BMO ETFs Summer Outlook Report

Canadian ETFs remain a beacon of innovation

Thus far, 2023 has shown to be a year of opportunity across most asset classes. Exchange Traded Funds (ETFs) continue to provide investors with liquid, easy-to-use, single-ticket solutions to navigate a market, which is balancing a record stock rally with the consequences of a historic rate hiking cycle. The Canadian ETF marketplace has grown to cover the entire gamut of investor needs, from high-interest savings accounts to covered calls and thematic and growth portfolios. Additionally, Canadian ETFs remain a beacon of innovation as liquid alternatives and active funds continue to make their way into the portfolios of investors seeking alpha¹ and diversification. As the year progresses, ETFs may provide the necessary tools to address any challenges and opportunities left to be seen.

ETFs have managed another strong start to the year regarding asset gathering, with nearly $20 billion in net new asset flows in Canada across asset classes, including equity, fixed income and balanced solutions.²

Global ETF flows

Global ETF assets under management (AUM) totalled 10.2 trillion in U.S. dollars (USD) as of June 2023, with net new assets of $1.2 trillion.³ Year-to-date (YTD) assets are up 13.2%, largely attributed to a strong, broad market recovery in early 2023. At the end of June 2023, the Global ETF industry had 9,839 ETFs, with 20,077 listings, from 651 providers on 79 exchanges in 63 countries.³

Through June 2023, the Canadian ETF industry reported $350 billion in assets on the back of a significant bull run at the start of the year, alongside a reported $19.7 billion in net inflows.⁴ This pace of inflows is slightly slower than the industry saw last year, driven partly by increased uncertainty about debt ceiling discussions that plagued markets in the second quarter of 2023. The top four providers by AUM, including BMO ETFs, captured over 46% of net new assets and 18 BMO tickers reported inflows greater than $100 million.⁵

Looking closer at inflows by asset class in Canada, fixed income ETFs saw a resurgence of demand with over $11 billion in net new flows as investors sought to capitalize on higher rates. More precisely, money market and cash ETFs led the way, capturing more than half of fixed income flows (amounting to over 31% of all flows) due to their capital protection and yield capture characteristics. Equities’ relative lacklustre flows — and the success of short-term fixed income — show investors’ uncertainty in broad economic conditions despite a strong start to the year, bringing in just over $6.5 billion in net inflows. Similar to last year, balanced ETFs continue to gain acceptance, capturing over $1.3 billion in net inflows through their one-ticket solutions. Crypto and commodity ETFs were the only fund categories to experience YTD net outflows — a consequence of investors’ desire to reduce some of their riskier portfolio holdings in the face of heightened uncertainty. 

The BMO Equal Weight Banks Index ETF (Ticker: ZEB) saw inflows of over $870 million year to date as investors looked for the relative stability of the Canadian banking sector.⁵

With more tickers coming to the market, core ETFs continue to show strength in equities and fixed income as key portfolio building blocks delivering returns. Year to date, 74 new ETFs were launched in Canada, bringing the total to 1,081 ETFs in the space. More innovative products deliver investors unique and tailored exposure to complement their portfolios. 

Banks on sale

Alfred Lee, CFA, CMT, Portfolio Manager &  Investment Strategist, Head of Index Equities

2023 has been shaping up to be a much better year than 2022 for investors. The consumer price index (CPI) shows that inflation has been waning. While still higher than central banks’ target levels, aggressive monetary tightening and supply chain healing have been effective in cooling inflation. This has allowed central banks to take a pause in their hiking, which has been fortunate timing, as higher rates have exposed systemic risks, particularly within the U.S. regional banking sector. The expectation for the U.S. Federal Reserve and its global counterparts to slow their pace on rate hikes has created a much more stable environment for risk assets.

