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Despite the hype around exchange-traded funds, these low-cost investment alternatives have barely dented the dominance of mutual funds in Canada .
"Canada has seen an explosion in the number of exchange traded funds (ETFs) over the last five years," CIBC World Markets analyst Robert Sedran wrote in a research report, "but collectively they still represent a small fraction of the mutual fund industry."
Even with major media attention, ETFs account for just 7 per cent of the total fund market. More troubling for the low-cost providers, mutual funds still outsell ETFs by a factor of four to five times.
Because mutual funds are still so popular, the big question is whether ETFs will ever achieve critical mass. in his report, Mr. Sedran concludes that a regulatory change is what could really move the needle for the low-cost funds.
At the moment, Canadian securities regulators are weighing whether they should impose new rules on fund providers, such as banning trailing commissions. Should that happen, retail advisers might be more likely to charge flat annual fees for their services, rather than working off commissions from selling products like mutual funds.
Here's Mr. Sedran's line of thinking. In the United States, where trailer fees don't have nearly as much prominence as they do in Canada, net sales of ETFs are more or less on par with mutual fund sales.
And even though Canada's total mutual fund sales still eclipse ETF sales, the relative percentage change is encouraging. Since 2008, "the number of [ETFs] has increased fourfold and [assets under management] has expanded by a compound annual growth rate of approximately 25 per cent. Mutual fund assets over the same time period grew by roughly half that amount ," he found.
ETFs are also evolving. Over the past two years, there has been much more chatter about "active ETFs," which operate much like mutual funds, but charge significantly lower fees. Mr. Sedran notes that their fee discount relative to similarly-oriented mutual funds is usually 30 to 40 per cent.
Now, the total amount invested in these active funds is still small, coming in at $7-billion, or about 10 per cent of the total ETF market in Canada, according to Investor Economics data. But their assets under management are growing quickly, up 33 per cent over the last year, and this threat will put even more pressure on mutual fund providers to match the lower fees.
However, Mr. Sedran acknowledges this won't be a cake walk for ETF providers even if regulatory changes are approved. Actively managed ETFs, for instance, are run in a way that is arguably at odds with the core values of traditional ETFs.
Transparency is one of the key ETF values – full disclosure of costs, portfolio holdings and fund prices – yet active portfolio managers are inherently against full disclosure because it gives their competitors insight into what they are doing.
And while the U.S. has seen strong ETF growth relative to mutual funds, the latter still sell extremely well in the United Kingdom – despite their higher costs, but also the regulatory changes there that ban incentives such as trailer fees.
For reasons like these, Mr. Sedran remains cautious. While ETFs are a credible alternative for investors, he writes, "that is not to say that mutual funds will give up their dominant market position, but they likely will cede market share and perhaps some profit margin as well."
Tim Kiladze