield.

“In past years, factor ETFs, or smart beta ETFs, have struggled to gain market share in Canada,” he adds. “However, in this newer environment of lower growth and higher interest rates, we have seen factor ETFs come back into vogue and really prove their worth with value, low volatility and dividend ETFs generating strong relative returns.”

Market volatility and declines have also created investment opportunities for those who are willing to be active and tactical with their portfolios. Amid a wave of tax-loss selling and portfolio repositioning, CI GAM is seeing investors turn toward more active ETFs – including quantitative and fundamental strategies – particularly within the fixed-income category.

The 2022 cocktail of higher inflation, aggressive monetary policy, and heightened market volatility has not paired well with the 60-40 balanced portfolio, as both equities and fixed income were hit simultaneously. As traditional asset classes become increasingly correlated, Kanagasingam says investors are turning toward liquid alternatives, which offer ways to enhance risk-adjusted returns, preserve capital, and achieve greater diversification by virtue of their unconventional strategies and flexibility.

“Liquid-alt funds, including alternative mutual funds and ETFs, have seen a 10% year-over-year increase in AUM as of October 31,” he says. “With liquid-alt ETFs particularly, we have seen 38% AUM growth year-on-year, with 20 new liquid alternative ETFs launched in 2022. We expect more innovation on the liquid alternative side the next couple of years.”

Coming into 2023, Canada is facing prospects of slowing economic growth and a higher risk of a recession. That risk is offset by the possibility of inflation continuing to cool going into next year, which would prompt central banks to slow the pace of their interest rate hikes.

“The current market environment of slower growth, higher rates and higher inflation has historically been better suited towards an active approach, whether it be factor ETFs or traditional active ETFs,” Kanagasingam says.

“On the fixed-income side, investors should consider active fixed-income ETFs, which can help investors better navigate the uncertain environment,” he adds. “In contrast to passive fixed income where a company or government that issues the largest dollar amount of debt will have the largest weight in the index, active fixed-income strategies are not bound by the same constraints as they’re able to tactically allocate across issuers and sectors in order to better manage duration and credit risks.”