Bucking a trend

When financial markets have a down year, sales of investment products usually move in the same direction. This is part of the natural ebb and flow of the 86-year-old Canadian mutual fund industry, which has endured multiple recessions and bear markets.

Yet in 2018, the trend of falling markets causing falling sales was only partly true. There was a pronounced shift in sales leadership: ETFs – outweighed by a factor of roughly 10 to one in assets under management – outsold mutual funds for the first time in a decade.

Plunging equities in the fourth quarter of 2018 spooked mutual fund investors, causing a reversal of the previously positive inflows. For the full year, long-term funds had $2.5 billion in net redemptions, the Investment Funds Institute of Canada (IFIC) reported. Meanwhile, the Canadian ETF Association reported net ETF creations of $20.9 billion last year, behind only 2017’s record $25.8 billion, with equity ETFs leading the way.

It would be wrong, however, to characterize the recent sales trends in terms of winners and losers among investment fund providers. Increasingly, mutual fund companies – in one form or another – are also involved in the ETF business. There’s an attitude of confidence that whatever fund structure investors and financial advisors want is fine. In a sign of industry convergence, IFIC began this year to also cover ETFs in its monthly reports on fund industry assets and sales.

For their part, fund companies that have chosen not to create ETFs can still draw upon huge distribution networks, such as deposit-takers’ branch networks, other proprietary sales forces and independent dealers who aren’t licensed to do business on stock exchanges. But these fund sponsors recognize that there’s intensified competition, downward pressure on management fees and high compliance costs. This situation has created a sense of urgency to operate efficiently, deliver competitive returns and provide excellent service.

In explaining why ETF inflows have been more resilient, Carlos Cardone, senior managing director with the Toronto office of New York-based Strategic Insight Inc., says ETFs are benefiting from a substitution effect. To a large extent, direct holdings of securities in the brokerage channel are being replaced by ETFs. This is particularly true of bonds. “You’re finding ETFs these days in the fixed-income space with flavours that are very difficult to access for brokers, for pretty much anyone,” Cardone says.

In many cases, ETFs are also replacing mutual funds in the full- service and discount brokerage channels. Among the funds most vulnerable to redemptions, says Cardone, are broadly based equity funds with holdings similar to the market benchmark that charge higher fees than their ETF rivals. “Those funds are not finding it very easy to continue to grow.”

Depressing sales of all investment types is the accelerated payment of household debt. Strategic Insight calculates that in 2018, an additional $45 billion moved into debt paydowns on top of everything else Canadians were already paying off. “Higher interest rates are constituting a very significant incentive for people to do more of that,” Cardone says.

In today’s mutual fund market, particularly in the advisor channels, says Cardone, there’s a greater emphasis on value for money. That does not necessarily mean low-fee passive strategies. “We continue to hear from some companies that have products that have been selling very well and are actively managed.”

Carol Lynde, president and CEO of Toronto-based Bridgehouse Asset Managers, cautions against reading too much into recent product preferences. Sales trends run in cycles and can change quickly, she says. For example, mutual funds again outsold ETFs in the first quarter of 2019.

“When we look at what we have to offer to Canadian investors and to advisors, it’s important for us to focus on the fundamentals of what we do, be consistent with our style [and] be consistent in how we service our clients, our advisors and our dealer firms,” says Lynde, who is IFIC’s vice chairwoman and will take over as the group’s chairwoman later this year.

As an industry leader, Lynde looks to work with securities regulators to create a “level playing field” for mutual funds. “In some cases, perhaps there’s a greater level of oversight and cost related to mutual funds than there is to other vehicles” she says. “We need to [ask], ‘Have we gone too far in terms of the regulation minutiae around owning a mutual fund?’ Because Canadians are questioning the cost vs that benefit, and [they] may be going to products that are less regulated than a mutual fund.”

Bridgehouse offers several lines of actively managed mutual funds but isn’t jumping on the ETF bandwagon. “What’s really important is the value that you’re receiving from the manager; the style, the investment philosophy of that particular manager,” says Lynde. “That’s what’s important, not so much the product structure itself.”

Jordy Chilcott, head of investment distribution with Toronto-based Sun Life Global Investments (Canada) Inc., says most advisors aren’t looking to be able to trade during the “23,400 seconds a day” that the market is open. Chilcott adds that for strategies that invest in less liquid markets, bid-ask trading spreads may make ETFs a less efficiently priced vehicle than mutual funds, which always trade at net asset value at the market close.

Even so, most of the mutual fund industry’s biggest names are now offering ETFs. At the forefront of this convergence is Toronto- based BMO Asset Management Inc., which ranks a strong second in ETF assets, and in 2018 it was the bestselling ETF sponsor for the seventh consecutive year.

