After record year, do Canadian ETFs have more room to run?

Merger of regulators will only help investment vehicle, says executive director of the Canadian ETF Association

After record year, do Canadian ETFs have more room to run?

As record-high inflation and soaring interest rates pummelled financial markets, Canada’s investment fund landscape saw a stark bifurcation.

According to the Canadian ETF Association, Canada-listed ETFs took in $38.5 billion in inflows over the course of 2022. Meanwhile, the latest annual report from the Investment Funds Institute of Canada (IFIC) found Canadian mutual funds bled $44 billion during the same 12-month period.

That begs the question: have ETFs finally replaced mutual funds as Canadian investors’ fund vehicle of choice?

“I don't know whether we can get to that statement yet. But I think ETFs are becoming more of an option to more advisors and investors,” says Pat Dunwoody, executive director of the Canadian ETF Association (CETFA).

According to Dunwoody, Canada’s ETF industry experienced its third-strongest year of net inflows in 2022. The bulk of those flows went into products suited for recent economic challenges, which she says could serve as a gateway for new investors to explore other categories within the ETF space later on.

“I think the industry as a whole was very good at seeing what individuals needed and wanted to invest in. In the last couple of quarters, the majority of assets went into high-interest savings account ETFs and bond ETFs,” she says. “But among the top 20 ETFs in terms of inflows, we also saw some broad-equity ETFs. People still wanted to keep their toes in the water of stocks, but not narrowing their exposure.”

The increased interest in fixed-income products isn’t surprising, Dunwoody notes, given the recent upward moves in interest rates over the past year. That has made yields on the products more attractive than they have been in more than a decade, prompting more advisors to recommend and use them in client portfolios.

Multi-decade highs in inflation proved radioactive to both stocks and bonds, which melted down in 2022. An analysis by Edward McQuarrie, an investment historian and professor emeritus at Santa Clara University, revealed last year was the worst on record for bonds in the U.S.; losses ranged from -10.6% for intermediate-term U.S. Treasurys to -29.3% for long-term government bonds.

Canada fared slightly better than its southerly neighbour. The S&P/TSX Composite Index’s annual return for 2022 was -8.5%, compared to -19.44% for the S&P 500. The Morningstar U.S. Core Bond Index, which reflects a broad cross-section of government and investment-grade corporate bonds, lost 12.9% last year, in contrast to -8.75% for the Canadian Core Bond Index.

The losses in broad benchmarks last year might give investors pause about investing in passive index strategies, which have historically driven growth in the ETF space. Still, Dunwoody says it’s too early to declare a regime shift toward active ETFs.

“I think people are still going to hold tight right now. Some banks are saying we’re going into a recession or are in a recession, while others are saying it’s going to be a soft landing,” she says. “I don’t think there’s going to be a huge shift unless there’s some concrete indication about what the next two or three years will look like.”

Because the economy is in uncharted territory, with some recession indicators flashing red even as job numbers stay strong, Dunwoody believes caution will continue to be the watchword for investors, which creates a short-term tailwind for broad-based equity ETFs and fixed-income strategies. New ETF launches in Canada will also likely continue to be muted compared to the heated activity five or six years ago, as asset managers become more selective and strategic about how they expand their product shelves.

“I think people are going to be very astute and do a lot of research before launching a product,” she says. “You don't want to go through the expense and time of launching something if you don't think it's got any kind of long-term value.”

Part of the explosive growth in ETFs could be attributed to the rise in awareness among investors over the years, as well as the increased use of online investing among younger investors. From Dunwoody’s vantage point, the merger of the Mutual Fund Dealers Association of Canada (MFDA) and the Investment Industry Regulatory Organization of Canada (IIROC) will also be a win for the country’s ETF industry.

Dunwoody estimates only less than half of the MFDA’s membership sell ETFs, which means there’s more room for exchange-traded funds to run as they make inroads into the businesses of large MFDA-registered firms.

“Because of the merger of the SROs, some larger firms from the MFDA are switching over to an IIROC platform so that it’s easier for them to manage ETFs. Others are partner with an IIROC firm or brokerage house,” she says. “And as advisors switch some or all of their accounts over into a fee-based model of compensation, ETFs will become a natural add-on to their shelf.”