Understanding Actively Managed ETFs

At their core, exchange traded funds (ETFs) are simply open-ended investment funds. ETFs were designed to combine the best features of mutual fund and stock investing. Like a mutual fund, ETFs are open-ended, meaning that new units of the fund can be created or redeemed at a price per unit that reflects the market value of the underlying securities the fund holds. Like a stock, ETFs trade on an exchange with a ticker symbol and can be purchased or sold at any time during the day.

The first ETFs launched were designed to seek to replicate a broad index of securities, such as the S&P/TSX 60™ Index or the S&P 500®, just to name two well-known examples. Since there is no expectation of trying to outperform these asset class benchmarks, these ETFs are referred to as “passively managed”. Cost is a key component of passive index investing — it needs to be as low as possible since there is no expectation of achieving additional returns beyond the benchmark index. Since ETFs are a low-cost and flexible way to offer index exposure, the rise in the use of indexing amongst the investing public coincided with the rise of ETF usage.

ETFs have traditionally been associated with passive indexing but this doesn’t mean they can’t be actively managed like a typical mutual fund using a portfolio management team to seek better risk-adjusted returns. In fact, we believe ETFs are an excellent vehicle to offer actively managed investment strategies, which is why we are the largest provider (by number of offerings) of actively managed ETFs in Canada. Our suite of actively managed ETFs offer the benefits of ETF investing — including low management fees, intra-day purchasing and liquidity combined with the benefits of active management — which we believe can deliver better risk-adjusted returns in many asset classes.

The Importance of Low Fund Management Fees

A central appeal of ETFs is their low management fees. Fees can have a significant impact on investment performance, since they create an additional hurdle for the investment to overcome in order to be profitable. Simply put, the higher the fee on an investment fund, the better the fund needs to perform in order to generate a higher return.

Statistics provided by Standard & Poor’s show that, on average, only about one-third (34%) of actively managed Canadian equity funds were able to beat the S&P/TSX Composite Index benchmark for the five-year period ending December 31, 2015. The single largest determinant of long-term performance between two similar funds (that invest in the same asset class) is fees. In a study of mutual fund fees conducted between 2010 and 2015, Morningstar Inc. found that the highest proportion of “successful” funds (i.e. those that both remained open and outperformed their peer group) are predominantly from the lower-tier categories for fees. In other words, the lowest-fee funds had the highest success ratio for out-performance.

Low costs are the path to success — subsequent total return success ratio


Source: Morningstar as of December 31, 2015.
From 2010-2015, the lower-tier funds produced better success ratios than the second-lowest and so on, showing just how important costs are to investing.

We believe the single largest hurdle to the performance of Canadian actively managed mutual funds is high fees. The cost disparity between Canadian actively managed mutual funds and Canadian actively managed ETFs can be dramatic: The average management fee of an actively managed Canadian actively managed equity ETFs in Canada is approximately 0.59% versus a full 1.00% for Canadian actively managed F-class mutual funds.


Source: Investor Economics as at December 31, 2015.

The cost savings on ETFs can add significant value to the long-term returns of the fund, as highlighted in the chart below which uses a modest return trajectory of only 5%. The longer the time horizon and the larger the cumulative return, the more of your return lost to fees.

Hypothetical $100,000 Investment in Funds with Different Fees


For Illustrative Purposes Only
*Assumes investment held for 10 years with no performance fees or distributions.

Our value proposition with actively managed ETFs is simple: We seek to offer top-tier investment strategies by some of the best-known portfolio management teams in Canada — at management fees that are often lower than active mutual fund solutions. By doing this, we reduce a significant hurdle faced by active managers in generating better risk-adjusted returns than passive index strategies.

The Limitations of Indexing

Indexing is not a one-size-fits-all investment solution. There are areas where indexing can fall short, particularly in asset classes that don’t offer sufficient transparency, liquidity or breadth of market to efficiently support an index strategy.

Much of the research on the merits of indexing comes from the United States. In many cases, indexing can be an optimal strategy because most of the major capital market asset classes are extremely efficient from both a depth and liquidity standpoint. Indeed, on an index like the S&P 500, less than 10% of actively managed mutual funds beat the benchmark on a five-year basis for the period ending June 30, 2016.

