‘Some dark horses could become Trojan horses’

Investment advisor speaks out on Canada's booming ETF industry and why new offerings require heightened diligence

‘Some dark horses could become Trojan horses’

The ETF space has cemented itself as the proverbial unstoppable force in the investing world, with assets under management and inflows continuing to accelerate even in the face of a decade-defining global pandemic. That has proven true as well in Canada, where 39 ETF providers took in a whopping $41 billion in inflows and ended 2020 with $257 billion in cumulative AUM held across 1,010 ETFs.

“The ETF has carved significant market share relative to conventional mutual funds, pools of assets, and wrap accounts,” said Claudio Chisani, investment advisor and portfolio manager at BlueShore Financial. “You know what they say in the investment trading community: ‘The trend is your friend.’ And I do believe the ETF expansionary trend is no exception.”

The ingredients for the ETF success story, as it pertained to Canada last year, followed a multi-decade trend of growth in the ETF sector. As Chisani highlighted, the value proposition of Canada-listed ETFs has certainly matured; drawing a parallel to the ongoing transition in the energy space, he said products are becoming cheaper and more efficient with each passing day, with no signs of slowing from ETF producers.

Giving credit where it’s due, he said Canadian investors showed remarkable discipline amid the pandemic and turbulence in 2020, while also acknowledging the larger systemic role of low rates, government intervention to support the broader economy, and low interest rates. The recent movements of the Canadian dollar have also been a source of support: as it gathered strength against the greenback, there’s been a lesser tendency for investors to convert in U.S. funds, and a greater propensity to look for Canadian dollar-denominated products that provide access to international markets.

Of course, it would be too much to say the overall explosion in interest and offerings is an absolutely good thing. “There are ETFs out there that go in areas that could be high return, and at the same time have risk or high volatility,” Chisani said. “That includes some dark horses, which in my view could become incredible winners or become Trojan horses.”

As an example, he pointed to life science index ETFs, which have thrived under the glow of a momentously bright thematic spotlight. Interest in cryptocurrency ETFs has also been revived as bitcoin mania reminiscent of that seen in 2017 took hold among investors starting in September last year; Arxnovum Investments has submitted an application to launch a bitcoin ETF with the OSC, and the TSX-listed Bitcoin Fund has already surpassed $1 billion in market capitalization.

From a personal perspective, Chisani said ETFs focused on the growth of the e-gaming industry, such as HERO from Evolve ETFs, were most interesting. While many today may find it hard to imagine e-leagues and e-tournaments as a prominent form of professional sport, he said they have the potential to surpass conventional sports leagues after a couple of decades.

“I know it sounds mind-boggling right now, but maybe not,” he said. “Three quarters of the American population have at least one gamer in their household, and more than 164 million adults play video games in the U.S. It’s a serious market.”

Given that the road to wide-scale electrification must be paved with copper, silver, and lithium, he said that the Canadian resource sector, notably mining ETFs, could see a revival. The current interest-rate environment, he added, makes preferred shares “a little bit more interesting,” while the amount of infrastructure and green energy investment in the U.S. and Canada make for interesting themes to watch and invest in at the right time.

He also highlighted the catalyzing effect of the pandemic on all things online. With the shift of business, work, leisure, and commerce to the digital world, ETFs focusing on cybersecurity, cloud computing, and a panoply of other business areas that support these activities have been turbocharged. Other areas of innovation, such as biotechnology and green energy, have likewise performed astoundingly well amid growing calls for the world to build back better.

But from a structural standpoint, Chisani said the continuing growth of ETFs could also plant the seeds for its future underperformance and investor dissatisfaction. One potential difficulty stems from the large incremental dollar amounts of capital and the reinvestment of the capital into the space.

“If you attempt to put money to work in the Canadian equity or bond market, which is a relatively small market in global terms, it could be a challenge,” he said, noting that the number of equity ETFs today easily exceed the number of natural listed stocks. “You can have many ETFs purchasing the same Canadian stocks and bonds … investors bid those bonds and stocks up, and we might get to the point where they end up fanning the flames of market volatility.”

The continued proliferation of ETFs, particularly those that track an index, also raises the need for investor education and sophistication. A Canadian market-cap weighted index ETF geared toward the S&P 500, he noted, might provide the perception of diversification to the uninitiated, but the top 20 members of the benchmark consist of companies with valuations on the order of 50 times earnings.

A sprawling marketplace of ETFs, Chisani added, could easily turn into a textbook manifestation of the paradox of choice. Faced with hundreds or thousands of ETFs, many self-directed investors might be forced to spend inordinate amounts of time on research or relying on money managers to explain their options. A trend of overdiversification and the development overly niche ETFs, he argued, could therefore drive the costs of business up across the industry.

“If I'm a client who would buy a cannabis ETF, a gaming ETF, and a cloud computing ETF, I might think I have a good investment plan being placed in three sectors,” he said. “But all those sectors could be quite volatile. Therefore, I think the larger the offer of ETFs, the more disciplined professional money managers and Canadian investors have to be. … Performance is very alluring, but I think it’s very important to have an investment portfolio that executes and rests against your goals and objectives.”


Follow WP on FacebookLinkedIn and Twitter