Active ETFs in play

Market volatility is favourably influencing growth in this sector

Exchange-traded funds (ETFs) have long been synonymous with the rise of passive investing, but heightened market volatility is driving demand for actively managed ETFs that may help mitigate risk and enable tactical portfolio adjustments. The rising appeal of debt and factor-based funds is also shifting investor perceptions of ETFs as purely plain-vanilla index investing.

Passive ETFs still dominate but active products are making inroads

Growth in the global ETF market shows little sign of abating as investors pivot from high-cost mutual funds to low-fee index-tracking products. In Canada alone, ETFs accounted for 99.5 percent of the total of USD 20.5 billion in investment fund sales in 2018, while mutual funds took only a USD 109 million slice.1

Passive ETFs continue to dominate the industry, with active funds comprising less than two percent of the market in the United States (US). However, active funds are expected to take a larger market share over the coming year due to shifts in investor sentiment. During 2018, 73 new active ETFs were launched, more than any other category, according to a report from Morgan Stanley.2 In Canada, 69 of 120 ETFs released over the calendar year were active, as reported by the Canadian ETF Association.3

Interest rate rises spurred issue of active fixed-income ETFs

While more expensive than their passive counterparts, active ETFs are often significantly cheaper than actively managed mutual funds and have become attractive amid market turbulence since the second half of 2018. Most of the active gains came from demand for fixed-income ETFs, a fast-growing segment that gained traction in 2018 as interest rates rose.

Allocations of ETFs in client portfolios nearly tripled in the decade from 2009 to 2018, from 5.4 percent to 14.1 percent

The popularity of active fixed-income ETFs has helped shift investor perceptions of the industry as a purely passive one. Bond ETFs drew more than USD 96 billion of inflows last year while factor-based funds added a record USD 86 billion, according to Bloomberg data.4 Low-volatility equity ETFs, focused on stocks with more stable prices, have proven particularly appealing, adding over USD 9.5 billion.

Heightened volatility is also triggering greater tactical use of ETFs by investment managers. Approximately 60 percent of institutions surveyed in a study by Greenwich Associates said they invested in bond ETFs in 2018, up from 20 percent in 2017. Three quarters of respondents said they were using or considering using factor-based ETFs, compared to 44 percent in 2017.5 “Along with market turbulence, pension funds and other institutions have become more proactive about utilizing factor strategies,” said David Linds, Managing Director and Head Asset Servicing, Canada at RBC Investor & Treasury Services. “We’re seeing investment managers look for more sophisticated applications of ETF strategies to back their market views or take tactical defensive positions,” he added.

Financial advisors are warming to ETFs

Financial advisors are also driving the uptake of ETFs as they show a greater willingness to invest in them on behalf of their clients. Allocations of ETFs in client portfolios nearly tripled in the decade from 2009 to 2018, from 5.4 percent to 14.1 percent, according to data from Cerulli Associates.6

The popularity of
active fixed-income
ETFs has helped
shift investor perceptions
of the industry as a
purely passive one

Financial advisors are expected to continue to boost allocations to ETFs in their client portfolios in 2019, amid sustained market turbulence and increased familiarity with new ETF offerings. Tax incentives and changing fee structures are playing a part. Many advisors favour ETFs’ tax-efficient structure through the in-kind creation and redemption process in which baskets of underlying securities are exchanged in kind for ETF shares. Such structures can diminish the likelihood of capital gains distributions for investors.7

Advisors are increasingly being paid with transparent fees based on clients’ assets, rather than indirect fees through brokerage commissions and retrocessions. Fee-based advisory models create more incentive to reduce management costs and simplify asset allocation, which could provide a boost for ETFs in client portfolios.8 The cloudy outlook in a number of economies has also made the direction of interest rates difficult to predict, which could turn advisors’ focus to more sophisticated and actively managed ETFs. “The uncertainty surrounding interest rates and how fixed-income investors may respond, will drive demand for new and innovative fixed-income products,” Franklin Templeton said in an investment note.9

Active managers are seeking relief on disclosure requirements

With US regulators requiring ETFs to disclose their holdings each day, most active products have focused on bonds due to the relative lack of liquidity and transparency in much of the fixed-income market. The opacity in bond markets makes it harder for third parties to “front run” ETF trades to the same degree that more transparent equities markets offer. End-of-day disclosure requirements have discouraged some active managers from issuing active ETFs for those reluctant to reveal their trading activities. Issuers have applied for relief from the disclosure requirement for certain active ETF structures, with a number of proposals under consideration by the Securities Exchange Commission. “Approval could pave the way for more fund managers to issue active products,” commented Linds.

With uncertain market conditions expected to continue in 2019, a growing appetite for active funds to support defensive and tactical portfolio adjustments may further change perceptions of ETFs investing as a purely passive undertaking.10

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  1. Investment Funds Institute of Canada (January 2019) 2018 Investment Funds Report
  2. Wall Street Journal (February 8, 2019) Market turbulence spurs demand for fledgling active ETFs
  3. Canadian ETF Association (2019) ETF Report Q4
  4. Bloomberg (February 27, 2019) Volatility spurs institutions to beef up their tactical ETF use
  5. Ibid.
  6. ETF Trends (February 6, 2019) ETFs find support from growing financial advisor demand
  7. Ibid.
  8. BlackRock (2018) Four big trends driving ETF growth
  9. Franklin Templeton (January 23, 2019) Canadian ETF Trends
  10. Lexology (January, 2019) Preparing for the next generation of actively managed ETFs