What's the next battlefront for Canada's ETF space?

Anyone can say 2023 has been a year for the books for the Canadian ETF industry. But with over 20 years of experience in the investing industry, including multiple leadership positions in which he helped shape the growth of Canada’s ETF space, Pat Chiefalo can say that with more conviction than most.

“This has been an interesting year in the industry, certainly for ETFs,” says Chiefalo, head of ETFs and Indexed Strategies at Invesco Canada. “Investors’ appetite on what they’re leveraging in their portfolio has changed.”

Chiefalo recalls how over the past era of low interest rates, flows into plain-vanilla and equity ETFs were strong and consistent. During that time, he took part in many conversations around fixed income’s value as portfolio ballast, though anaemic yields on bond ETFs made them a tougher sell.

But with the dramatic increase in interest rates over the past year and a half, he says interest in fixed income has roared back. “The use of ETFs for cash-like purposes, people running to shorter duration, and demand for higher credit quality has been quite apparent,” Chiefalo says. “This year, I think we really saw investors beginning to use ETFs for that part of the portfolio where they’re looking for ultra safety.”

A dash for cash-like and fixed-income ETFs

The torrent of demand for cash-like ETFs in 2023 has certainly been strong, but Chiefalo believes we could see a moderation of flows into 2024. Broadly, he sees further expansion for fixed-income ETFs, which have attracted close to $20 billion in assets this year, a tsunami of inflows far outpacing the approximately $8 billion that’s gone into equity ETFs.

“Now, not only do you have some of the protection qualities of fixed income as part of a traditional portfolio, but you also have yields which are incredibly attractive,” Chiefalo says. “I think that significantly raises the bar for any other asset class in terms of the return that they could offer.”

To put things in perspective: Chiefalo estimates a triple-A rated fixed-income product with zero duration today could see yields as high as 5.5%. That makes it harder than it has been to convince investors to take on additional duration, credit, or other risks that defined the past decade of having to go further out on the risk spectrum in search of yield.

“I think fixed income has become an incredibly attractive area of the market. People are acknowledging this with their dollars,” he says. “Whether rates move, and how they move will have a significant impact on where investors allocate their capital in the fixed income space moving forward. But I think as a whole, it’s seen a resurgence in appetite … it’s become an area of huge emphasis.”

Looking at other asset classes, Chiefalo notes how despite Canada’s status as a resource-dependent economy, commodity ETFs have only captured roughly $2 billion of the total $380 billion of the Canadian ETF space’s total AUM, and development around broad commodity ETFs has been limited.

“We have all these products in the space. But because Canada is already heavy on commodities as a benchmark anyway, it may have more limited appeal as an asset class,” he says.

After a burst of product launches in 2021, crypto ETFs suffered a harsh winter at the tail end of 2022 alongside broad difficulties in the public markets. While cryptocurrencies as an asset class are starting to regain some traction, it remains to be seen whether they’ll have the staying power needed to bring Canadian crypto ETFs up significantly from their current $2.4-billion AUM market share.

Options and factors on the rise

Coming onto the back half of 2023, Canada’s ETF space has seen derivatives take on a growing role in traditional ETFs and 81-102 funds. For investors looking to get more juice out of every dollar squeezed, the non-delta one exposure offered by layering derivatives on top of traditional market exposure could offer some opportunities.

But on the flip side, Chiefalo says the bar of expectation is going to be set higher for these emerging products. Over its multi-decade history, Canada’s ETF industry has seen several examples of ETF innovations that took off from a base of investor excitement, only to see nothing but outflows after failing to perform how investors imagined they would.

“Those products become much more complex, and the fee structures become much higher and complex very quickly,” he says. “I think the bar to help and educate investors, and for investors to understand how these products are going to work is significantly higher than any traditional ETF out there. I think that’s something the industry needs to be aware of.”

One area that’s seeing more interest, Chiefalo says, concerns factor ETFs. While the category has existed for a number of years, he argues this year has brought the seeds of a coming-of-age for factors.

“Recently, there have been some products in the space that are not necessarily offering straight factor exposure to investors,” he says. “What I’m seeing this year is more leveraging of factors, bundling them with an asset manager’s strategy to deliver a particular outcome for investors.”

While thousands of factors have been created that cut through the stock market in different ways, Chiefalo sees development and interest coalescing around traditional factors like value, momentum, low volatility, and market cap.

As 2023 comes to a close, the Canadian ETF industry is entering a new year with a challenging outlook. With higher interest rates, an economic slowdown, and other difficulties in the offing, Chiefalo anticipates investors will look to narrow the number of providers and relationships they work with. Parallel to that is an increased likelihood of asset managers rationalizing their shelves as strategies fail to win investors over or see their time in the sun end.

“Products that are working well and resonating with investors should be very well supported. For other products that people haven’t connected with yet or haven’t quite panned out as hoped, I think it’s absolutely proper for people to pull back,” Chiefalo says. “We certainly don’t have a shortage of ETFs in Canada … At the same time, I have a continued firm belief that the number of products will grow, and we’ll see additional providers come in.”