Back to earth

And then came 2022. “It’s been basically a full 180-degree reversal,” Noble said. After a record number of ETFs launched in 2020 (173) and again in 2021 (201), according to National Bank Financial Inc., some manufacturers are pausing to consider their strategies. Some see the downturn in the first half of this year as more than just a correction.

Steven Leong, head of product for iShares Canada with Black-Rock Inc., described the current market environment as the end of the great moderation: the period of steady growth, low inflation and short recessions that prevailed from the mid-1980s until the pandemic. Inflation is back, globalization is retreating and geopolitics is interfering with supply chains and commodity prices.

“It was very comfortable to develop a higher-risk product in a regime where most of those riskier assets were going up,” he said.

Now, investors have seen those investments go down, and volatility and correlation across asset classes has increased.

“We find ourselves in a place where we have to reimagine how a well-diversified and risk-adjusted portfolio is constructed,” said Kevin Gopaul, president and chief commercial officer, BMO ETFs, with BMO Global Asset Management (BMO GAM).

We spoke to leaders at Canada’s four largest ETF manufacturers to find out how they see the product market adapting.

Equities

After two years heavy on technology and ESG products, manufacturers are more focused on downside protection and capital preservation.

“A lot of the product providers have pivoted heavily toward defensive income strategies because that seems to be where the psychological outlook for clients and advisors is focused,” Noble said.

Demand is up for products that offer more transparent outcomes, such as dividend, low-volatility and covered-call ETFs. Clients seeking income who expect the market to be flat or slightly negative may want to consider covered calls to generate slightly better returns, Noble said.

This may appeal especially to older clients, he said, as generating income from equities could mean taking less risk on the fixed income side — a priority for some after this year’s nasty bond performance.

Sal D’Angelo, head of product with Vanguard Investments Canada Inc., said he doesn’t think covered-call products are necessary in long-term accumulation portfolios because they limit upside: “Having broadly diversified assets, and controlling your growth potential and risk exposure via broad asset allocation of stocks and bonds, is probably going to serve you better than trying to incorporate some of these more niche strategies.”

But Noble said more investors may be willing to accept the limit on gains in the current bearish environment.

Gopaul said BMO GAM’s covered-call suite, which had more than $12 billion in assets as of July 31, has attracted the most flows in its lineup this year.

The Canadian market may also begin to see more leveraged products. These are most likely to catch on in areas where investors want growth quickly or with lower capital deployment, Gopaul said. This could be the case for high-yielding sectors such as banking and utilities, or on the fixed income side.

However, “the deployment of leverage on a volatile sector, like energy, could lead to a very negative client experience,” he said.

Gopaul pointed to the rise of leveraged single-stock ETFs in the U.S. Those will likely come to Canada, he said, though they’re used primarily as trading tools for volatile stocks such as Tesla Inc.

Investors are also becoming more attuned to geopolitical risk and seeking tools to manage international allocations more deliberately, Leong said.

Russia’s invasion of Ukraine earlier this year led many asset managers to divest their Russian holdings. In most cases the allocation was small, but the change was still disruptive.

“Is there critical mass for tools that will more precisely control, for example, emerging market allocations or global equity allocations for people who want to avoid certain parts of the world or certain countries?” Leong asked. “I think you’ll see some work around those types of questions.”

And what about the innovative tech products that thrived in the past two years? BMO launched a suite of innovation ETFs in January 2021, and iShares released its tech-heavy “megatrends” ETFs in May of this year.

Gopaul still believes investors should have some exposure to the potential “next big thing,” and that the average portfolio is underweighted to disruptive technology. “That said, the market returns recently may pause further launches from issuers right now,” he said. “The market timing’s not right and we’re not sure when it’s going to be.”

Fixed income

Noble said aging clients may want less risk in fixed income after the historically bad first half of this year. Advisors more interested in 6% or 7% annual returns than in beating the market can now generate a larger portion of those gains from low-risk products, he said, pointing to flows this year into high-interest savings ETFs.

“There’s been a huge reversal toward those cash strategies, because why would you mess around with the risk dynamics of a portfolio if you can reach your target return on income using these effectively risk-free cash products for these high rates of interest that are now being paid?” he said.

While most economists and central bankers expect inflation to eventually come down, Leong said it’s likely to remain higher than it was before the pandemic. This may heighten demand for inflation-linked products and lead manufacturers to branch out in this area.

“You could imagine products that, for example, try to align inflation protection with access to corporate bonds,” Leong said.

Gopaul said this year’s bond drawdown may lead to more products in the private credit space to minimize volatility, as well as more structured products that use derivatives for the same ends.

D’Angelo, however, continued to advocate for the balanced approach. The simultaneous drop in stocks and bonds in the first half was “a very unique event,” he said, and bonds are better placed for stronger returns and to again act as portfolio ballast in the event of a recession.

He pointed to the continued popularity of asset-allocation ETFs, which had $16 billion in assets as of July 31, according to National Bank Financial, up from $13.1 billion a year earlier.

ESG

Perhaps the hottest trend in ETFs over the last two years has been ESG products. There were 127 ESG ETFs in Canada in August, according to National Bank Financial, and many launched in the past two years. In 2021, one in every five new ETFs used some form of ESG screening; in the first quarter of this year, that increased to one in three.

However, the combination of a more challenging market environment, new regulations and an ESG backlash from some corners could lead manufacturers to slow their ESG rollouts.

“I think the boom in product launches is over,” Noble said.

After the initial push to release products, manufacturers are being held to higher standards, Gopaul said. Investors want companies that perform well on ESG criteria and that will also grow their portfolios. A lot of those companies were the “high-flying names” that have come back down to earth this year, negatively impacting some ESG funds.

Noble said the “incredible” number of ESG fund launches in the last two years is part of manufacturers’ “long game.”

“It’s a multi-decade trend,” he said. “The large product providers that launched ESG funds are effectively launching placeholders in anticipation of a wealth transfer from boomers.”

In the meantime, the conversation around what sustainable investing really means, what these products deliver and which metrics funds use will continue to evolve, Leong said, and investors can expect more emphasis on the correct classification of products.