Broad-based ETFs tracking major equity benchmarks, such as the BMO S&P/TSX Capped Composite Index ETF (ticker: ZCN) and the BMO S&P 500 Hedged to CAD Index ETF (ticker: ZUE), were up 5.7% and 16.1% respectively on the first half of the year.⁶ Despite the aggressive tightening policies from central banks and the yield curve exhibiting its steepest inversion in decades, cyclical stocks have led the charge higher, as the stable rate environment has benefitted longer-duration stocks. As a result, the technology-heavy BMO Nasdaq 100 Equity Hedged to CAD Index ETF (ticker: ZQQ) led broad-based ETFs, returning 38.3% on a total return basis.⁶ Flow wise, we have seen many investors shift allocations to international equities through the BMO MSCI EAFE Index ETF (ticker: ZEA), based on lower relative valuations, which proved to be the right call. International stocks comprise more mature businesses, which are less interest rate sensitive. In recent months, however, we have seen some flows return to the BMO S&P 500 Index ETF (ticker: ZSP) as interest rate expectations have subsided in North America. 

While strategic asset allocation mixes may continue to drive returns, we believe sustained higher rates will create tactical asset allocation opportunities as the year progresses. Intra-market correlation, measured by implied correlation indices, continues to drift to post-pandemic lows. Consequently, broad beta, factor and sector-based ETFs will allow investors to better generate alpha and/​or manage risk. While we don’t envision the BMO Covered Call Technology ETF (ticker: ZWT) and the BMO Global Communications Index ETF (ticker: COMM) to continue their pace of gains up to the halfway mark, central banks nearing their terminal value will remove much of the headwinds investors faced in the previous year. Longer-term investors may want to look to Canadian banks, as the 9.4x forward-looking price-to-earnings (P/E) ratios represent a 31% discount relative to the broader S&P/TSX Composite. In the last two decades, forward-looking P/​Es on the ​“Big-Six” banks have been this low on two occasions: once in 2009 and again in 2020. ZEB provides an efficient way for investors to get exposure to Canadian banks and has a distribution yield of 5.1%.⁷

Factors: Quality takes the wheel

Chris Heakes, Head of Disciplined Equity & Portfolio Manager

Factor ETF performance has reversed course in 2023, as opposed to 2022, with Growth and Quality back in the fold, and defensive factors, such as Low Volatility and Dividends taking a back seat. As a reflection of Growth, the Nasdaq 100 index has returned 38.6%, as of June 2023, driven by strong gains in the ​“Magnificent 8” large-cap Tech stocks: Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla. From a factor perspective, Quality has done well. The BMO MSCI USA High Quality Index ETF (ticker: ZUQ) has benefitted, holding five of the eight stocks, and is up 20.4% for the year, outperforming the S&P 500 by a 6% margin.⁶

Defensive factors have not kept pace with broad markets focused on growth, particularly in the U.S. However, there have been some bright spots within regions. The BMO Low Volatility Canadian Equity ETF (ticker: ZLB), which received a 10-year Lipper award in 2022,⁸ has returned 7.0% for the year.⁶ In contrast, the S&P/TSX Composite Index has returned 5.8%, partially held back by banks and Energy stocks, which low volatility has been underweight. Another light has been on international dividend equities.⁶ The BMO International Dividend Hedged to CAD ETF (ticker: ZDH) has returned a healthy 13.0%, as investor sentiment on international equities has improved relative to last year, and dividend-based companies have been viewed favourably in the region.⁶ Given the uncertainty about inflation and central bank policy, defensive factors may prove valuable portfolio components in the year’s second half.

Quality Factor ETTFs off to Strong Start

Volatility levels normalize

Chris McHaney, Portfolio Manager, BMO ETFs

At the beginning of the year, equity market volatility declined from the relatively high levels experienced throughout 2022. What looked like a more stable equity market was short-lived, as the U.S. regional banking crisis played out in March, and volatility spiked once again. However, this, too, proved to be brief, as equity markets quickly normalized, and the banking sector issues looked to be resolved. By the end of the first half of 2023, options market pricing of expected volatility (implied volatility) reached low levels not seen since pre-COVID. This is best illustrated by the VIX Index (the market’s expected volatility on the S&P 500).

VIX Index

As the largest input into the option pricing model, implied volatility can be considered a proxy for option prices. Strategies that sell equity options to generate cash flow, such as BMO’s suite of Covered Call ETFs, can generate more with higher implied volatility. More normalized levels of volatility can be good news for investors who hope for growth potential from their equity portfolios.

