Executive Summary

Canadian Institutions Turn to ETFs in Challenging Markets stat bar

Canadian institutions made aggressive use of exchange-traded funds in their portfolios last year as they navigated a sharp market downturn, a surge in volatility and a series of unpredictable geopolitical events. As they contend with these risks and implement the adjustments needed to reposition their portfolios, growing numbers of Canadian institutions are using ETFs to strategically replace other investment vehicles.

Building upon an already robust use of ETFs, institutions are adding the funds to their portfolios for three main reasons:

  • Flexibility, Ease of Use and Cost-Effectiveness: ETFs have proven to be highly flexible vehicles that institutions find easy to use and cost-effective when taking on both strategic and tactical investment exposures across asset classes and portfolio functions.
  • Index Exposures: Throughout the market volatility of 2018, investors in Canada and around the world continued moving assets from active to index strategies, and ETFs are by far institutions’ vehicles of choice for index exposures.
  • Fixed-Income Liquidity: Diminished liquidity in global bond markets is fueling demand for bond ETFs, with 45% of ETF investors in the study using the funds to obtain fixed-income exposures.

Continued strong demand for factor-based strategies will remain one of the key drivers of ETF growth in 2019. Almost half of current smart beta ETF investors in the study plan to increase allocations to these strategies in the next 12 months. Of these, almost 40% are eyeing increases in excess of 10%. Additional growth will come from larger asset classes: 27% of current ETF investors plan to increase allocations to bond ETFs in the coming year, and 20% plan to boost allocations to equity ETFs. Over a longer horizon, Greenwich Associates expects the continued integration of environmental, social and governance (ESG) into institutional investment processes to emerge as an important source of demand for ETFs in Canada.

Canadian Institutions Turn to ETFs in Challenging Markets stat bar

Executive Summary

Canadian institutions made aggressive use of exchange-traded funds in their portfolios last year as they navigated a sharp market downturn, a surge in volatility and a series of unpredictable geopolitical events. As they contend with these risks and implement the adjustments needed to reposition their portfolios, growing numbers of Canadian institutions are using ETFs to strategically replace other investment vehicles.

Building upon an already robust use of ETFs, institutions are adding the funds to their portfolios for three main reasons:

  • Flexibility, Ease of Use and Cost-Effectiveness: ETFs have proven to be highly flexible vehicles that institutions find easy to use and cost-effective when taking on both strategic and tactical investment exposures across asset classes and portfolio functions.
  • Index Exposures: Throughout the market volatility of 2018, investors in Canada and around the world continued moving assets from active to index strategies, and ETFs are by far institutions’ vehicles of choice for index exposures.
  • Fixed-Income Liquidity: Diminished liquidity in global bond markets is fueling demand for bond ETFs, with 45% of ETF investors in the study using the funds to obtain fixed-income exposures.

Continued strong demand for factor-based strategies will remain one of the key drivers of ETF growth in 2019. Almost half of current smart beta ETF investors in the study plan to increase allocations to these strategies in the next 12 months. Of these, almost 40% are eyeing increases in excess of 10%. Additional growth will come from larger asset classes: 27% of current ETF investors plan to increase allocations to bond ETFs in the coming year, and 20% plan to boost allocations to equity ETFs. Over a longer horizon, Greenwich Associates expects the continued integration of environmental, social and governance (ESG) into institutional investment processes to emerge as an important source of demand for ETFs in Canada.

Introduction

Canadian institutions entered 2018 with risk management top of mind. Almost two-thirds of the institutions participating in the Greenwich Associates 2018 Canadian Exchange-Traded Funds Study say the primary challenge they face in portfolio construction this year is managing risk/return that is in line with objectives/outcomes. That share far surpasses the 46% naming “finding attractive investment opportunities that deliver good investment returns” as their primary challenge in the year ahead.

Top Challenges

This focus on risk management stems from heightened concerns about the economy and market environment. Nearly three-quarters of study participants are worried about what they see as the looming end of the current economic cycle and a possible recession in 2019. Contributing to those concerns are fears about potentially disruptive geopolitical events. In particular, Canadian respondents are worried about the negative impact of trade wars—including the ongoing renegotiation of NAFTA. Among the other top risks to institutional portfolios cited by respondents are central bank tightening, increased market volatility and current high market valuations.

