Exchange-traded funds (ETFs) are well on track to overtake mutual funds. That was the sentiment at the fifth annual ETF Conference for Institutional Portfolio Managers and Traders in September 2016. “Canada is a test bed of ETF innovation,” said Daniel Straus, citing currency hedges and dynamic hedging as recent examples.

“Due to dramatic declines in energy prices, Canada has been for sale,” continued Straus, an analyst for ETFs and financial products at National Bank Financial. He noted that the July 2016 outflow from Canadian ETFs hit $1 billion, and that low-volatility ETFs are attracting interest. “In 2013, we had a calm bull market, and then low volatility came roaring back in 2015.”

Nowadays, Straus said, the most popular ETFs have options in them. Options and ETFs have a “symbiotic relationship” because they have similar high liquidity, so have become a “favourite tool” of institutional investors.

“ETFs are the democratization of OTC products,” said Camilo Gil, executive director of ETF services at CIBC Capital Markets, in a look at the current market structure. “Setting up a basket of emerging markets currencies on your own would be virtually impossible.”

Not surprisingly, technology investment in ETFs has been significant in the last three to five years, according to Gil. In order to manage volatility in ETFs, he said, single-stock security breakers were brought into place for Brexit. Any volatility in markets after the U.S. election would be handled in a similar fashion.

“The relationship between the market maker and the issuer starts well before the ETFs get to market,” added Frederic Viger, managing director at National Bank Financial.

The operational risk for ETFs is relatively low: “There’s redundancy throughout the system,” said Paris Smith, a principal at Wolverine Trading. Model risk is low, too, she adds. “We try to have multiple models because we know others in the market have them.”

Operational risk links to workflow, which Bloomberg has been working on. “Two initiatives streamline fixed income ETFs,” said Dave Mullen, senior business manager of fixed income ETF products at Bloomberg LLP, who discussed creating standardization and efficiencies in tracking ETFs. The first initiative is Bloomberg’s yield and spread analysis (YAS) function, which aggregates cash flow within the fund. The second is the virtual basket (BSKT) function, which streamlines the creation and redemption workflows. (YAS is in use; BSKT 2.0, scheduled to come on stream last November, is now in use.)

Good Returns

There are three reasons for excess returns, according to Brad Zucker, senior product manager at FTSE Russell: rewarded risk, behavioural bias (such as following high-profile investors), and structural impediments (such as mandates against leverage that institutional investors have). Then there are two key questions that factor investors need to ask, he added: What are the factors, and how can they be evaluated? A “factor” in a multi-factor model is a stock characteristic, such as value or quality or momentum. About 330 factors have been suggested in the academic literature, Zucker said. Even the renowned financial experts Eugene Fama and Kenneth French didn’t have a clear understanding why certain factors worked, “but they do,” Zucker said. As for evaluation, “based on historical back-tested data, our comprehensive factor methodology displayed improved risk-adjusted index returns.”

ESG

Emily Ulrich, senior manager, sustainability, at S&P Dow Jones Indices, told attendees that, while ETFs provide good returns, there are global trends and demands for environmental, social, and governance (ESG) funds.

“Sustainable investing is slowly trickling into the mainstream,” Ulrich said, noting that many ESG funds will attract the interest of millennials, who want their investments to reflect their values around sustainability and ethical impact.

Ulrich said that some European countries have increased ESG regulation for institutional investors. “North America is a little bit behind,” she said. In Ontario, pension plans are required to disclose whether ESG factors are incorporated into their plans’ investment policies and procedures.

And there’s much thought that goes into designing ESG ETFs, according to Priti Shokeen, vice-president of Index Coverage at MSCI, an ESG index provider. “Where does the strategy fit in, who are you targeting, and what are the distribution channels?” she asked. For example, with COP21, the agreement from the 2015 United Nations Climate Change Conference, carbon is a prominent interest to institutional investors. Rules-based transparent ESG indexes will effectively communicate ETF strategies to clients.

The future for ESG funds is bright, said Toby Heaps, CEO of Corporate Knights, a body that has been ranking sustainability of corporations for 12 years. “There’s an explosion of data, interest in fintech is growing, and increasing social awareness means people want to take ESG into account,” he said.

“We compile data so people can see [ESG metrics] in a credible way,” Heaps said, adding that ETFs provide great transparency. That, in turn, can be used by robo-advisors to customize ETF offerings according to individual investors in a cost-effective way.

Smart Beta

Dave Nadig, director of ETFs at research firm FactSet, discussed smart beta ETFs, which try to combine the benefits of passive strategies with the advantages of active strategies. He noted that these products do deliver, but investors and analysts need to sort the wheat from the chaff. He described an analytical framework for the “new normal” of the investing world. “Most of the risk comes from the fact you are in the market,” he said. “Industry tilts make an enormous difference.”

Snapshot of ETFs in Canada

• Largest ETF in Canada: XIU, with C$12 billion in assets
• XIU refers to: iShares S&P/TSX 60 Index ETF from Blackrock, begun in 1990
• Number of ETF providers for Canadian institutional investors: 17
• Global growth of ETFs in the past five years: C$1.4 trillion
• Global CAGR of ETFs in the past five years: 22 percent
• 2015 inflows to ETFs: C$16.5 billion (28 percent year over year)
• 2015 inflows to mutual funds: C$29.8 billion (2.2 percent year over year)
• Number of the past calendar years in which ETFs have outsold mutual funds: 6
• Canadian equity fund outflow, as at September 1, 2016: C$2.8 billion