Looking ahead to the second half of 2023, we see the potential for equity market volatility to rise again. There is a great deal of uncertainty surrounding the impact of interest rate hikes on the economy and the timing of when any effect may be felt. The sizeable gap between the highest and lowest projections for the S&P 500 Index year-end targets by strategists on Wall Street illustrates the variability of possibilities.

This disparity (the highest since 2003) demonstrates the heightened uncertainty around the direction of equity markets for the second half of 2023 and the potential for implied (and realized) volatility to rise. Investors looking to take advantage of a potential rebound in market volatility can look at strategies that attempt to monetize this volatility through the selling of equity options. The BMO Covered Call Canadian Banks ETF (ticker: ZWB) and BMO Covered Call Utilities ETF (ticker: ZWU) are designed for investors seeking more defensive equity exposure. For investors who are more constructive on the outlook for equities and want a bit more growth tilt, ZWT may be a consideration. For those who are less bullish and are looking for a more conservative option-based strategy, the BMO Premium Yield ETF (ticker: ZPAY), which sells both put and call options to generate cash flow, provides some element of equity growth potential but primarily focuses on income generation through option selling.

Fixed income took a trip to the 2000s

Matt Montemurro, Director, Portfolio Manager, BMO ETFs

After an extremely challenging year for all asset classes, fixed income investors looked to 2023 with hope. Central banks raised interest rates at an unprecedented pace in 2022, but as we moved into the new year, many believed the banks were nearing the end of their hiking cycles. Fixed income securities yielded levels not seen in over a decade, and investors of all types were re-evaluating their positioning. Years of being plagued with record-low interest rates were gone, and investors could now rely on both income and stability for their fixed income allocations.

The number and magnitude of interest rate hikes have led to a prolonged yield curve inversion (shorter-term interest rates are materially higher than longer-term interest rates). Yield curve inversion is often a leading indicator of an upcoming recession. 

During the first half of the year, fixed income markets have done well, with longer-term bonds outperforming. Short-term rates have risen, and longer-term rate expectations have fallen (further yield curve inversion). Corporate bonds continued to perform well — most pronounced in the short-end, with credit spreads tightening. While there are headwinds in the economy, there also is an excellent opportunity for fixed income. Short-term yields have not reached these levels since the early-2000s. 

Investors can capitalize on the current inversion of the yield curve, with the potential to earn an extremely attractive yield, while taking very little duration risk. Traditionally, you would have to increase your duration risk to add yield and meet your income needs. In the current market, that paradigm has flipped, enabling investors to take less interest rate risk while capturing an attractive yield. The short end definitely looks like a sweet spot in terms of risk and reward.

By using the BMO Money Market Fund ETF Series (ticker: ZMMK), BMO Ultra Short-Term Bond ETF (ticker: ZST/ZST.L) and BMO Ultra Short-Term US Bond ETF (ticker: ZUS.U/ZUS.V), there is an opportunity for investors to capitalize on this trade and capture over a 5% yield, as of June 2023. In the near term, this will enable investors to complement the core of their fixed income portfolio by reducing overall portfolio duration while enhancing yield. The inversion of the yield curve should also provide ample downside protection if volatility increases as growth slows.

Rising to meet Canadians’ income needs

Kevin Prins, Managing Director, Head of Distribution, ETFs and Digital Distribution

ETF flows best show the overall investor sentiment. High short-term interest rates coupled with interest rate hikes drove investors into money markets and short-term bond ETFs. 

While the rising interest rates impacted valuations in the banking sector, retail and institutional investors looked at this as an opportunity and increased their allocation into the banks. Despite a rally in Technology stocks, investors kept the trend toward enhanced income solutions. This reflects Canadians’ record retirement and related income needs. 

The need for due diligence was also heightened. Given this, trust has once again become a key attribute when selecting an ETF provider.

The ETF industry brings together the demands of retail investors, Advisors and institutions. Looking at each of these markets provides insights on the growing utilization of ETFs in portfolio construction. 