As they implement changes needed to reposition portfolios quote

As they implement changes needed to reposition portfolios to contend with these risks, growing numbers of Canadian institutions are using ETFs to replace other investment vehicles. The share of study participants reporting that they are using ETFs to displace other investment vehicles climbed to 45% in 2018 from 30% in 2017. Almost 60% of institutional funds in the study say they’ve replaced some other product or vehicle from their portfolios in favor of ETFs.

Institutions are turning to ETFs over other investment options for two main reasons: 1) ETFs are highly flexible, cost-effective vehicles that institutions can apply across asset classes and portfolio functions, and 2) Throughout the market volatility of 2018, investors in Canada and around the world continued moving assets from active to index strategies, and ETFs are by far institutions’ vehicles of choice for index exposures.

Amid Volatility, Canadian Institutions Stick with Strategic ETF Exposures

Throughout the tumultuous market conditions in 2018, Canadian institutions used ETFs as a primary means of obtaining the strategic investment exposures needed to implement their long-term portfolio strategies. Although Canadian investors experienced challenging market conditions in 2018, their use of ETFs remained heavily weighted toward long-term, strategic investment exposures. In fact, average ETF holding periods actually increased, with 74% of respondents reporting holding periods of one year or longer, up from 63% in 2017. Study participants currently categorize 70% of their ETF holdings as strategic in nature—up slightly from 2017.

By comparison, in both the United States and Europe, institutional use of ETFs last year tilted toward short-term changes to portfolios that were being buffeted by surging levels of volatility and a punishing market sell-off. That shift can be seen in the increasing use of ETFs to make tactical portfolio adjustments in both markets, and in a noticeable shortening of average ETF holding periods.

In Canada, two-thirds of this year’s study respondents are using ETFs to obtain core allocations, and half use ETFs for international portfolio diversification—both strategic applications. In keeping with their increased focus on risk, 42% of the asset managers in the study are using ETFs in risk management/overlays—another critical and highly strategic function.

Applications for ETFs

Tactical applications also remain a key focus among Canadian institutions investing in ETFs. Half the study participants use the funds to make tactical portfolio adjustments, and sizable shares are employing ETFs for portfolio completion, rebalancing and transition management.

However, U.S. institutions led their Canadian counterparts in their tactical uses of ETFs last year. Average ETF allocations among current U.S. institutional ETF investors jumped to 24.7% of total assets in 2018 from 18.5% in 2017. In Canada, where institutions maintained their more steady and long-term perspective, allocations among ETF investors were essentially stable from year to year, at about 19% of total assets.

A senior financial official for a Canadian Provincial Treasury fund summed up the comments from many study participants when he explained that, in his mind, the primary reasons ETFs have become mainstream vehicles in institutional portfolios are “the ease of being able to obtain them, the ease of price discovery by going onto the Bloomberg screen and seeing where they’re trading them, and the ease of getting exposure to the asset classes without having to hire a manager to do a mandate.”

Indexation Fuels ETF Demand

At the top of the list of investment vehicles being replaced by ETFs in Canadian institutional portfolios are active mutual funds. That finding demonstrates the impact that the indexation of assets has had on the growth and evolution of ETFs in institutional portfolios.

Products/Investment Vehicles Being Replaced with ETFs

Forty-one percent of institutions that used ETFs to replace other vehicles say they switched out of active mutual funds for ETFs. Also being displaced were other products and vehicles associated with active exposures, including institutional separate accounts and individual stocks and bonds.

The institutions in the study now have 24% of total assets invested in index strategies, including 28% of equity assets and 19% in fixed income. Those allocations fall well short of institutions’ optimal target allocations—a sign that index investments are likely to continue growing in the coming months and years. In both equities and fixed income, 41% of institutional ETF investors in the study set their target index allocations above 30% of total assets.

Index Allocation

Any additional increases in index allocations in Canadian institutional portfolios will equate to more growth for ETFs, which are named as the index wrapper of choice by 81% of respondents and have already been used to replace index mutual funds by nearly 30% of study participants.

