Why passive strategies still dominate in ETFs

The ETF industry began with index funds, and more than three decades later, indexing still dominates, accounting for more than three-quarters of assets in Canada. Yet over time, the asset mix by strategy type has evolved, as have how advisors use ETFs.

Led by the $11.2-billion iShares S&P/TSX 60 Index ETF and the $9.4-billion BMO S&P 500 Index ETF, broad-market index strategies remain the most popular type of ETF. But their market share has shrunk to 55%, according to TD Securities Inc., amid proliferation of innovative approaches such as rules-based indexing, thematics and fully active management.

When all types of index-based strategies are included, according to the TD Securities analysis, the total market share of index ETFs rises to a commanding 77%. Style and custom indexing constitute 13% of the market.

Additionally, what TD Securities refers to as “discretionary indexing” makes up 9%. Although these strategies are index-based, they’re not fully passive. “The manager does have some sort of discretion to a degree, especially when it comes to tracking error,” said Andres Rincon, TD Securities Inc.’s head of ETF sales and strategy.

Along with not being compelled to track the index exactly, discretionary index managers may themselves created the index. Alternatively, Rincon said, an index provider might have created it on behalf of an issuer. “But we generally find in many of these cases the portfolio manager or the issuer had a lot of input into construction of the index.”

Among non-index strategies, “fundamental active” accounts for 15% of the market, with another 8% in factor-based and quantitative approaches, according to TD Securities. “The discretionary world will continue to grow,” said Rincon, as more mutual fund companies leverage their existing capabilities in active management by creating ETF share classes. “We have a lot of active managers [running] active strategies that don’t have ETF versions.”

Among the most prolific providers of actively managed ETFs is Toronto-based CI Global Asset Management. Of its roughly 120 listings, about 90% are “non-passive” strategies, said Nirujan Kanagasingam, vice-president and head of ETF strategy. Half of the CI listings consist of fully active mandates in which the portfolio managers may select and weight securities.

“Where we really built our name was on offering non-passive solutions. But we do understand that there’s definitely a market for traditional passive ETFs,” said Kanagasingam, referring to a suite of index ETFs that CI launched in 2021.

“The way we look at it is to provide investors with choice and really let investors complement the beta or index solutions with actively managed products, whether [they] be systematic or fully active.”

Nor does the use of passive index ETFs necessarily mean passivity in how they’re deployed. “The vast majority of ETF users are using ETFs more in what we would consider an active way,” said Tim Huver, head of distribution at Toronto-based Vanguard Investments Canada Inc.

Advisors can use index ETFs as portfolio building blocks or to make tactical calls, taking advantage of their transparency and predictability of holdings. “We’re seeing the blending of both passive and active strategies more so than what we’ve seen in the past,” Huver said. “So to create better risk-adjusted returns, to help lower the overall cost of a portfolio, the inclusion of passive ETFs are a good fit.”

Some asset classes better lend themselves to active approaches, said Kanagasingam. “The less efficient a market is, the more opportunity there is for active managers to exploit and really outperform an index-based strategy.”

Kanagasingam cited fixed income, since passive market-cap-weighted strategies hand the largest weightings to the largest debt issuers. “Intuitively, this doesn’t make a lot of sense, as it leaves you with the greatest exposure to borrowers with the greatest amount of debt.” Elsewhere, large active managers like CI have greater access to new offerings in less liquid asset classes such as preferred shares and real estate investment trusts.

Huver downplayed asset class as a factor in choosing active over passive. He said competent portfolio managers, a patient long-term outlook and cost are more important considerations for active management.

Though best known as a provider of passive indexing, the U.S.-based Vanguard organization also is one of the world’s largest active managers, Huver said, employing both factor-based and fully discretionary strategies.

In Canada and elsewhere, Vanguard has chosen to offer traditional active strategies as mutual funds rather than as ETFs. One reason is being better able to manage capacity constraints: it’s much easier to impose a sales cap on a mutual fund than on an ETF.

Another key consideration is the requirement to make daily holdings disclosure to ETF market makers. “We ultimately are looking at the best interests of investors,” said Huver. “Does it provide a level of transparency we’re comfortable with? You want to avoid front-running and piggybacking on the strategy as well.”

Though Vanguard isn’t alone, most active managers don’t share its unwillingness to offer fully active ETFs. “Continuous disclosure to market makers has not been an impediment to active growth in Canada,” Kanagasingam said. He noted that, as with mutual funds, public disclosure of holdings by ETFs is required only quarterly.

Rincon said “a very small subset” of managers simply don’t want to disclose their holdings daily, even though market makers such as his firm have processes in place to ensure confidentiality. “Generally it’s never been an issue across the Street.”