Do-it-yourself (DIY) investing gathering steam

Erin Allen, Vice President, ETF Online Distribution, BMO ETFs

ETF adoption among DIY investors continues to increase, driven by the growing recognition of the many advantages offered by this cost-effective, diversified and highly efficient investment tool. Asset Allocation ETFs are a good example of these benefits in an all-in-one package. Investors find value in using these solutions to build the broad market core of their portfolio. The automatic rebalancing benefit is a great value-add for investors, keeping their investments on track with their selected risk tolerance and objectives as markets shift. These are generally low-cost solutions, with BMO’s suite of Asset Allocation ETFs having a management expense ratio (MER) of 0.20%, which means more money in investors’ pockets. 

While ETFs are often considered passive investment vehicles, we see DIY investors seeking alpha through ETFs in their portfolios as well. A study by the Ontario Securities Commission (OSC) found that one-quarter (27%) of investors who primarily invest with an Advisor have a secondary self-directed account.⁹ The reason: to take risks with their self-directed account while their Advisor manages their retirement portfolio. 

Thematic ETFs continue to grow in popularity, allowing investors to identify and take advantage of long-term structural trends by targeting a specific theme or industry to seek alpha and build wealth over time. Thematic ETFs can be used as effective satellite positions in a portfolio, representing a smaller allocation. Many discount brokerages now offer greater value on their platforms through educational resources and online tools, further motivating investors to take control of their investments. The pandemic accelerated the DIY investing trend, driving a surge in online trading activity, which has remained elevated relative to pre-pandemic levels. ETFs continue to prove themselves as effective market access tools, helping to democratize investing for DIY investors. 

A streamlined approach

Laura Tase, Director, Institutional & Advisory ETF Distribution

Advisors continue to be a driving force for asset gathering in the ETF space, as these solutions are an effective tool that can quickly adjust to tumultuous market outlooks. As recession fears permeated the channel, driven by the rapid pace of rate hikes, clients were seen implementing barbell strategies supported by significant cash and money market allocations. 

Treasury inflation-protected securities (TIPS) addressed inflation concerns, and income remained top of mind as covered calls continued to be a one-stop solution for Advisors seeking yield. Tactically overweighting to specific sectors, such as Tech and banking, was a common strategy as investors balanced recessionary and inflationary concerns with broad enthusiasm for the potential of AI. 

Regulatory changes, including know-your-product (KYP) requirements, acted as a catalyst for investment professionals to streamline their services. Instead of several providers and products, Advisors focused on fewer and larger names with immediate access to information and knowledge, including portfolio management teams. As providers were reviewed, so were their mandates, leading to larger allocations to fixed income ETFs. Advisors created core exposures supported by smaller and more precise active allocations. 

Factors, emerging markets and real assets

Mark Webster, Director, Institutional & Advisory ETF Distribution

Institutional investors fall into a broad category encompassing asset owners, like pension plans and endowments, asset managers and large investment counselling firms. Over the first half of 2023, their interests and asset flows reflected their inherently different approaches. Asset owners continue to evaluate responsible investment (RI)/environmental, social and corporate governance (ESG) strategies across their mandates in all asset classes. Discussions waver between carbon-focused themes and broader ESG considerations, but their interest in managing incumbent risks continues apace despite the divisive debates occurring in some jurisdictions.

Asset owner searches in the institutional eVestment database reveal several other trends, including:

• A heightened interest in factors, particularly Low Volatility and Quality. Investors should consider the following ETFs: ZLB, BMO Low Volatility US Equity ETF (ticker: ZLU), BMO Low Volatility International Equity ETF (ticker: ZLI), BMO MSCI All Country World High Quality Index ETF (ticker: ZGQ), ZUQ, BMO MSCI Europe High Quality Hedged to CAD Index ETF (ticker: ZEQ).
  
• Significant activity evaluating emerging markets mandates, likely attracted by the long-term demographics and very attractive valuations. Consider the BMO Low Volatility Emerging Markets Equity ETF (ticker: ZLE) and BMO MSCI Emerging Markets Index ETF (ticker: ZEM).

