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Canada’s rapidly growing ETF industry is expected to continue to expand faster than its more mature mutual fund counterpart in 2019, albeit at a reduced pace. This growth in ETF AUM is likely to be accompanied by an increasing shift toward actively managed ETFs and ongoing fee compression.

As the two types of investment funds converge, ETFs and mutual funds are likely to coexist in clients’ portfolios as financial advisors use asset-allocation strategies to meet their clients’ investment objectives, says Raj Lala, president and CEO of Evolve Funds Group Inc. in Toronto.

Mutual fund firms have adjusted their strategies in recent years to account for competition from ETFs. These strategies will affect the investment funds industry in 2019.

To avoid losing assets under management (AUM) to ETFs, mutual fund companies have had no choice but to embrace ETFs, says Steve Hawkins, president and CEO of Horizons ETFs (Canada) Inc. in Toronto. Many traditional mutual fund manufacturers have launched ETF classes of their mutual funds, even if that meant cannibalizing their mutual fund asset base.

However, Barry McInerney, president and CEO of Mackenzie Investments in Toronto, views ETFs as “portfolio building blocks” that can be used in tandem with mutual funds. He notes that flows of assets into both his firm’s ETFs and its mutual funds are roughly the same and that there’s “no cannibalization of mutual fund assets.”

Lala anticipates continued growth in mutual fund assets will be dependent on fees. “I think mutual funds will grow,” he says, “as long as fees are consistent with those of active ETFs.”

Hawkins adds that mutual funds also will benefit from products that cannot yet be used in an ETF structure, such as “real estate and liquid alternatives, which ETFs cannot yet handle.” (See Will clients embrace alteratives?)

On the other hand, Hawkins says, ETF sales will increase further as clients become more educated. According to a study by Mississauga, Ont.-based Credo Consulting Inc., the report for which was published in September 2018, overall penetration and awareness of ETFs is low among Canadian investors. The report concluded that “current rates of flows [into ETFs] would likely be astronomically greater” if these weaknesses were addressed.

In addition, ETFs will become a larger part of clients’ portfolios, and sales will increase, as more advisors adopt fee-based compensation models, says Pat Dunwoody, executive director of the Canadian ETF Association (CETFA) in Toronto.

For now, the trend toward faster ETF growth and slower mutual fund growth is evident in the AUM of both types of funds. For the 12 months ended Nov. 30, 2018, total AUM in ETFs increased to $160.9 billion from $145.7 billion, according to CETFA. Meanwhile, total mutual fund AUM declined marginally, to $1.47 trillion from $1.48 trillion, over the same period, according to the Investment Funds Institute of Canada in Toronto. In addition, ETF AUM as a percentage of mutual fund AUM increased by slightly more than one percentage point, to 10.9% from 9.8%.

Another significant development is the increase in the number of actively managed ETFs. This is, in part, because of mutual funds’ traditional emphasis on active management, Dunwoody says.

Adds Hawkins, whose firm offers the largest family of actively managed ETFs in Canada: “Almost two-thirds of ETFs launched in 2017 are actively managed, and the proportion in 2018 was higher.”

The number of actively managed ETFs will continue to grow in response to demand for investment products that suit clients’ specific needs, says Dennis Tew, head of national sales at Franklin Templeton Investments Corp. in Toronto.

But continued growth in actively managed ETFs “will not replace mutual funds,” says McInerney.

Nor will the rise of actively managed ETFs lessen the importance of passive ETFs, which will continue to have a place in clients’ portfolios. There’s a place for both active and passive strategies, depending on the asset class, Lala notes: “I would use a passive ETF for large-cap Canadian stocks, but I would use an active ETF for asset classes such as preferred shares.

“Over the course of the past few years,” Lala adds, “investors gravitated to low-cost beta investments and ignored concepts such as diversification and asset allocation. However, recent market volatility and the prospect of a volatile 2019 highlight the importance of active [portfolio] management.”

The variety of available ETFs enables investors to shift to ETFs without disrupting their investment strategies. Moving a client’s assets to an actively managed ETF from an actively managed mutual fund is a much smaller jump than moving to a pure beta, low-cost ETF from an actively managed mutual fund, Lala explains.

Fee compression will remain a driving force of AUM growth for both investment vehicles.

Hawkins, for one, believes that fees for both ETFs and mutual funds will continue to decline.

“There are different spots where fees can go lower,” Tew says, noting that there may be room for fee reductions for some strategic-beta ETFs.

Core products, such as global and domestic equity funds, may see fee reductions as well, based on AUM, Tew adds. But fee compression on actively managed, alpha-generating strategies is unlikely.

McInerney expects fee reductions to be gradual. Still, that will put pressure on companies that cannot absorb lower fees.