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Canadian ETF demand surges past mutual funds in 2017

Canadian Exchange Traded Fund demand had a banner year in 2017, but the upward trend should ease in 2018 as expected headwinds make a repeat of last year’s levels unlikely.

Net inflows of $26 billion into the ETF industry’s growing array of available products resulted in a boost of almost 60 per cent over the inflows in 2016 and 2015 this past year, while net flows into the domestic mutual fund industry stood at $44.2 billion in 2017, compared with $30.1 billion the year before.

Considering that the mutual fund industry is 10 times the size of the ETF industry, measured by assets under management, ETF demand in relative terms was some seven times stronger.

Demand for Equity ETFs represented 57.4 per cent of the 2017 total versus 53 per cent in 2016. Demand for Fixed Income ETFs stood at 39 per cent of the 2017 total versus 42 per cent in 2016.

The growing popularity of so-called active ETFs (not simply based on an index) took a pause during 2017 as net flows accounted for some 29.5 per cent of the total versus 28.4 per cent the prior year. In contrast, demand for so-called Smart Beta or Strategic Beta products (primarily index based but with rule based strategies to augment returns or reduce volatility) represented 11.4 per cent of total flows in 2017 versus 24 per cent in 2016 (it must be noted that there is no exact measure of strategic beta products so other analyst conclusions will vary).

While ETF industry members and participants are in a frenzy of anticipation about ongoing and escalating demand, it’s important to remember that 2017 saw a “perfect storm” for investing – one that we may be hard pressed to repeat or sustain in the period ahead.

Strong equity market returns are typically the number one factor in encouraging overall ETF and mutual fund demand. There were several new ETF providers in 2017, a supply that helped create its own demand over the short run.

So far, interest rate increases in the U.S. and Canada haven’t been big enough to cause meaningful damage to longer-term interest rates and hamper fixed income investment demand. Unless the U.S. government intervenes, the Federal Reserve should remain on a rising interest rate trend, which will eventually scare bond investors more intensely.

The demand momentum for ETFs during 2017 was such that the first half of the year ran at an annualized pace of about $30.4 billion while the final six months of the year managed an annualized demand pace of $21.8 billion (a deceleration of 28 per cent).

Accordingly, and other things being equal, the demand momentum for ETFs heading into 2018 is downwards. Against this background, we think ETF flows during 2018 will amount to about $24 billion – which would normally be a great year, but currently marks a pause in the uptrend.

If a few things go wrong (for instance, a meaningful reversal in global equity markets and more volatile bond markets), ETF demand could easily recede significantly more than we currently project.

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