ETFs getting active

Active strategies gaining in popularity

Over the past month or two, I have been looking at different ETF options, with a focus on actively managed alternatives to the classic passive, index-tracking ETF model. I’ll wrap up this series by highlighting some of the available active ETF options, and I am highlighting Canadian-traded ETFs only.

Active strategies

Active ETF strategies are still somewhat rare with only a handful of options currently available. Quite frankly, at the moment, if you’re looking for high-quality actively-managed investments, you’re still better off using a traditional mutual fund. There is a much wider selection of high-quality mutual funds available than there are active ETFs. But that is very likely to change in the not so distant future.

As more of the conventional mutual fund companies begin to offer more ETF products, I expect we’ll see ETFs becoming even more widely available as they begin offering new active mandates or wrap some of their current active offerings into an ETF structure. We have already seen a few companies come to market with ETF versions of existing mutual fund strategies. BMO, Mackenzie, and Invesco are a few that have done that already, with more likely to follow.

Increasingly, we’re seeing funds being offering in both ETF and mutual fund structures, with the main difference being how you purchase them. Most of the current fund company ETF offerings are already structured in that way, with fees matching those charged for their fee-based units.

Here, I have focused only on those actively managed ETFs that are available in an ETF structure. Of the currently available offerings, two of my favourites include the following:

Horizons Active Corporate Bond ETF (TSX: HAB). This is an actively-managed bond ETF that is run by the fixed-income team at Fiera Capital. Fiera is a Montreal-based Canadian money manager with more than $144 billion in assets under management. This ETF is managed using a blend of top-down macro analysis and bottom-up security selection.

The process starts with an overview of the economy and bond market, with managers considering the outlook, their expected outcomes, and how the market has priced each area. This helps to identify any mispricing of assets and the consequent potential for outsized gains. The managers will also review current trends and develop some projections for central bank activity and the direction of yields.

Once this research process is complete, managers will then look for the sectors that offer the most attractive opportunities, seeking to identify individual issues where the true value has not been fully recognized by the market. The managers have the flexibility to invest in the areas where they see the best opportunities, irrespective of the constraints of a benchmark.

The portfolio is expected to be overweight corporate fixed-income issues in most scenarios as corporates tend to offer higher yields and less interest-rate sensitivity than government bonds. That will lead to outperformance in most market environments, compared with government bonds. However, it is likely there will be underperformance if we see significant market volatility leading investors to seek safe haven in government bonds.

While more expensive than the passive bond options, costs for this ETF are very reasonable. The management fee is 0.50%, which results in an MER of 0.59%.

Horizons Active Canadian Dividend ETF (TSX: HAL). This systematically managed ETF has delivered solid absolute and risk-adjusted returns for investors since its launch in February 2010. Its 5-year average annual compounded rate of return to May 31 was 4.4%, matching the S&P/TSX Composite, which returned 4.2% over the same period.

Manager Sri Iyer and his Systematic Strategies team at Guardian Capital look for Canadian companies that have the ability to pay, sustain, and grow their dividends. The team uses a rules-based screening process that analyzes 31 different factors, looking for positive rates of change. These factors focus on growth, payout ratios, efficiency, valuation, and investor sentiment.

The result is a well-diversified portfolio of around 45 names, with the top 10 making up roughly a third of the ETF’s holdings. The managers can invest in companies of any size, and approximately half the portfolio is allocated to large-cap names, with the balance in small- and mid-caps.

The sector mix of the fund is dramatically different than the broader Canadian market, with an overweight in energy, real estate, and utilities. It is significantly underweight financials, which is rare for a dividend-focused mandate.

Valuation levels are slightly higher than the broader market and the peer group. However, the stronger-quality metrics, combined with the higher forward-looking earnings growth rate, more than offsets the higher valuation, making this fund one of the more attractive options in the dividend ETF category.

The fund has also been one of the least volatile in the category, while delivering well above average returns. Looking at the defensive positioning of the portfolio, there is nothing to indicate a higher level of volatility ahead. The biggest knock on this ETF is its cost, with an MER 0.67%, which is above the category average. Still, the alpha generated has more than offset this higher cost.

Dave Paterson, CFA, is a money manager and an expert on investment fund research and due diligence on a variety of investment products

Notes and Disclaimer

Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently, and past performance may not be repeated. No guarantee of performance is made or implied. This article is for information purposes only and is not intended as personalized investment advice. Dave Paterson is employed as an advising representative (portfolio manager) by Empire Life Investments Inc. (ELII), a subsidiary of Empire Life Insurance Company. ELII is the investment fund manager and portfolio manager of the Empire Life Mutual Funds and the portfolio manager of the Empire Life Segregated Funds (collectively, the Empire Funds). As such, his employment and his compensation may be connected to the success of ELII and the Empire Funds. From time to time, the Empire Funds may buy, sell, hold, or otherwise have an interest in securities that may be discussed in this report.