Incremental innovation in Canadian ETFs

Expanding choice and meeting investor needs

There are over 8,000 products listed on 68 exchanges in 58 countries by 461 ETF providers. U.S, European, and Canadian ETF assets all sit at record levels. From humble beginnings in 1990, the global ETF industry has paired utility with innovation. This innovation has taken different forms with a full spectrum of traditional index, strategic beta, and active ETFs now available to investors across equities, fixed income, commodities, and currencies as well as alternative investment strategies. One overlooked but important development in the ETF industry is that of incremental innovation.

Innovating, incrementally

Incremental innovation is defined as utilizing existing technology and increasing value to customers within an existing market.

Some of the largest ETFs globally are also among the most mature with track records that date back to the early 1990s. The world’s largest ETF, SPDR S&P 500 ETF Trust (NYSE: SPY), was listed in the U.S. in 1993 and is also widely held by Canadian institutional and retail investors. It was structured as a unit investment trust (UIT) under U.S. securities law, which was a popular structure in the early days of the ETF industry but is somewhat restrictive for today’s investors (at the time, some observers went as far as to say that ETFs using the UIT structure were misnamed and should be called exchange traded trusts).

UITs have limits on securities lending and on the reinvestment of dividend distributions. Securities-lending revenue allows ETFs to earn a small additional profit, which can reduce overall costs. Dividend reinvestment allows an ETF to redeploy distributions paid by underlying holdings rather than have them sit in cash until scheduled to be distributed to unitholders (e.g., ExxonMobil pays a dividend on Feb. 1, which is kept in cash until the scheduled ETF dividend distribution in April).

The majority of ETFs today use the more conventional open-ended fund, or mutual fund, structure with units issued continuously and having the ability to reinvest dividends and generate income from securities lending. But 20 years ago, this open-ended fund structure was considered “innovative” in the ETF industry. It was indeed incremental innovation.

Another example of incremental innovation has to do with index design. SPY, the world’s largest ETF, seeks to replicate the performance of the S&P 500 Composite Index, one of the most widely followed equity indexes in the world. Like all indexes, the S&P 500 is subject to periodic reconstitution, which now garners much attention from market participants that may seek to buy (sell) expected additions (deletions) before they are announced by index providers.

For ETFs replicating these indexes, this trading transparency can be very costly and inefficient if the market knows in advance what changes are being made to the them. It means that someone can earn an arbitrage-type profit at the expense of unitholders by front-running index rebalances.

The latest generation of index ETFs offers off-schedule rebalancing that is still transparent but avoids the congestion around popular index rebalance and reconstitution. This is another example of incremental innovation in the ETF industry.

Canadian innovation

There was a time when the Canadian ETF market lacked choice and innovation, compelling investors to go cross-border shopping to buy U.S.-listed ETFs. Accessing U.S.-listed ETFs is relatively easy, cost effective, and offers good liquidity, but introduces meaningful tax and currency considerations for investors. Canadian financial professionals and investors strive to achieve the best investment outcomes from the standpoint of Canadian investors. In doing so, they are often better served by selecting Canadian-listed ETFs.

Forex innovation. Incremental innovation is once again evident in the way in which a growing number of Canadian-listed ETFs are designed. For example, even in non-currency-hedged index ETFs, the timing of currency conversion matters. Many indexes based on non-Canadian stock and bond markets strike a foreign exchange (FX) spot rate from USD to CAD at 11:00 a.m. EST (4:00 p.m. London time) for an index calculated outside Canada (e.g., S&P 500).

Canadian-domiciled ETFs that track such indexes strike FX spot rates from CAD to USD at the 4:00 p.m. EST close of North American trading. This results in tracking error and is sub-optimal for Canadian investors. However, there are now index-based ETFs in Canada that address this need for Canadian investors by aligning FX conversion prices to North American trading hours.

Tax efficiency. Taxes are another important consideration for Canadian investors. U.S.-listed ETFs investing in international stocks as well as Canadian-listed ETFs holding U.S.-listed ETFs, investing directly in international stocks, or investing in U.S. fixed income ETFs can all be subject to withholding tax depending on the type of account holding the ETF.

U.S. estate tax can arise on the death of a Canadian taxpayer who owns property that is connected to the U.S. (more than US$60,000) at the time of death. By investing in Canadian-domiciled ETFs, investors can gain exposure to U.S. markets without holding shares of a U.S.-domiciled ETF, thus ensuring that U.S. federal estate tax is not triggered on death.

Cost. Cost is also a form of differentiation. Many legacy ETFs are not among the cost leaders, because ETF providers enjoyed some measure of pricing power. But the dynamic nature of the ETF industry has brought more competitive pricing and innovation from newer ETFs and providers.

A growing universe of innovation

There are now more than 800 Canadian-listed ETFs, providing investors in this country with more choice and the potential for better investment outcomes. The biggest and most liquid ETFs (whether Canadian or U.S.-listed opportunities) may be popular and useful as proxies, but they’re not necessarily the best choices for investors.

Incremental innovation has created a broader group of ETFs that are probably better for most investors based on cost, exposure, and construction. This is especially true as it relates to achieving the best possible investment outcomes for Canadian advisors and investors.

Michael Cooke is Senior Vice President and Head of Exchange Traded Funds at Mackenzie Investments. This article first appeared in the Winter 2021 issue of Your Guide to ETF Investing, published by Brights Roberts Inc. Reprinted with permission.

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