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Retail investors who rely on low-cost exchange-traded funds in their portfolios have good company: Increasingly, sophisticated institutional investors are also turning to ETFs as building blocks in their own portfolios.

This may be a welcome trend for investors of all stripes.

ETFs are essentially baskets of stocks that trade on exchanges throughout the day, making them convenient for do-it-yourself investors. But since many of these funds track equity indexes, such as the S&P 500 or the S&P/TSX Composite Index, rather than trying to beat them, ETFs are sometimes denigrated as plain-vanilla investments for cost-conscious investors who can’t afford savvy professional stock pickers.

This isn’t the case. According to research from CIBC World Markets, Canadian mutual funds held $65-billion in ETFs at the end of 2020, up from about $14-billion in 2015 – a 37 per cent compound annual growth rate over five years.

Canadian mutual funds hold about 18 per cent of Canadian-listed ETFs. For mixed-asset funds, which invest in a mix of stocks and bonds, ETFs accounted for 7 per cent of assets, up from a 2-per-cent share in 2015 – all of which suggests that mutual fund managers have become key customers of a financial product originally designed to level the playing field for all investors.

“Of course, mutual funds are but one part of the institutional marketplace in Canada. We would not be surprised if other institutional users, such as pension plans, insurers and family offices, actually use these products more extensively,” CIBC analysts said in a report this week.

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Why are ETFs rising in popularity among Canadian institutional investors? Part of the explanation relates to the sheer number and variety of funds now available.

“The development of new ETFs has provided portfolio managers with choice to execute on precision strategies,” Helen Hayes, head of iShares Canada, said in an e-mail. Examples include sector and factor exposure strategies, numerous fixed income strategies, as well as environmental, social and governance, or ESG, investing, Ms. Hayes said.

Efficiency is another reason. ETFs offer easy exposure to indexes that tend to change their holdings infrequently, which makes them tax-efficient and allows fund managers to quickly deploy cash across a broad market.

“Imagine a mutual fund that gets $50-million of inflows one day. Every day where that money is still in cash and not invested is a drag on its performance, so you can park that in an ETF and get exposure to the overall stock market until you know which individual stocks you want to buy,” Financial Times reporter Robin Wigglesworth said in an e-mail. Mr. Wigglesworth is the author of Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever.

A third attraction is cost. Most ETFs come with very low management expense ratios. Even so, mutual funds have discovered that they can bring these costs down even further by creating their own in-house funds in some cases. This explains the proliferation of ETFs from the likes of Bank of Montreal, CI Global Asset Management and others, which they can then use in their own mutual funds.

But for retail investors, the rising interest in ETFs among institutional players underscores passive investing, or indexing, as a sound investing strategy. And no wonder: Academic and industry evidence has long suggested that indexing comes with no performance downside after fees are taken into account, especially over the longer term.

According to S&P Dow Jones Indices, which tracks mutual fund performance against indexes through its regular SPIVA reports, 60 per cent of domestic large-cap U.S. equity funds underperformed the S&P 500 in 2020. This is not an anomaly. Over the past five years, 75 per cent of funds underperformed the index.

Even more astounding, 98.6 per cent of Canadian equity funds underperformed the S&P/TSX Composite Index over the past five years, according to S&P Dow Jones Indices.

With an ETF, you won’t outperform the market, but you’ll beat most of the pros – which is something the pros themselves appear to be finding increasingly attractive.

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