When Raj Lala launched his ETF firm two years ago, there were 25 ETF issuers in Canada. Now, there are 37.
“[The ETF space] is definitely becoming more crowded,” says Lala, president and CEO of Evolve Funds Group Inc. “The banks are getting more focused on [issuing ETFs]. The big asset managers are getting a bit more focused on the space as well.”
(All organizations are based in Toronto unless specified otherwise.)
In January, CIBC Asset Management Inc. launched its first ETFs, making it the last of the Big Five banks to enter the market. (Montreal-based National Bank Investments Inc. (NBI) followed in February.) That same month, BlackRock Asset Management Canada Ltd. and RBC Global Asset Management Inc. formed RBC iShares, a blockbuster partnership that combines Canada’s largest and fifth-largest ETF providers and distributes BlackRock ETFs through RBC’s parent bank’s network.
“I don’t know whether I would do it today,” Lala says of launching an independent provider. “I don’t know that there are as many opportunities today as there were when we launched.”
Canada’s ETF market continues to grow. The number of products has ballooned to 715 as of the end of June, according to data from New York-based Strategic Insight Inc., compared with 513 two years earlier. There was $181.1 billion invested in ETFs as of the end of June, up from $157.1 billion a year ago, according to NBI’s data. That 2019 figure compares with $1.53 trillion invested in mutual funds.
Pat Dunwoody, executive director of the Canadian ETF Association (CETFA), says the difference between assets under management (AUM) held in ETFs and in traditional mutual funds shows there’s still plenty of room for the ETF market to expand. “If the flows continue the way they are, I can comfortably see [ETF AUM] at $500 billion in a couple of years,” she says.
There are questions arising from that growth: what will that growing market look like; and will it include the smaller providers and niche products that exist today? Smaller firms face a number of challenges, including compliance costs, gaining advisor attention, competition for shelf space and cost compression that pushes investors to hold passive funds.
Dunwoody says she hasn’t seen broad impact from the RBC/BlackRock deal yet. Small firms still come to market when they believe they have the right product, she says. “Whether [the RBC/BlackRock joint venture] is the first of many, I have no idea,” she adds.
The RBC/BlackRock partnership has the ETF industry talking about consolidation, though. Mark Yamada, president and CEO of PÜR Investing Inc., says Canada’s market is too small for niche firms to survive. The main barrier is shelf space: know-your-product regulations require financial advisors to know more about what they’re selling, he says, which gives advisors an incentive to draw from a narrower product shelf.
From a compliance perspective, a narrow product shelf is much easier to manage than one with hundreds of ETFs. Managing liability takes precedence over product fit, Yamada says, and this favours big, established ETF manufacturers — even if small providers offer excellent products. Building a client’s ETF portfolio “is a whole lot easier if somebody knows the product manufacturer or the asset manager that is constructing these ETF portfolios; then, [advisors] don’t have to worry about the underlying product itself,” he says. “Advisors will think: ‘How could I go wrong putting an iShares product up there, as opposed to some itsy, wee, six-product ETF sponsor?'”
There’s no transfer agent for ETFs that keeps track of which advisors are selling which products, which makes reaching advisors even more difficult for ETF providers, Dunwoody says. Providers know the total AUM by firm, but not at a more granular level. Although CETFA is working to build a database, she says, ETF providers have to take a “shotgun approach” to disseminating product information. This necessity further favours banks’ extensive distribution networks.
Evolve uses thematic ETFs — what Lala refers to as “conversational alpha products” — to win advisors’ attention. The company has ETFs focused on niche themes such as cybersecurity, e-gaming, the future of the automobile and gender diversity. To some extent, the products’ marketing is built into their themes.
Carol Derk, partner at Borden Ladner Gervais LLP in Toronto, says niche players often use a prospectus as an opportunity to create buzz because of the distribution challenge. She’s helped firms, including Calgary-based SmartBe Wealth Inc. and Evolve, launch ETFs.
“[A prospectus] is definitely much more of a marketing document for these smaller players,” Derk says. “Without that, advisors and investors are not going to be asking for those products.”
Thematic ETFs also open the door to selling more conventional products, Lala says. Clients read an article about a niche product and call their broker, who asks Evolve for more information about the product. That often leads to the advisor selling a global bond or preferred-share fund rather than the niche product.
“In many cases, that’s just more straightforward, in terms of positioning within client portfolios,” Lala says.
Fitting a niche product such as an e-gaming ETF into a client’s portfolio is a challenge. When creating the products, Lala says, Evolve tries to offer access to new areas of the market while ensuring the holdings won’t duplicate what investors already own. For example, only three of the 37 holdings in Evolve’s cybersecurity ETF overlap the S&P 500 composite index, he says. Still, he says, “it’s not always easy for advisors to see that specific line between their interest level and how an ETF actually fits in with the portfolio.”