• A continued interest in real assets, particularly Infrastructure and Real Estate, but also in Global Agriculture. There is concern over inflation, due to supply chain issues, tight labour markets, cracks in globalization and energy transition, all of which will provide inflationary issues in the near term. The BMO Global Infrastructure Index ETF (ZGI), BMO Equal Weight REITs Index ETF (ticker: ZRE) and BMO Global Agriculture ETF (ZEAT) can offer an inflation hedge.

Some large asset managers have played defensive cards, accenting government bonds or lengthening their duration,¹⁰ anticipating possible economic or market softness. Some have shifted to U.S. aggregate bonds, which provide exposure to U.S. currency stability. There have also been significant flows to international mandates, tracking good valuations, such as ZEA.

Investment counsellors have shown renewed interest in fixed income mandates now that rising rates have made bond yields much more attractive. Many of these firms have been equity-heavy, but a significant number have recognized that the asset class now provides very attractive long-term yields. 

Large block trades have increased over the first six months of the year, indicating more institutions are using ETFs to express their investment views, buoyed by effective and timely execution.

Looking ahead

Mckenzie Box, Director, ETF Product Management & Strategy

Persistent inflation, high interest rates and recession risk have fuelled market uncertainty throughout the first half of 2023, creating a bumpy ride for markets. However, all roads must lead somewhere, and investors can find opportunities across many sectors and asset classes — with themes like Quality and Technology appearing to stick around. As the various macroeconomic risks play out, ETFs continue to prove their worth both strategically and tactically.

Source: BMO Global Asset Management, as of June 30, 2023.

¹Alpha: A measure of performance often considered the active return on an investment. It gauges the performance of an investment against a market index or benchmark which is considered to represent the market’s movement as a whole. The excess return of an investment relative to the return of a benchmark index is the investment’s alpha.

² National Bank Canadian ETF Flows, June 2023.

³ ETFGI Global Insights, June 2023.

⁴ National Bank Canadian ETF Flows, June 2023.

⁵ BMO GAM and Morningstar, June 2023.

⁶ Bloomberg, as of June 2023.

⁷ Annualized Distribution Yield: The most recent regular distribution, or expected distribution, (excluding additional year end distributions) annualized for frequency, divided by current NAV.

8 About the Lipper Methodology: The Refinitiv Lipper Fund Awards, granted annually, highlight funds and fund companies that have excelled in delivering consistently strong risk-adjusted performance relative to their peers. The Refinitiv Lipper Fund Awards are based on the Lipper Leader for Consistent Return rating, which is a risk-adjusted performance measure calculated over 36, 60 and 120 months. The fund with the highest Lipper Leader for Consistent Return (Effective Return) value in each eligible classification wins the Refinitiv Lipper Fund Award. For more information, see www.lipperfundawards.com. Although Refinitiv Lipper makes reasonable efforts to ensure the accuracy and reliability of the data contained herein, the accuracy is not guaranteed by Refinitiv Lipper.

The highest 20% of funds in each category are named Lipper Leaders for Consistent Return and receive a score of 5, the next 20% receive a score of 4, the middle 20% are scored 3, the next 20% are scored 2 and the lowest 20% are scored 1. Lipper Leader ratings are subject to change every month.

BMO Low Volatility Canadian Equity ETF (Ticker: ZLB) was awarded the 2022 Refinitiv Lipper Fund Award in the Canadian Equity ETF Funds category for ten years ending on July 31, 2022, out of a classification total of 17 funds. Performance for the fund for the period ended October 31, 2022: 0.64% (1 year), 7.34% (3 years), 7.53% (5 years) and 11.44% (10 years). The corresponding Lipper Leader ratings of the fund for the period ending October 31, 2022, are as follows: 2 (3 years), 4 (5 years), 5 (10 years).

⁹ OSC (2021, April). Self-Directed Investors: Insights and Experiences. Ontario Securities Commission. https://www.osc.ca/sites/defau…

¹⁰ Duration: A measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with lower duration when interest rates fall (rise).