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Inside the Market Canadian fund investors are slow to join a global shift from active to passive strategies

As the passive indexing movement gains support around the world, Canadian investors are mostly putting their faith, and their money, in stock-picking strategies.

Globally, passively managed funds claimed three-quarters of fund flows last year, as higher-cost active investing – in both exchange-traded funds and mutual funds – continues to shed market share and decline in popularity.

In Canada, however, active funds drew in US$23.1-billion last year, more than three times the US$7.4-billion invested in passive funds, according to Morningstar data.

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“The financial crisis brought about a shift in investor behaviour from expensive to cheap. We haven’t seen that shift in Canada,” said Daniel Straus, head of ETF research and strategy at National Bank Financial.

Canadian investors remain beholden to active management, even as ETF investing gains traction.

Last year, Canadian-listed ETFs outsold mutual funds for the first time in nearly a decade. Net sales in mutual funds amounted to near zero, while a net $20.1-billion was pumped into the ETF space, according to data from Strategic Insight and National Bank.

Outside of Canada, the increased popularity of ETFs has facilitated the rise of passive investing strategies, which target broad-market exposure at the lowest possible cost.

But the Canadian ETF space has a distinctly active tilt. Actively managed ETFs, which carry higher management fees, account for 21 per cent of all ETF assets under management in Canada. In the United States, that figure is just 2 per cent.

One reason active ETFs are more prevalent in Canada is that there are looser disclosure requirements for active managers here, while U.S. regulators require ETFs to disclose portfolio holdings daily.

“Most active managers balk at that kind of radical transparency,” Mr. Straus said. “They don't want to give up their secret sauce.”

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On the demand side, Canadian investors also seem more willing to pay for higher-cost strategies, said Dan Hallett, vice-president and principal with HighView Financial Group.

“A big part of it has to do with our domestic stock market,” he said. “I think it's been easier to find strategies that can outperform the broader market.”

By comparison, the U.S. market is a famously tough one to beat. Not to mention the fact that S&P 500 Index exposure has provided passive investors with an average annual return of 14 per cent over the past 10 years, before fees – double the return generated by the S&P/TSX Composite Index.

That favourable backdrop for passive investing has seen U.S. mutual funds experience outflows for several years now, while enormous sums are committed to indexing. U.S. passive funds drew in US$459-billion last year alone, according to Morningstar.

With investor demand and supply both trending toward passive alternatives in the United States, the pressure to lower fees has been intense. Some fund providers have even begun offering zero-fee funds.

Canadian funds aren’t quite so cheap. About 38 per cent of Canadian-listed ETF assets are in funds that charge less than 0.2 per cent, compared with 63 per cent of U.S. funds.

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And some Canadian-listed versions of U.S. funds carry higher fees. The Invesco S&P 500 Low Volatility ETF has an expense ratio of 0.25 per cent in the United States, while the same fund trading on the Toronto Stock Exchange has an MER of 0.36 per cent, Mr. Hallett said.

“We have seen good price competition here, but it’s not quite as aggressive as what we’ve seen in the U.S.," he said.

There are some signs of passive investing assuming a greater profile in Canada. The global index-fund giant Vanguard saw its Canadian inflows rise by 30 per cent to US$3.3-billion last year. And the growing comfort level with ETFs, as evidenced by last year’s inflows outpacing mutual funds, could translate into greater adoption of passive investing, Mr. Straus said.

“If the U.S. is a leading indicator for investor behaviour, it could represent an inflection point. But mutual funds are here to stay for a long time."

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