Long-time mutual fund sponsor Mackenzie Investments, also of Toronto, ranked third for the year in net ETF creations, less than three years after the launch of its first ETFs.

Meanwhile, mutual fund giant RBC Global Asset Management Inc. (RBC GAM) has teamed up with the largest ETF provider, Toronto-based BlackRock Asset Management Canada Ltd. Consisting mostly of BlackRock’s iShares ETFs, the strategic alliance, announced in January 2019, is being marketed as RBC iShares. As of the end of the first quarter, it held $65 billion in assets and a 38% market share.

“We are very much an ETF business as well,” says Doug Coulter, president of Toronto-based RBC GAM, which has more than $225 billion in mutual funds under management and a 15% market share of that product segment. “It becomes a choice from the consumers’ perspective.”

Depending on the distribution channels RBC GAM is targeting, investment strategies can be offered as mutual funds, ETFs or both, Coulter says. The company can launch new offerings that have identical holdings, “priced exactly the same, and one would be called an ETF and one would be called a mutual fund.”

Another ETF entrant is long-time mutual fund firm Franklin Templeton Investments Corp., which is based in Toronto and began offering ETFs in May 2017. As of February 2019, offerings now include Canada’s first passively managed ETFs investing in Japan and in Europe, excluding the U.K.

“At the end of the day it’s not so much we market product, but we market our investment capabilities,” says Duane Green, president and CEO of Franklin Templeton. “Our goal is to put whatever wrapper an investor wants to have in terms of creating that vehicle that suits their purposes when they’re building their portfolios and give them the right building blocks.”

Recognizing that not all advisors can access its ETFs, the company launched three Franklin Multi-Asset ETF Portfolios in February, with management fees of 0.40% for Series F units for fee-based advisors. Green says the firm’s key strategies for success include providing institutional quality of investments to all market segments, being competitively priced and “making sure that we have strong relationships with our key intermediaries, distributors and partners.”

For fund companies that sell through advisor channels, these relationships are evolving. At the end of 2018, for the first time in history in the full-service brokerage channel, more than 50% of the assets were fee based, according to Strategic Insight. This has had an impact on product choices.

“When advisors move to fee based, the movement is not necessarily product neutral,” Cardone says. “What happens in many cases is that advisors try to preserve and maybe in some cases even increase their own compensation within fee-based accounts.” As a result, he adds, these advisors may be more inclined to recommend index types of products, or lower priced products in general, though not necessarily exclusively.

Steve Hawkins, president of Toronto-based Horizons ETFs Management (Canada) Inc., expects ETFs’ share of the investment fund market to continue to increase, as it has in the U.S. over the past five years. “ETFs make up 35% of the marketplace in the U.S., compared to only 11% in Canada,” he says. “Canada always lags [behind] the U.S. when it comes to investment products.” Though Hawkins acknowledges that there has been a significant downward shift in mutual fund fees, “ETFs still have a strong hold on being a lower-cost product for investment advisors to use for their end clients. And we’re seeing a significant increase in self-directed investors.”

While the number of ETF providers has grown rapidly, there’s been a trend toward consolidation among fund companies, with smaller firms being swallowed up. “Not everyone in the mutual fund space or the asset-management space is able to survive that margin compression we’re all experiencing,” says Chilcott. “It’s extremely difficult for the smaller asset managers that haven’t achieved scale.” Excel Funds Management Inc. of Mississauga, Ont., for one, was acquired by Sun Life Global Investments in January 2018.

Fund managers need to be flexible in their product development, Chilcott says. As a recent example, he points to the October 2018 launch of five Sun Life Tactical ETF Portfolios, which hold low-fee ETFs within an actively managed mutual fund.

Why not an ETF structure for the portfolios themselves? “I don’t think ETFs in all situations are as cost-effective as portrayed when you get into certain asset classes,” says Chilcott. “Mutual funds, especially in the F series without the advisor compensation, are continuing to come down and are getting quite aggressive in management fee reductions.” For Series F units, management fees of Sun Life’s ETF portfolio funds range from 0.45%-0.5%, which is competitive with non-passive ETFs that are rules-based or actively managed.

Among bank-owned management firms, which control about half the mutual fund industry and are increasing their presence in ETFs, mutual funds are solidly entrenched as the investment product of choice in their huge retail branch networks. RBC GAM’s Coulter notes that bank branches, through which 60% of RBC mutual fund assets are held, aren’t set up to process ETF transactions.

Nor are most fund purchasers looking to make intraday trades at their bank branches.

“If they did want that, then we have a discount channel and we have a brokerage channel,” says Coulter. “What’s under the hood in terms of the investments and how we manage the money wouldn’t change from a mutual fund structure to an ETF structure.”