Products proliferate as investors flock to exchange-traded funds

The Canadian exchange traded fund market still has some distance to go to approach the glut of mutual funds that are available. But it’s taking a good run at it. Almost 50 new TSX-listed ETFs sprung up in 2010, raising the number to more than 150. Assets in ETF products now top $36 billion — more than double what they were just three years ago.

Many of the new products are specialized niche instruments that have yet to acquire much of a following. A few hardly seem to trade at all. Some of the big established ETFs, on the other hand, are regularly among the most actively traded securities on the TSX.

While the mutual fund industry still has almost 20 times the assets, ETFs are still creating a buzz far beyond their relative size. Investors are increasingly drawn to them for their low cost and simplicity, notwithstanding the ETF clutter that’s begun to appear.

These days, interest in ETFs isn’t confined to the average retail investor. The consulting firm Investor Economics found that 40 per cent of ETF assets are now held by institutional investors like pension funds and endowments. That’s quite different from mutual funds’ client base, which is overwhelmingly retail. Some mutual funds and [wrap accounts] are starting to use ETFs as underlying investments, adds Investor Economics consultant Carlos Cardone.

A bit of history

There was a time when you had to buy an index fund from a mutual fund company if you wanted an investment that would track a major market benchmark. That all changed in 1990, with the introduction of TIPS. That stood for Toronto Index Participation Shares. This product traded on the Toronto Stock Exchange just like a stock and was designed to track the Toronto 35 Index, which included the 35 biggest companies listed on the TSE. TIPS weren’t called exchange-traded funds back then, but they were among the first ETFs anywhere in the world.

Now, more than 2,400 ETFs trade on dozens of stock exchanges around the world with total assets of more than $1.2 trillion US. Clearly, the age of the ETF is at hand.

What is an ETF?

Exchange-traded funds, as the name suggests, trade on stock exchanges just like regular stocks. They can pay dividends, just like stocks. But unlike stocks that track the fortunes of just one company, ETFs can track an entire stock index, sector, asset class, or commodity. This can give them the diversification that mutual funds have, but in a vehicle that trades like a stock. They are often referred to as passive investments, because there is usually no overall manager dictating which companies or investments the ETF should buy or how much it should buy.

Most ETFs are designed to automatically track an underlying benchmark or index. Sometimes they do this by holding the underlying securities directly; sometimes they use derivative products that track in index. Some ETFs that track foreign stock indices are also hedged to the Canadian dollar so there’s no currency risk.

What ETFs trade on Canadian markets?

ETFs are among the most actively traded securities on stock exchanges.

There are several providers of ETFs in Canada. The biggest ETF provider by far is Barclays Global Investors Canada (now merged with U.S. private equity firm BlackRock ). It runs the biggest ETF in Canada, the $11-billion iShares Canadian Large Cap 60 Index Fund (trading symbol XIU) along with 37 others. The iShares ETF portfolio includes offerings from a variety of sectors, like gold, energy, and financials, several bond funds, as well as ETFs designed to track small-cap stocks, value and growth indexes, and real estate income trusts. BlackRock’s iShares have 80 per cent of the total ETF assets under management in Canada.

Claymore Investments. the Canadian subsidiary of Illinois-based Guggenheim Funds Services Group, offers 29 ETFs in Canada that can provide exposure to Canadian, U.S. or global equity markets, as well as a variety of fixed income ETFs, sectoral ETFs, and commodities. It has a number of unique offerings, including the only Canadian oilsands ETF and a water infrastructure ETF.

Many of Claymore’s ETFs use what it calls fundamental weighting rather than a traditional market cap weighting. This is designed to avoid the problem created when one company is so big that it dominates an index (as when Nortel accounted for a third of the worth of the Toronto market in 2000). Fundamental weighting involves weighing companies by total sales, cash flow, book value and dividends. Claymore also offers an adviser class version for most of its funds. The higher fees are used to compensate financial advisers for selling their ETFs.

BetaPro Management. which markets 45 Horizons BetaPro ETFs, is owned by Toronto-based Jovian Capital Corp. BetaPro says it has $2.4 billion under management in its ETFs. It offers Canada’s only leveraged and inverse ETFs — features that have made a few of their ETFs (like the bull and bear versions of their gold, oil, and natural gas ETFs) among the most actively traded securities on the Toronto Stock Exchange. Leveraged ETFs go up two per cent for every one per cent rise in the underlying commodity or index being tracked. Bear versions of these ETFs will rise two per cent for every one per cent drop.

Because leveraged ETFs are rebalanced every single day, they do not necessarily produce similar leveraged results over long periods of time. For that reason, many advisers say these ETFs should be used just as short-term trading vehicles and held for no more than a few days.

Canadian assets by industry (Nov. 2010)