By Paul Kovarsky, CFA
Ever since Toronto 35 Index Participation Units (TIPs 35) went up for sale in 1990, Canada has played an outsized role in the development and evolution of exchange-traded funds (ETFs).
So where are ETFs headed in Canada and around the world? Peter Haynes, CFA, managing director of index products at TD Securities, explored these questions in a recent interview with Paul Kovarsky, CFA, touching on the rise of fixed income ETFs, the role of market makers in the ETF space, and even the potential of marijuana ETFs, among other topics.
What follows is a lightly edited transcript of the conversation.
CFA Institute: Can you start at the proverbial 30,000 feet up and tell us how ETFs fit into the major investment themes playing out in the Canadian market?
Peter Haynes, CFA: The way to think about the role of ETFs in Canada is to look back on the evolution of the product and its time of arrival in the Canadian investment landscape. The way the institutional investment industry evolved in Canada was to be an early adopter of diversification strategies outside the home country through mostly derivative-based strategies.
If you look back to when the first ETF in the world was launched - the TIPS product on the Toronto 35 Index in 1990 - it was designed primarily for retail investors. However, the entire $150 million issue, when it was launched, went to the institutional community, partly because this community was accustomed to using non-standard trading vehicles to gain beta exposure.
As ETFs became a popular asset allocation tool in the last, say, five to 10 years, those same institutions have realized the benefits of ETFs as part of those asset allocation strategies. You'll see significant holdings among the pension funds and asset managers in Canada that are holding ETFs for exposure to specific segments of the market around the world and in individual countries.
Sounds like investors are feeling much more comfortable with ETFs invested in public equities, but that is not quite the case when it comes to fixed income investments. Have you paid much attention to that?
Absolutely. However, I don't view this as negative as it is important to discuss liquidity issues and an understanding of the structure of fixed income ETFs.
To that end, there's been a lot of work done with fixed income participants in Canada and globally by the large providers to educate the fund managers about liquidity concerns, maybe in some cases, unfounded concerns.
It is, however, extremely important for investors to understand that the liquidity of an ETF is not a function of the number of shares that ETF can trade each day or its bid-ask spread. It is primarily a function of the liquidity of the underlying securities that exist in that particular market. People need to understand that there is a linkage. It doesn't mean that there's anything wrong with the ETF product or that fear-mongering is justified. It just simply needs to be understood.
That's the education process that's ongoing right now in the Canadian fixed income world. Like equities, in the Canadian fixed income space, institutions are very active in owning ETFs for access to fixed income exposures in other marketplaces - high yield in the US and elsewhere.
Like in the United States, ETF market makers play a big role in Canada. In the United States, how they exchange underlying securities for shares in the ETF through create-redeem mechanisms may be re-shaped by proposed FINRA regulatory developments. How is this part of the evolving ETFs environment in Canada?
One of the least understood risks associated with the ETF business, in my opinion, is that there is an infinite number of market makers to support any new products being launched.
Maybe it is a lack of understanding that each one of those new products requires capital to be provided by a market maker, and also for a market maker to be responsible for keeping bids and offers on the exchange where the ETF is listed at all times within a certain spread requirement. That requires a significant technological outlay for the dealer as well as capital, which is much more dear for banks, in particular, in today's marketplace. I think that at some point there is going to be a consolidation of capital that's provided in the market‑making space to a smaller group of counterparties.
Like it or not, existing and prospective ETF providers need to know this fact: There is not an infinite amount of market‑making capability in the United States or here in Canada. You've seen high profile organizations like Goldman Sachs pull back from market making in certain US ETFs. I do think there will be a point in time where we reach a limit.
One of the proposals that has come out of FINRA is changes to Rule 5250 to allow ETF issuers to compensate market makers for the job that they're doing, both the capital they're committing as well as keeping markets in line on an ongoing basis.
I'm intrigued by that possibility and in favor of it. Perhaps that's because I work for an organization that is a market maker. I do believe that this would be a way for organizations to compensate for what, right now, is a very low margin service that can only make sense when combined with broader mandates for investment banks. I don't think the specific market-maker role is well understood as an integral part of the ETFs ecosystem. It is not a free good or philanthropic service.
We've seen payment programs for market makers implemented in Europe and proposed in the United States. It's an interesting divide among the ETF issuers in the US between some that are in favor and some that aren't. I'm in favor. I would recommend a similar process in Canada should we see that type of approval occur in the United States.
The proposed FINRA Rule 5250 may be one of those rare cases when people who typically have very different commercial interests agree with one another. What's the argument against it?
There are some extremely thoughtful letters. I'll point specifically to the one from State Street that was written in response to the FINRA Rule 5250 proposal. They raised several very important points.
Part of the concern is that you will have consolidation among a very narrow group of partners. Potentially, you're picking winners and losers. We're into a world where there is perhaps certain relationships that are being favored over others.
The other aspect of the 5250 proposal that needs to be understood is that when you read it and you read the comments, it sounds like the whole purpose of the proposal is to narrow bid ask spreads to make markets better.
To me, the proposal is more about being able to maintain the market‑making relationship that exists today as a very, very low margin business for organizations that are in it, and being able to continue and find ways to earn an appropriate return on investment. Market making on its own is a very, very low margin business with significant technology outlay and significant technology risk.
