Morningstar expert weighs in on headwinds to market share, why fee competition hasn't taken hold, and investors' outcome focus
Canada’s strategic-beta ETF space is over a decade old, but if a new report from Morningstar is any indication, there’s still room for it to develop.
In its recently released annual Global Guide to Strategic-Beta Exchange-Traded Products (ETPs), the research firm noted that the strategic-beta space has exhibited more rapid growth than the broader ETP market. In 2019, assets in such products globally grew by more than 36.1%, with top-line growth propelled by rallying equity markets and US$93.2 billion in net new cash flows going into strategic-beta ETPs.
A growing sliver of the Canadian ETF market
With US$15.4 billion at the end of 2019, Canada represents just a 1.4% sliver of the world’s US$960.6-billion strategic-beta ETP market. From an asset standpoint, the Great White North grew in pace with the global average, registering a 37% surge last year.
But even with that growth, strategic-beta mandates still represented only 9.8% of the total Canadian ETF market by assets. In fact, its market share by this measure has held steady at around 10% since 2014.
“I think that’s really reflective of the market being saturated in the types of investors that use those products,” said Alex Bryan, Director of Manager Research, Passive Strategies, North America at Morningstar and one of the report’s authors. “Investors who would find these types of products attractive have known about them for a while, and there hasn’t been a whole lot of new adoption.”
Performance is also part of the issue. Many strategic-beta products overweight stocks with lower valuations and smaller market capitalizations, which have faced headwinds over the past five to 10 years.
“While strategic-beta funds may be cheaper than traditional active stock-picking strategies, they still for the most part charge much higher fees than the lowest-cost index funds,” Bryan added. “And most investor money has tended to go to the lowest-cost corners of the broader fund universe.”
A cost-conscious attitude has evidently taken hold in Canada, he said: asset-weighted average fees are lower than equal-weighted average fees in almost every case across the whole fund space, not just strategic-beta funds. But that hasn’t translated into strong price competition among asset managers, as management fees in Canada remain far above those seen in the U.S.
Fees have certainly gone down over time in Canada, thanks in no small part to the so-called “Vanguard effect” that’s manifested since the investment giant made its debut in the country in 2011. But that pressure, Bryan suggested, may have been offset by the grip certain players have on distribution.
“In many cases, particularly among the banks, you have a captive distribution network; one provider has its funds that it’s able to sell through its advisor network without really talking about funds from BlackRock or Vanguard,” he said. “It’s not the same as in the U.S., where there are more self-directed brokerage accounts and people can pick and choose the fund provider they want.”
An outcome orientation
Canadian investors in strategic-beta ETFs appears to be driven by outcomes. Dividend strategies were the runaway leader across multiple measures of popularity: they made up around 40% of Canada’s strategic-beta space by assets at the end of 2019, and attracted US$494 million of investor capital that year – more than any other strategic-beta group.
“The data suggests most investors may not be so well versed with factors or the academic research underlying them,” Bryan said. “They don’t care how the sausage is made. They just care about what they’re ultimately getting.”
That outcome orientation was also reflected in Canadians’ appetite for risk-oriented funds. They accounted for 21.2% of assets in the country’s strategic-beta ETF space and were the second-largest strategic-beta group by the end of last year; they also received the third-largest amount of capital with US$396 million in inflows. Together, dividend and risk-oriented strategies soaked up around two thirds (68.4%) of total 2019 net inflows into Canada-listed strategic-beta ETFs.
“The whole strategic-beta space is slowing down as far as new product launches and flows show,” Bryan said. “Dividend funds continue to see healthy flows from a market-share perspective. I don’t think we’re at maturation yet, but the growth of those strategies certainly has been slower over the past five years compared to the half-decade before that.”
As the extreme low-interest-rate environment appears set to persist for the foreseeable future, Bryan believes dividend strategies will continue to resonate with investors seeking to meet their income goals. And given the recent resurgence of volatility in the markets, the same can likely be said for risk-oriented strategies, though investors would need to temper their expectations.
“During the COVID selloff, which by our measures happened between February 19 and March 23, a lot of those strategies actually lost as much as the market; some lost a bit less, some a bit more,” Bryan said, noting how betas for all stocks converged toward 1 amid a broad rush from equities into safer assets. “So while low-volatility strategies tend to offer better downside protection over the long term, they’re still 100% invested in stocks and won’t offer protection all the time.”
The implied lesson is a twist to Warren Buffett’s famously quoted advice for people to invest in what they know. Instead of letting their decisions be determined by trends or taking outcomes for granted, investors should do a deep dive before making any long-term allocation to strategic-beta funds.
“Strategic-beta funds may be index funds, but they’re active strategies; you’re making a bet relative to the market,” Bryan said. “Sometimes those bets will pay off, and sometimes they won’t. I think the key to success is for investors to do their homework, understand what it is they’re getting, and stay committed in those funds for the long term so they can benefit when the strategies do work.”
