Amid the dazzling array of choices available to Canadian ETF investors, the best sellers have been the most pedestrian products. “Cash is undoubtedly the most popular theme this year,” TD Securities Inc.’s ETF strategists noted in a recent report.
As of late May, according to the report, high-interest savings account (HISA) ETFs had attracted $3.4 billion in inflows. Other popular ETF themes this year identified by TD Securities included government bonds ($2.4 billion), ESG strategies ($1.9 billion), covered-call equities ($1.7 billion) and the perennially popular asset allocation funds ($1.3 billion).
These represent a shift from a year earlier, when 64% of first-half inflows went to equity ETFs, versus only 29% to fixed income, according to National Bank Financial Inc.
Nirujan Kanagasingam, vice-president and head of ETF strategy with Toronto-based CI Global Asset Management, said the large allocations to HISA ETFs make sense, given the volatility and uncertainty in the financial markets, and attractive yields. HISA ETFs such as the $7.3-billion CI High Interest Savings ETF can serve as a good replacement for traditional retail savings accounts, he added.
Despite earnings yields in the 5% range, investors in HISA ETFs and other cash substitutes, such as money-market ETFs, risk missing out on unpredictable market surges. Not being invested during the equity market’s best days could have a material impact on long-term returns, said Prerna Mathews, vice-president, ETF product strategy with Toronto-based Mackenzie Investments.
By sitting on the sidelines in cash, “you’re getting a nice healthy yield, but at what cost is that going to be, depending on when you’re going to be able to come into the market?” Mathews said. “Historically, that’s been quite a challenge for investors.”
At Franklin Templeton Investments, which manages the Franklin Bissett Ultra Short Bond Active ETF but doesn’t offer cash-based ETFs, there’s been a push to encourage investors to move a little further out along the duration risk curve.
“We have an oversold bond market, where essentially bonds are at discount,” said Ahmed Farooq, senior vice-president and head of retail ETF distribution with Toronto-based Franklin Templeton. As a result, in addition to high income because of the highly inverse yield curve, investors in short maturities will earn tax-advantaged capital gains from bonds that are maturing.
Farooq contended that investors aren’t being compensated for the higher risk associated with longer-term bonds. The Franklin ETF recently had a yield to maturity of 5.4% with a duration of less than six months, while the broad Canadian bond universe had a yield to maturity of roughly 4.2% with a duration of about seven years.
By going long in duration, Farooq said, “you’re going to get less yield or total return, and you’re also going to pick up a lot more volatility because bonds have an inverse relation with rates.”
Even so, according to TD Securities, government bonds have been popular this year because of their low risk profile and defensive nature. “Government bonds historically outperform during recessions and investors have accumulated government bonds to pre-position themselves for a potential recession this year,” the TD ETF strategists said.
According to the firm’s analysis of first-half flows, most purchases of cash ETFs have come from retail investors. While the retail side has also been active in government bonds, “institutions have been key players in this space,” TD Securities reported.
As for ESG ETFs, TD Securities said it observed limited interest from the retail advisor channel, while institutions have been the main contributors of trading activity and inflows into these products.
Equity ETF inflows have been weaker than normal, and U.S. equities, despite strong returns among the technology giants that dominate the broad market indexes, have seen outflows.
“The main play this year in equities has been in international stocks,” said Andres Rincon, head of ETF sales and strategy with TD Securities. This may be because investors feel they have sufficient exposure to U.S. equities, he added, “but also likely because of the tech-heavy rally we have been seeing.”
While U.S. ETFs have been out of favour, other major equity categories attracted new money in the first half. “We saw a lot more interest in international equity and emerging markets, as well as Canadian equity over that same time period,” said Mathews, who characterized the shift in investor preferences internationally as a valuation play.
Despite recent weakness in financial services and energy — the two largest sectors of the Canadian market — the domestic market continues to dominate sales of equity ETFs. “Financials really drives that in a significant way,” Mathews said, noting benefits such as the dividend tax credit. “So you tend to see continued sticky flow into Canadian equity, because financials are still providing you a very healthy yield.”
While covered-call ETFs appeal to investors because of their attractive payouts and limited downside protection, Mathews cautioned that some of these products are giving out return of capital to fund some portion of that yield. “Some of that [buying] interest may be coming from investors who don’t actually fully understand what they’re buying, and how that yield is being funded,” she said.
For investors worried about market volatility or a potential recession, Kanagasingam suggests looking for more defensive sector exposure, as well as exposure to factors that are currently in favour like quality or low volatility.
“We stress the importance for investors to remain in their strategic allocations and not risk missing out on returns, especially when they have longer time horizons,” he said. “We believe that diversified factor strategies or tactical factor tilting provide an interesting opportunity given the current economic forecasts.”
Additionally, according to Kanagasingam, long-short funds and liquid alternatives such as those based on commodities futures provide diversification and uncorrelated returns to the broad equity market. These types of strategies “have started to see some interest, but have not been fully embraced.”
Another non-core investment worth considering is infrastructure-themed ETFs. “Infrastructure can provide that defensive approach for clients with a steady income stream, and also take advantage of some of the inflation pressures that we’re all feeling,” Farooq said. He noted regulated utilities that provide essential services such as electricity or natural gas can pass cost increases on to consumers.