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The shifting ETF environment in Canada

ETFs are adapting to regulatory change while seeking opportunities to manage costs

The popularity of exchange-traded funds (ETFs) remains strong as investors look for convenient and cost-effective options to help grow their portfolios. The interest is evident in the growing number and types of ETFs on the market today, encompassing a broad range of sectors, geographies, and asset mixes.

As the ETF space continues to expand and evolve, regulators have introduced several changes, including closing tax loopholes for specific types of funds. The latest change was in the 2019 budget, when the Canadian government targeted how ETFs redeem units in the primary market and the potential tax impact to market makers.

Key insights

  • The growth in ETFs demonstrates that the industry is responding to the evolving needs of the market, and investors
  • Regulators are closing tax loopholes in specific types of funds and ETF providers have been making adjustments to comply and keep costs low
  • ETF providers are turning to indexes with lower licensing costs and passing along the savings to investors through lower fees

While all mutual fund trusts were initially included in the original legislation proposal, changes were made in July 2019 that deferred the legislation on capital gains and proposed applying enforcement of the allocation of income in the 2020 tax year. This will include settlement of derivatives, which are primarily income.

ETF providers affected by the federal government decision have been making adjustments, such as changing structures and closing funds, with an eye on maintaining tax benefits for investors.

Meanwhile, ETFs continue to build their reputation as being cost competitive through various strategies such as tracking lower-profile benchmarks to help keep investment fees low.

ETF assets continue to expand

Worldwide assets invested in ETFs reached USD 5.65 trillion at the end of August 2019, according to a report from London-based consultancy ETFGI. The report says global ETF assets have grown at a compound annual rate of about 20 percent over the past decade.1

ETF providers are making the necessary adjustments in response to market demands and the changing regulatory environment

From a Canadian perspective, growth remains steady. As of August 31, 2019, there were 729 ETFs offered by 38 providers with a total value of CAD 185.9 billion, representing a 13.4 percent increase in assets from the prior year. In 2018, there were 623 ETFs from 28 providers with a value of CAD 163.7 billion.2

"ETF providers are making the necessary adjustments in response to market demands and the changing regulatory environment. The positive growth trajectory in Canada is indicative of their efforts to remain relevant and attractive to investors," says David Linds, Head, Asset Servicing Canada, RBC Investor & Treasury Services.

Regulatory adjustments for ETFs

Regulators are also monitoring the growth and shifts in the ETF environment in Canada, with a view to eliminating what might be considered unfair tax advantages.

In Budget 2019, under a section called "closing tax loopholes," the federal government moved to end a practice that allows investors in certain ETFs to defer taxes. It proposed to "prevent the use by mutual fund trusts of a method of allocating capital gains or income to their redeeming unitholders where the use of that method inappropriately defers tax or converts fully taxable ordinary income into capital gains taxed at a lower rate." 3

The move follows a federal government decision in 2013 to cut back on the use of “character conversion transactions" that used derivatives — which were a specific type of forward agreement using subsection 39 (4) of the Income Tax Act — to turn income into capital gains. In 2016, the federal government eliminated tax-free switching between corporate-class funds.4

ETF providers adapt to changing regulations

Horizons ETFs Management (Canada) Inc., was affected by this change given its use of derivative arrangements across various funds, including its flagship Horizons S&P/TSX 60 Index ETF.5 Following "an extensive review," Horizons announced plans in August 2019 to restructure about half of its assets into corporate-class funds. Horizons said the move, which affects about CAD 5.2 billion of its overall CAD 10 billion in assets under management, will be "in the best interests of the unitholders of the relevant ETFs."

Those funds currently structured as mutual fund trusts will be merged into a single multi-class mutual fund corporation, which Horizons said will allow the ETFs "to improve operational efficiency, aggregate all future gains and losses on both the income and capital accounts, and substantially reduce the likelihood of distributions."

Steve Hawkins, president and CEO of Horizons ETFs, said his company had been exploring the potential of making this structural change even before the proposed changes to the taxation of mutual funds were announced by the government.

“Based on our review of the existing regulatory environment, including the tax changes proposed in the recent Federal Budget, we feel confident that the proposed corporate class structure will allow us to continue to offer our synthetic ETFs to investors in a manner that provides unitholders with all of the same benefits that they have enjoyed for the past 10-plus years, including minimal tracking error, tax efficiency, and competitive fees," Hawkins said in a statement.6

Lowering costs for investors

Another shift in the ETF landscape is the use of indexes with lower index-licensing costs to help reduce fees for investors.

New indexes help sharpen the level of fee competition in the ETF and index fund business

While the Canadian stock market benchmark remains the S&P/TSX Composite Index, a growing number of funds are tracking lesser-known benchmarks such as the Solactive Canada Broad Market and FTSE Canada indexes. ETF providers often examine a range of factors before making the switch, such as sector weightings and performance.

"New indexes for investing in the Canadian stock market are a welcome addition to the marketplace because they help sharpen the level of fee competition in the ETF and index fund business," wrote Globe and Mail columnist Rob Carrick.7

Linds notes, "ETF providers are always looking for new ways to provide investors with the most innovative, cost-competitive options in the market. These indexes help to achieve that."

While change is inevitable in the investment world, a consistent objective for ETFs is to provide enhanced risk-adjusted returns that deliver income and diversification while helping to reduce overall volatility in investors' portfolios.

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Sources

  1. ETFGI (September 12, 2019) ETFGI reports the Global ETFs and ETPs industry gathered US$3.43 billion in net inflows in August 2019
  2. Canadian ETF Association (Sourced Sept. 24, 2019) Industry statistics page
  3. Government of Canada (March 19, 2019) Budget 2019
  4. The Globe and Mail (March 10, 2019) Federal government looks to quash tax loophole for ETFs in new budget
  5. Horizons ETFs Management (Canada) Inc. (March 20, 2019) Press release
  6. Horizons ETFs Management (Canada) Inc. (August 23, 2019) Press release
  7. The Globe and Mail (September 13, 2019) Investors who like their ETFs simple and cheap have some new choices for covering the Canadian market