The tug-of-war between active and passive investing
This week, we talk to the head of the first active ETF company in Canada, Steve Hawkins, president & CEO, Horizons ETFs Management Canada. Horizons was the first to bring active ETFs to the market. To be fair, I did not think active ETFs would get broad adoption. I was wrong. You have to think about the cost of active ETFs compared to passive ETFs to be sure, but you also need to compare them with their mutual fund counterparts. The cost of the average active (I’m including smart beta in this category) is well less than half of their mutual fund counterparts — an annual savings of 50-75bps depending on the category. There are several asset classes where it just makes more sense to pay a bit more for an active approach versus a passive index-based approach. High yield, preferreds, corporate bonds, and small caps stand out to me as sectors where active selection can make a difference. Not every year and not necessarily every manager, but it’s worth a look.
About 20 per cent of the Canadian ETF industry is actively managed. This does include some of BMO’s ETF strategies, which are “technically” passively managed but don’t follow a publicly-available index methodology (passive but not index replicating). Horizons is the largest provider of actively managed ETFs in Canada.
Much of the focus of active ETFs managed in Canada is on income focused mandates. Nine out of the top 10 active mandates in Canada have some sort of income-bias.
There are number of key reasons for the preference for active:
1. Canadian income investments, particularly corporate bonds, high yield bonds and preferred shares are not very liquid. It can be expensive to transact index strategies in somewhat illiquid or tightly constrained markets.
2. Active managers can conduct independent credit analysis on issuances
3. By not being forced to buy or particularly sell issues can protect the portfolio from liquidity event to a greater degree than index strategies.
The first actively-managed fixed income ETF was the Horizons Active Corporate Bond ETF (HAB), which is sub-advised by Fiera Capital. The idea behind this ETF was actually pretty simple: Fiera was one of the largest institutional holders of the iShares Corporate Bond ETF (XCB) and came up to us in 2010 with the idea that they felt they could effectively replicate most of the exposure of the underlying index of that ETF – FTSE TMX Corporate Bond Index (Formally the DEX) with better performance by managing transaction costs and liquidities.
XCB was already at a disadvantage because it cannot hold all the bonds that are in the index, so it already had significant tracking error. Tracking error is the cost of tracking the index, which includes things like execution costs. Since not all bonds in an index are not easy to own (because they are held by others to maturity) returns can deviate from the index universe.
In the table below you can see the performance of HAB vs. XCB. Both have underperformed the index but HAB has significantly outperformed XCB. This just highlights some of the inefficiencies of indexing in the fixed income space. There is even a starker contrast in preferred shares, where active management has beat passive in the Horizons Active Preferred Share ETF (HPR).
HAB is still managed with full discretion but is a high-beta strategy to XCB. It shows us that active management can be used to generate better index or broad index-like returns than a traditional index ETF, but with a slightly higher volatility.
|1 year||3 years||5 years||10 years||15 years||Common inception|
|Horizons Active Corporate Bond ETF Comm (HAB)||0.67||2.67||3.42||4.10|
|iShares Canadian Corporate Bond ETF (XCB)||0.58||2.26||3.21||5.06||3.85|
|FTSE Canada All Corp Bond (CASH)||1.10||2.73||3.68||5.65||5.07||4.28|
Source: Morningstar Direct as at Dec. 31, 2018.
Tax benefits of super passive investing
Horizons innovated the Canadian ETF space with ETFs linked to indexes via total return (TRI) swaps for maximum tax efficiency. Tax efficiency is only available in taxable accounts (with no trading). These are ideal for investors with very long-term horizons and no need for periodic distributions. The compounding effect can be extremely powerful.
TRI ETFs are all passive index ETF mandates that use a synthetic replication process, where instead of physically holding the underlying securities of the index directly, the ETF enters into a total return swap agreement with a large Canadian bank. The counterparty (the bank) provides the total return of the index – the price return plus the compounded value of any distributions – to the unit holder upon redemption of the units of the ETF.
The key advantage of this type of strategy is the after-tax costs, since these ETFs don’t pay any taxable distributions. Regardless of whether an investor re-invests their distributions, they have to pay annual tax on those distributions. With the TRI ETFs, tax is only paid when units are sold, and when it is, it is taxed as capital gains. There are two components of costs with TRI ETFs. The management fee which tends to be very low and the swap fee. A swap fee is the charge the counter party makes for delivering the return of the underlying index.
For any Canadian equity strategies, where the dividend distributions are Canadian-eligible there is no swap-fee, which makes the ETF extremely low cost. The Horizons S&P/TSX 60 Index ETF (HXT) is the lowest-cost ETF in Canada with a management fee of 0.03 per cent and it tracks the index perfectly.
For non-Canadian equity strategies there is a swap-fee charged, which is highlighted in the table. Horizon’s believes that the after-tax advantages of holding these ETFs in taxable accounts more than offset the extra-fees associated with owning the ETF, such as non-registered accounts or even corporate accounts.
Horizons is launching two more TRI ETFs this week and a third in the next few weeks, these will provide exposure to REITS, equal-weight Canadian banks and preferred shares.
You can also find more information about my new ZZZD ETF at www.ZZZPortfolios.com . There will be a free webinar on Jan. 22, 2019 at 2:00 p.m. ET with my market update and more information on how I manage the ZZZD ETF with a Q&A session. You can sign up for the webinar on the site.
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