Dale Jackson

Personal Finance Columnist, Payback Time

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The amount of money flowing into Canadian exchange traded funds (ETFs) spiked by 49 per cent in 2020 from the previous year to a record $41 billion, according to a National Bank of Canada study.

The report, released earlier this month, found that buying peaked in the first half of the year amid the pandemic-inspired market selloff in March and subsequent recovery, when investors plowed cash into all asset classes – with more than half in equities.

With a total of $257 billion in assets, ETFs outsold mutual funds for the third consecutive year. Actively-managed mutual funds are still by far the most popular investment vehicle for Canadians, but the trend shows a growing preference for lower-cost, passively-managed ETFs.

But as the number of ETFs available on the Canadian market tops 1,000, the line between passive and active has blurred, and many of the newer offerings are looking a lot like mutual funds. 

When ETFs were first introduced in the 1990s, they were also referred to as index funds because they mimicked popular indices like the S&P/TSX Composite, S&P 500 and the Nasdaq. Index ETFs use derivatives to track individual holdings according to their market weight in the corresponding index. In other words, if Apple Inc. has a six per cent weighting in the S&P 500, the corresponding ETF would strive to hold a six per cent weighting, which adjusts as Apple’s weighting in the S&P 500 changes with day-to-day price fluctuations.

Index ETFs appeal to investors because they are inexpensive and transparent. You can see how the major indices are performing on a minute-by-minute basis on BNNBloomberg.ca throughout the trading day. If the index rises five percent, for example, the ETF should rise proportionally minus an annual fee that can be as low as one-tenth of a per cent.

In contrast, mutual fund managers are required to disclose very little about the stocks they pick and choose from the benchmark index. A typical annual fee (management expense ratio) is 2.5 per cent, which is subtracted from the fund’s return. As a result most mutual funds underperform their benchmark, which suggests many are merely mimicking the index as well.

Over the decades, ETFs have morphed to become more like actively managed mutual funds, with actively managed fees (and even trailer fees to compensate the advisor). Offerings with terms like “hybrid,” “smart-beta,” and “thematic” go beyond the index by using other factors such as equal weighting where every company in an index has the same value. Other strategies seek to minimize volatility or focus on criteria more closely tied to the economic fundamentals behind a country or sector. 

In addition, other methodologies include fundamental factors for selecting companies such as sales, cash flow, book value or dividends. Some ETFs target themes like climate change or disruptive technologies such as 5G.

And then there are the ETFs that fall somewhere in between.

Payback Time is a weekly column by personal finance columnist Dale Jackson about how to prepare your finances for retirement. Have a question you want answered? Email dalejackson.paybacktime@gmail.com.