When an asset class has less liquidity, indexing becomes less efficient. Even in a relatively large asset class like U.S.High Yield Corporate Bonds, indexing has delivered only limited success. Since January 1, 2008, more than 90% of active high-yield managers tracked by Morningstar Inc. have posted better returns than the average high yield index ETFs for the period ending June 30, 2016.

Part of this disparity has to do with the nature of index construction in the fixed income category. Many of the large fixed income benchmarks determine the weights in the index by the amount of outstanding debt — the companies with the largest amount of debt are the largest weights in the index. For equity indexing, weighting based on the size of the company can be an indicator of company strength, but weighting a company based on its level of outstanding debt may not necessarily be a reliable way to rank the value of an issuer in a fixed income index.

In addition, you have the issue of liquidity with fixed income investments. Unlike equities which trade openly on stock exchanges, bonds are traded over-the-counter (OTC), where pricing is relatively opaque and commissions are embedded in the prices paid for the bonds. The closed nature of this market means that two different investors could pay different prices for a similar bond at the same time, since much of the pricing is determined by the dealership model they use to buy the bond. Large index ETFs, which have real-time net asset values (NAVs), have not helped this pricing problem in fixed income but, in parts of the fixed income market where there is less liquidity (such as high yield bonds), sourcing issues can be more difficult — particularly in a market sell-off where buyers may not be readily available with sufficient capacity to take on bond inventory.

This doesn’t make index ETF investing in fixed income flawed, since many of these issues are structural within the underlying asset class itself. It does however suggest that indexing may not be the optimal way to get exposure to this asset class.

Canada has a much smaller capital markets footprint than the United States, so these types of structural challenges can occur more frequently. For instance, look at the most widely followed fixed income bond benchmark in Canada — the FTSE/TMX All-Bond Universe Index. As at September 30, 2016, it had roughly 1,400 constituent issues. However, the largest ETF in Canada tracking this index only held less than 1,100 of those issues. This means that roughly 300 issues in the Index didn’t have enough market liquidity or were a drag on the replication process. We see similar liquidity problems arise in other Canadian asset classes, such as Canadian corporate bonds, preferred shares and to some extent, dividend stocks.

Dividend stocks are another interesting example. It’s important to evaluate whether a certain index methodology is ideal for a universe of securities. For example, the S&P Dividend Aristocrats Index methodology is a tried-and-tested approach used in the United States that requires all stocks in the index to have raised their dividend in the previous 25 years. The U.S. stock market has the breadth to support a strategy like this, where the Index ends up with about 50 names. The stocks are then weighted proportionately so that the higher yielding stocks have a higher weighting in the Index.

The S&P/TSX Dividend Aristocrats Index, which is replicated by a popular Canadian index ETF, has to utilize a highly modified version of this methodology in order to cultivate enough stocks from the Canadian market, which overall is much smaller and has a shorter track record.

The following table outlines the key methodology requirements and crucial change that occurred during the December 2012 rebalance which significantly altered the composition of the Index’s portfolio. These changes were made in response to the elimination of large dividend-paying stocks from the Index; most notably TD and Scotiabank.


Source: Standard & Poor’s.

The 2012 methodology change may have caused more problems than solutions, since it requires the Index to hold stocks that aren’t raising their dividends for an extended period of time. A prime example of this is the fact that the Index’s heaviest weighting for some time was AGF — over 5% — a stock that raised its dividend in 2011 and didn’t raise it again (it fact, it subsequently cut it). The stock lost 37% over the three-year period ending April 30, 2014.

The Aristocrats Index strategy has been a successful one on an absolute returns basis, but it’s hard to argue that it is an optimal strategy given its limited stock selection pool. Utilizing a professional money manager at a low management fee could help alleviate some of these structural challenges. Active management presents opportunities to enhance returns and reduce risk through:

  1. Independent valuation analysis: Can conduct independent research on portfolio holdings, including cash flow analysis, risk analysis and earnings forecasts.
  2. Institutional access: A key benefit for fixed income. Fixed income managers can generally attain favorable execution costs for bonds. This would extend to options pricing as well.
  3. Not forced to buy/sell: Actively managed ETFs can opt out of buying securities with questionable valuations or liquidity. They are not forced to buy or sell issues blindly when an index rebalances.
  4. Independent credit analysis: In fixed income, active managers will undertake full independent credit analysis of the underlying holdings of the portfolio. Credit analysis is a key determinant of the risk/return profile of fixed income investing and the likelihood of a issuer meeting its debt obligations.