Yamada says thematic products are the easiest way to “create mind space” among investors. But that ability still doesn’t get around the difficulty of persuading advisors who may be uncomfortable with untested products or providers to use a thematic ETF. “[Advisors] are much happier to fail conventionally than to succeed unconventionally,” Yamada says.
Art Johnson, co-founder and chief investment officer with SmartBe Wealth, says big companies will dominate the index fund space, but there’s room for smaller players in active ETFs. His firm launched SmartBe Global Value Momentum Trend Index ETF in January, a multifactor product with a management fee of 0.86%. It’s SmartBe’s only ETF.
Johnson’s pitch to advisors is education: if you want to understand smart beta products, that’s all his company does. “There’s a huge interest in smart beta, but there’s a disconnect,” he says. “You have to educate the advisors. Factor portfolios have to be explained.”
Furthermore, advisors’ ability to demonstrate their value to their clients is “under assault,” and so is their time, Johnson says: “They just can’t be investment managers anymore; they have to be planners and they have to be estate people, and they have to have all these additional value-adds in their business to compete now.”
Advisors won’t buy passive ETFs, Johnson says, “because they’re afraid that their value proposition goes away. Active ETFs are kind of the sweet spot.”
Johnson says he’s working with advisors who have discretionary power who are looking to put 10%-20% of their overall book in a strategy that matches SmartBe’s. This makes for a “long incubation” period to explain the firm’s product and how it fits into portfolios. The sales cycle is six to 18 months, he says, but referrals are frequent.
Factor products’ complexity means traditional ETF wholesalers, who attend multiple meetings per week, can be hard-pressed to put in the time required to explain these products, Johnson says.
However, Derk says, niche players can also be more nimble than some of their larger competitors. “Because [niche players] are focused on one particular strategy, they’re much closer to what’s happening in the marketplace,” she says, while banks have more departments involved, which potentially slows product releases.
ETF providers also can be optimistic that the number of advisors selling their products will increase. Dunwoody says roughly 55% of advisors licensed through the Investment Industry Regulatory Organization of Canada use ETFs — i.e., slightly more than 16,000 advisors. That’s only about 15% of the broader advisor universe if advisors who are licensed through the Mutual Fund Dealers Association of Canada (MFDA) are included, and she hopes the overall percentage will rise as MFDA- licensed advisors begin selling ETFs.
“There’s still a lot of room for [the ETF market] to grow when you compare it with the mutual fund industry as a whole,” Derk says.
While Dunwoody anticipates ETF AUM will grow exponentially, that may not be the case for the number of products. She says the number could plateau once banks introduce their suites.
The glut of options is a concern, says Yamada, who believes the glut will lead to simple model portfolios of ETFs. Bank branch networks provide further incentive for this approach, he says: banks aren’t likely to invest in certifying MFDA-licensed branch advisors to sell ETFs, so banks will create mutual funds that comprise ETFs for those advisors to sell at competitive prices.
Meanwhile, some of the 715 ETF products extant in the market today won’t remain viable. “There are so many that are just orphans out there,” Yamada says, attributing the reluctance to terminate ETFs to branding concerns.
Fourteen ETFs have terminated or announced impending termination this year as of July, according to Strategic Insight, while another five merged as part of the RBC/BlackRock deal. Issuers launched 55 over the same period.
Derk says $20 million in AUM is the low end of the break-even mark for an ETF, with large manufacturers looking at $100 million.
Determining when to give up on an ETF is a mix of art and science, Lala says, combining the ETF’s operating costs with an assessment of its potential to catch on. He says it’s difficult for niche products to reach $100 million in AUM. (Evolve’s cybersecurity ETF’s AUM is around $75 million.) Reaching that $100-million threshold has other benefits, though. Sometimes, Lala says, advisors may be interested in a niche strategy, only to find it averaged just $10,000 of volume in the past few days, so they change their mind. “When you get a fund to $100 million, you’ll tend to have decent volume on a daily basis,” he says, adding that reaching $100 million in AUM opens up the product to some fund allocators, institutional investors and family offices.
Derk says it’s very difficult for advisors to predict which funds will endure and which won’t. For example, no one anticipated TD Asset Management Inc. (TDAM) would shut down its initial ETF products a few years after their launch in 2001, she says. (TDAM launched another lineup of ETFs in 2016.)
The challenge for advisors is that they may not be able to find a comparable replacement if a niche-thematic ETF is withdrawn, Derk says. They must be able to explain to clients that there isn’t an alternative.