There have been some thoughtful comments on both sides of the debate. I just happen to believe that this is something that market makers are going to need in the long run to continue to provide the services - not necessarily for the extremely liquid names that we're all familiar with, but maybe more for the niche products that don't trade as frequently.
Another less-well-understood part of the trading environment with ETFs is how orders are routed and managed by dealers. Can you help us make sense of the relationships between marketplaces and the incentive structures that create so-called agency conflicts? How does Canada differ from the United States in this respect?
One of the issues that investors and brokers are concerned about is that marketplace rebates that are offered to incentivize order placement may, in fact, lead to conflicts of interest and agency conflicts for brokers that are executing those orders.
The SEC is in the process of proposing a pilot study that would basically separate stocks and ETFs into four different groups with differing exchange fee structures, one of which would be a group of securities where marketplaces cannot offer rebates. The whole purpose of creating this segmented market of different groups with different fee structures on exchanges is to test and determine whether or not there, in fact, is an issue with respect to rebates and creating bad behavior.
I do believe that rebates contribute to a lot of the complexity in market structure, in terms of enabling different marketplaces to exist solely on the basis of different fee structures. I'm certainly a proponent of this study. It's interesting. When you look at the comments that have come back to the SEC, when you look at the different categories of participants that have responded, one thing is universal: Asset owners and asset managers are completely in favor of the SEC doing this pilot.
The one area where there is some concern is around exchange‑traded products. There are some participants that believe that exchange‑traded products should not be included in the study. I believe that with careful consideration, regulators can construct the groups and make sure that like ETFs are in similar pockets so as not to create some form of fee arbitrage differentiating one product from another.
Not surprisingly, the primary listing exchanges are diametrically opposed to this study, and these organizations certainly are launching some fairly aggressive defensive campaigns and rhetoric that suggest this study would be bad for issuers and investors. With due respect, if issuers are concerned by the listing exchange rhetoric, then I suggest they contact their shareholders for perspective.
We'll see how this plays out. My sense is that with asset owners and asset managers in favor of this, it will move forward. It will include exchange-traded products and we will mirror the exact same process here in Canada.
Keep in mind, one interesting aspect about trading in Canada is that our most active stocks like BlackBerry (NYSE:BB) and TD Bank (NYSE:TD) are also listed in the United States as the exact same fungible security. The fact that these so-called inter-listed securities trade in two different markets and different currencies makes it important that we are aligned with whatever rules are contemplated in the US.
Sounds like a market micro-structure battleground out there. Equally consequential to investors in Canada - sometimes not in a good way - is the foreign-exchange risk inherent in investing outside the home country. What are your thoughts on how this foreign exchange risk can be managed in the ETFs context?
As early adopters of global diversification, Canadian investors are very experienced at measuring and managing currency risk.
What is very interesting in the last, say, five to 10 years is, as we've moved down to a very low‑volatility environment for equities and even lower for fixed income, we have an environment now where volatility in equity is not that much higher than it is in currency. This means that the percentage of returns for investors through currency bets and hedging decisions is, in some cases, very material relative to the overall portfolio returns. So I think, now, more than ever, institutions are following very carefully their decisions around hedging foreign exchange.
Generally speaking, these sophisticated institutions that would use ETFs for global exposure would manage their own currency risks associated with that rather than looking for a currency wrapper inside an ETF.
You mentioned that despite a recent spike, which has since abated, equity market implied volatility is low compared to long-run averages. How does this phenomenon influence the net inflows of investor funds into ETFs?
First of all, prevailing low volatility has created a new segment on the ETF market related to low volatility strategies in the smart-beta space and also ETFs utilizing a strategy of buying stocks and selling out-of-the-money call options - a so-called buy-write or covered call ETF.
Given the popularity of these option strategies, it is possible that, to some degree, the low‑volatility environment that we're in is self‑fulfilling, and that some of these overwriting fund structure guys are actually having an impact of dampening stock moves through the option trading required by option market makers' hedging.
Global investors perceive the Canadian market as relatively concentrated in a few sectors of the economy, such as commodities, property and financials. What else should they know?
Canada, historically, has been known as a marketplace where, when you see perhaps an inflationary outlook that's positive or aggressive, that you might think that with its exposure to cyclical industries, commodities, energy, etc., that Canada would be a marketplace where you would want to jump in if you felt that that was the direction of the market.
It's been a long time since we've seen that bid from non‑domestic investors. It's really been a very slow‑moving environment here in Canada. Selfishly, we're hopeful at some point, as a Canadian brokerage firm supporting the Canadian equity market that we will see a late cycle "Made in Canada" rally that draws in non-domestic investor assets.
Funny enough, if you were to ask global investors today, "What's the number one theme in Canada?" It would be investing in marijuana stocks. We've seen a significant number of ETF products launched that are linked to the fledgling marijuana industry in Canada that will benefit from the legalization of marijuana for Canadians expected to occur at the end of this summer.
The size of the market for recreational marijuana use is perhaps three or four times as big as the medical marijuana space. A lot of Canadian and global investors and particularly retail investors have been trading the marijuana theme in the Canadian market. That's been probably the most interesting theme that has been capturing the mind space of the individual investor and, more recently, certain institutions in Canada, as well.
"Capturing the mind space of the individual investor" seems to apply to both legalized marijuana, in particular, and ETFs in general. Thank you for sharing your insights, Peter.
No problem, Paul. Thanks for including me.
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