Unique Features of Actively Managed ETFs in Canada

In our view, a major reason that actively managed ETFs have been more successful in Canada than other developed ETF markets — representing about 15% of Canadian ETF assets according to Investor Economics as at June 30, 2016, — is the regulatory environment of the Canadian investment industry. The vast majority of actively managed ETFs are regulated under National Instrument 81-102, which regulates all investment funds. This ostensibly means that ETFs are governed under the same laws that govern mutual funds.

In Canada, the disclosure for ETFs and mutual funds is generally the same. In the case of Horizons ETFs for example, the ETF’s top 10 holdings are disclosed publicly on a monthly basis. We view this as a suitable level of transparency, particularly since most investors in actively managed ETFs are usually seeking longer-term holding periods than index strategies, which can be (and often are) used for trading purposes.

A key feature of ETFs compared to mutual funds, is their liquidity — as units can be bought and sold throughout the business day on an exchange. In order to ensure that the units trade at or very near their current NAV throughout the day, an institutional capital markets trader, known as the designated broker, creates and redeems units of the ETF with both the ETF provider and the secondary market.

This process has worked well for actively managed ETFs, many of which now trade at bid/ask spreads equivalent to spreads observed on comparable index ETFs.

The Best of Both Worlds

Horizons ETFs currently offers 27 Actively Managed ETFs overseen by eight sub-advisors representing some of the largest and most respected asset managers in Canada. These ETFs combine all of the benefits of active management, including the potential to generate better risk/adjusted returns than index strategies, coupled with the unique benefits of ETF investing, including low management fees and intra-day liquidity.

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Horizons ETFs is a Member of Mirae Asset Global Investments. Commissions, trailing commissions, management fees and expenses all may be associated with an investment in exchange traded products managed by Horizons ETFs Management (Canada) Inc. (the "Horizons Exchange Traded Products"). The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the Horizons Exchange Traded Products. Please read the relevant prospectus before investing.

The Horizons Exchange Traded Products consist of the Horizons Index ETFs ("Index ETFs"), 2x Daily Bull and -2x Daily Bear ETFs ("2x Daily ETFs"), Inverse ETFs ("Inverse ETFs"), VIX ETFs (defined below) and active ETFs. The 2x Daily ETFs and certain other Horizons Exchange Traded Products use leveraged investment techniques that can magnify gains and losses and may result in greater volatility of returns. These Horizons Exchange Traded Products are subject to leverage risk and may be subject to aggressive investment risk and price volatility risk, which, where applicable, are described in their respective prospectuses. Each 2x Daily ETF seeks a return, before fees and expenses, that is either 200% or -200% of the performance of a specified underlying index, commodity or benchmark (the "Target") for a single day. Each Index ETF or Inverse ETF seeks a return that is 100% or -100%, respectively, of the performance of a Target. Due to the compounding of daily returns, a 2x Daily ETF's or Inverse ETF's returns over periods other than one day will likely differ in amount and possibly direction from the performance of their respective Target(s) for the same period. The Horizons Exchange Traded Products whose Target is the S&P 500 VIX Short-Term Futures Index™ (the "VIX ETFs"), one of which is a 2x Daily ETF and one of which is an Index ETF, as described in their prospectus, are speculative investment tools that are not conventional investments. The VIX ETFs' Target is highly volatile. As a result, the VIX ETFs are not generally viewed as stand-alone long-term investments. Historically, the VIX ETFs' Target has tended to revert to a historical mean. As a result, the performance of the VIX ETFs' Target is expected to be negative over the longer term and neither the VIX ETFs nor their Target are expected to have positive long term performance. Investors should monitor their holdings, as frequently as daily, to ensure that they remain consistent with their investment strategies.

*The indicated rates of return are the historical annual compounded total returns including changes in per unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The rates of return shown in the table are not intended to reflect future values of the ETF or returns on investment in the ETF. Only the returns for periods of one year or greater are annualized returns.