A New Frontier for ETF Investments: Cash Holdings

Bond ETFs Provide a Source of Liquidity and Yield

Canadian institutional ETF investors have allocated about 20% of fixed-income assets to ETFs for the past two years, with the highest current average allocations found among institutional funds, at 26%. Those shares could climb in 2019, as Canadian institutions implement strategies to manage volatility and risk, and to source badly needed yield.

45% of ETF investors in the study use the funds to obtain fixed-income exposures

The Canadian fixed-income market is primarily domestic in nature and, thus, differs markedly from its counterpart in the United States. Domestic assets make up approximately 80% of fixed-income portfolios among study participants overall, and approximately 90% among Canadian institutional funds.

Within this domestically oriented universe, ETFs are a mainstay for institutional fixed-income exposures. Forty-five percent of ETF investors in the study use the funds to obtain fixed-income exposures, second only to the 63% using individual bonds. Two-thirds of the insurance companies and 63% of the asset managers invest in fixed-income ETFs. By contrast, only about 30% of respondents overall use active mutual funds in fixed income, and only 20% use index mutual funds.

Reasons for Using Bond ETFs

Canadian institutions are adopting bond ETFs for three main reasons: 1) They are relatively simple to use, 2) They provide quick access to the exposures investors need, and 3) They can enhance the liquidity of a fixed-income portfolio. Other specific benefits cited by study participants include low trading costs and management fees, and the ability to achieve diversification in a single trade. In both fixed income and equities, many Canadian study respondents cite intraday pricing and trading as an important reason for investing in ETFs.

Expected Increase in Bond ETFs

To some investors, these attributes seem even more enticing today, after the volatility of 2018—and at a time when a flat yield curve is prompting many investors to look beyond government debt to corporate and high-yield bonds for yield. Twenty-seven percent of current ETF investors plan to increase allocations to bond ETFs in the coming year—more than double the share planning reductions. All of those investors are planning increases of 5% or more, with a quarter planning to boost allocations by more than 10%. Meanwhile, about 1 in 5 study participants not currently investing in bond ETFs say they are at least somewhat likely to start using the funds in 2019.

ETFs Are Institutions’ No. 1 Vehicle for Equity Exposures

Two-thirds of Canadian institutions in the study use ETFs for equity exposures—easily topping the 51% investing in individual bonds, the 35% using active mutual funds and the 22% using index mutual funds.

These institutions have integrated ETFs into their equity portfolios for one primary reason: They are easy to use. More than 70% of study participants cite an “ease of use” that makes it relatively simple to employ ETFs in a range of functions and for a variety of exposure types as a main reason for investing in equity ETFs. Beyond this basic factor, institutions point to a long list of benefits, most relating to ETFs’ ability to deliver fast market access and liquid exposures, and their relatively low costs and trading fees compared to individual stocks and mutual funds.

Reasons for Using Equity ETFs

This widespread usage has lifted ETF allocations to a steady 20% of total equity assets in 2017 and 2018 among the ETF investors in the study. We are projecting at least modest growth in 2019, as 20% of existing investors plan to increase allocations to equity ETFs in the coming year, and 40% of those investors expect to boost allocations by 10% or more. Overall investment levels will also get a boost from the arrival of new entrants: 40% of study participants not currently investing in equity ETFs say they are at least somewhat likely to start in 2019.

Expected Increase in Equity ETFs

The Smart Beta ETF Boom Rolls On

More than 80% of the ETF investors in the study use smart beta ETFs. That’s in line with usage levels in the United States, and well ahead of the two-thirds of European institutions investing in these strategies. However, relative to their peers in both markets, Canadian institutions seem to be taking a different and possibly more sophisticated approach to factor-based investing.

Institutional investors around the world now have several years of experience with factor-based strategies, which began picking up momentum in the decade since the financial crisis. Over this period, institutions have become familiar with how these strategies work and are comfortable utilizing them in their portfolios. In both the U.S. and Europe, this familiarity has brought a sense of conviction: More than half the institutions that are increasing their use of smart beta say they are doing so because they have views on specific factors they want to implement in their portfolios. Reflecting these convictions, the most popular smart beta ETF products in these markets are dividend/equity income, minimum volatility and single-factor ETFs.

