Fund trends evolve in a “dangerous” time

This article appears in the March 2022 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

Mutual funds and ETFs set record sales last year as markets rallied, federal stimulus funds flowed and Canadians hunkered down with extra savings. With markets more volatile to start this year, fund selections and strategies may take on heightened significance for clients.

Products are entering “a new era of diverse experimentation,” said Daniel Straus, director of ETF research and strategy with National Bank Financial. Gone are the days of serial copycats, he said; the parade of ETFs tracking identical indexes has ended. Instead, manufacturers are putting their own spin on strategies such as ESG, sometimes in partnership with index providers. Differences among similarly labelled funds can be significant, increasing the diligence burden for investors, he said.

Straus described ETF trends such as thematic products, cryptocurrency, ESG and active management as “entrenched and barrelling forward at a rapid clip.” These trends will continue to evolve, he said, and be influenced by volatility, rising interest rates and inflation.

Given those economic challenges, greater product diversity may contribute to better returns.

Yves Rebetez, partner with Credo Consulting Inc., said firms have “a lot of clients who are getting on in age and increasingly dependent on what their portfolios are going to do for them. And this is happening at a very dangerous time” — as the market cycle ends and monetary policy evolves. “It’s difficult to foresee that we will be able to maintain the kind of performance results that people have enjoyed in recent years,” he said.

Passive or active? Yes, please

In a challenging market, low costs are a first line of defence and thus an important ongoing trend as advisors’ practices evolve to fee-based.

Dozens of studies show that fees are “a consistent detractor to performance over time,” said Ian Tam, director of investment research with Morningstar. And with consideration of fee impact on returns being part of the client-focused reforms (CFRs), he expects more assets will flow to lower-cost funds. (He’s studying asset flows to measure the CFRs’ impact.)

Tim Huver, head of intermediary sales with Vanguard Investments Canada, said the only certainty for investors is what they will pay for a product.

Advisors increasingly use passive-active combinations and core-satellite strategies — and in innovative ways, Huver said. For example, he’s seen advisors use passive, broad-based ETFs for tactical overweights and underweights.

And as advisors use ETFs to replace single stocks, there’s a movement away from home bias to more globally diversified portfolios, Huver said.

On the fixed-income side, ETF use will only increase given rising market volatility and interest rates.

“ETFs are playing a bigger and bigger role in people’s fixed-income portfolios,” Straus said. “It’s a no-brainer value proposition,” because the funds make for easier access and are diversified, transparent and low cost.

Because finding yield requires creativity, current demand favours active management, low duration, corporate credit and cash funds, Straus said.

ESG and sustainability: Opportunities and challenges

ESG is “moving money and shaking the foundation” of the industry, a National Bank report said last year, with products comprising index funds, active mandates, quantitative scoring methodologies, niche themes like green energy, and carbon-offset products.

ESG funds made up 1.6% of total Canadian mutual fund assets and 2.4% of ETF assets last year, according to the Investment Funds Institute of Canada.

Many advisors aim to capitalize from strong consumer demand — especially among younger demographics set to benefit from generational wealth transfers — as well as use the funds as a differentiator, Straus said.

Rebetez noted that investor perception of reduced returns within the ESG space seems to have abated, and product costs have dropped significantly.

Further, “investors have evolved from viewing sustainable as a satellite strategy to now viewing their whole portfolio through a sustainability lens,” said Helen Hayes, head of iShares Canada.

But challenges remain — specifically the lack of classification standards and the alignment of a fund’s investment approach with an investor’s motivation, Tam said. For example, an investor may wish to avoid oil companies, but funds may be labelled “sustainable” whether they include them or not. “It’s a bit of work for the advisor to do the research” and to determine what the client wants, he said.

Also consider the crowded market. Of a record 37 ETF launches in January in Canada, 19 were ESG-themed. (Seventy-three ESG and sustainable funds launched in 2021.) The flurry of products “runs the risk of potentially saturating the ability for the investing public to learn and adopt a lot of these ESG strategies,” Straus said.

The Canadian Investment Funds Standards Committee, which Tam chairs, is creating a responsible investment identification framework for manufacturers that aligns with the CFA Institute’s ESG disclosure framework. The Canadian Securities Administrators also issued guidance in January as to how manufacturers should disclose their sustainable practices.

Inflation represents another challenge to ESG adoption.

Energy is seen as “one of the standby trades to help withstand an inflation shock,” Straus said. “If energy performs well and the ESG category of products underperforms … that might put a damper on some of the ESG adoption, at least initially.” He added that many ESG funds did well during the pandemic because they were overweight the technology sector, which experienced a sell-off earlier this year in anticipation of rising interest rates.

Betting on themes

Beyond ESG, thematic fund choices run the gamut from cannabis and crypto to tech disruption and the metaverse.

Thematic funds can pay big, but “you’re making three bets,” Tam said: that you picked the right theme, that the theme’s value isn’t already priced in, and that you picked the right manufacturer. “The risks are substantial.”

Further, survival rates for thematic funds are much lower than for traditional ones. “The stats tell the story,” Tam said. About 30% of U.S.-based thematic funds over the last three decades are gone, and the rate is even higher for funds in other markets.

That means thematic funds should serve as complements, not core holdings. When tweaking a portfolio to take advantage of opportunities, a thematic fund offers better diversification than a single name, Rebetez said.

Alt revolution?

“Deep divergence” will also be seen, Straus said, in the innovative space of alternative investments, which use various hedge fund strategies to try to achieve performance uncorrelated to the market.

Retail investor access to alternatives is a growing trend, especially with increased market volatility and as more products become available, said Jason McIntyre, vice-president and head of advisor distribution with TD Asset Management. The firm expanded its footprint in the space when it acquired institutional investment manager Greystone Capital Management in 2018.

AGF is also focused on expanding its listed alternative offerings. “Whether that be thematic, cryptocurrency or infrastructure, there are lots of opportunities for growth,” said Judy Goldring, president and head of global distribution with AGF Management.

Product support amid KYP reforms

Asset managers are receiving more inquiries as advisors consider their enhanced obligations under the CFRs, TD’s Jason McIntyre said.

In support of the reforms, manufacturers can communicate to advisors how a product fits in a portfolio to help with suitability determinations, Morningstar’s Ian Tam said. Some fund companies are already offering portfolio consulting for advisors.

Also, as dealers assess their shelves, manufacturers can ensure the products they offer fill an appropriate part of asset allocation. For example, among the market’s hundreds of mutual funds, how many are small- or mid-cap? “Not only the depth of the shelf but also the breadth is important,” Tam said.

Does this fund make me look boring?

Thematic funds and meme stocks may grab headlines, but “advisors should be putting the majority of client assets in boring, traditional mutual funds or ETFs that get them to their financial goals,” said Morningstar’s Ian Tam.

Cap-weighted passive ETFs dominate when it comes to equities ETF flows. Consequently, in 2021, more than 50% of ETF assets and flows went to products with fees between zero and 30 basis points. Source: National Bank Financial