Type of Smart Beta/Factor ETFs

In Canada, institutions are far less likely to have strong views on any specific factor and are much more inclined to invest in diversified, multifactor ETFs. Three-quarters of Canadian smart beta investors are using multi-factor ETFs, far surpassing the 37% using min-vol funds, the 32% investing in dividend/equity income ETFs and the 47% using singlefactor ETFs. (Forty-two percent invest in equal-weighted ETFs).

Expected Increase in Smart Beta/Factor Allocation

Institutions are clearly satisfied with factor-based ETFs. Almost half of current smart beta ETF investors in the Canadian study overall and 62% of the asset managers plan to increase allocations to these strategies in the next 12 months. Of these, almost 80% are planning to boost allocations by at least 5%, with almost 40% eyeing increases in excess of 10%.

ESG Enthusiasm to Drive ETF Demand

Approximately a quarter of all institutions in the study and 46% of the asset managers have altered their portfolios by selling out of or investing into a specific strategy on the basis of environmental, social and governance considerations. That finding demonstrates the growing influence of ESG in institutional investing and points to another potential growth driver for ETFs.

ESG Approach Led to Changes in Investment Process Products

Compared to Europe, where institutions have taken a global leadership position on the issue, ESG investing among Canadian institutions has plenty of room for growth. Although nearly two-thirds of Canadian study participants aren’t taking any action at all on ESG, 38% report that they are keeping a close eye on the topic, with the implication that they could introduce ESG into their investment processes at a later date.

Percentage of Assets Expected to be Managed According to ESG Criteria in Next 5 Years

In fact, a large majority of Canadian institutions expect to be regularly employing ESG standards in their portfolios within five years. While most of those expect the share of assets managed under an ESG framework at that point to be less than 25%, a substantial minority of one-third expect to be managing more than half of total assets based on ESG criteria by 2023.

A large majority of Canadian institutions expect to be regularly employing ESG standards quote

And rather than implementing ESG through a system of relatively simple screens that filter assets in or out of consideration for investment based on ESG criteria (the preferred method among institutions in the United States), Canadian institutions seem to be following in the footsteps of their peers in Europe and taking a more holistic view. Approximately two-thirds of Canadian study participants say they prefer an approach that systematically integrates ESG factors into all phases of the investment process.

Education from ETF providers and other sources could encourage adoption of ESG investing. One-third of study participants say they could use more information and support when it comes to understanding how to implement ESG in a portfolio.

iShares/BlackRock Remains ETF Provider of Choice

iShares/BlackRock has cemented its position as the ETF provider of choice to Canadian institutions. Almost 90% of the ETF investors participating in this year’s study use iShares/BlackRock as a provider. And study participants name iShares/BlackRock as the market’s No. 1 provider in all 10 product and service categories covered in the study, ranging from liquidity and transparency of products to service platform, innovation, range of products, and value.

Top ETF Providers

When it comes to selecting a specific ETF for investment, Canadian institutions review a long list of criteria. Starting first with the fundamental question of how well or poorly a given ETF matches exposure needs, study participants then evaluate the fund’s liquidity/trading volume, expense ratio and past performance, including tracking error. Institutions then turn to what they see as the next most important consideration: the fund company and management behind the ETF. As they increase ETF allocations, Canadian institutions are paying more attention to the tools, service and educational support provided by the companies behind the funds in their portfolios.

Top Criteria for Selecting ETFs

Andrew McCollum


Methodology

Between October and December 2018, Greenwich Associates interviewed 51 institutional investors for its sixth annual edition of the Canadian Exchange-Traded Funds Study.

The research universe included 24 asset managers, 24 institutional funds and three insurance companies/insurance company asset managers. Thirty-eight of these institutions currently invest in ETFs. Most of the participants are large institutions. More than 30% of the institutions in the study have assets under management (AUM) of more than $10 billion, 40% manage in excess of $5 billion, and nearly three-quarters have AUM of more than $1 billion. The research universe included 35 portfolio managers/chief investment officers, 11 research analysts and representation from buy-side risk management, product development/sales/marketing and trading.

Respondents