The recent expiry of a U.S. patent that was held for decades by investment giant Vanguard Group is threatening to upend the growth of Canada’s $650-billion exchange-traded funds industry.
More than 20 years ago, Vanguard received a game-changing patent that allowed the fund company to easily launch ETF versions of its existing mutual funds. Known as ETF share classes, the funds were able to provide investors greater tax efficiency and cost savings.
The patent prohibited other U.S mutual fund companies from creating their own ETFs based on their existing mutual fund. The ability to launch ETF versions of mutual funds is much less expensive and onerous than launching a new fund altogether and gifted Vanguard a long advantage of easily launching both funds at the same time.
But since the patent expired in 2023, around 80 U.S. mutual fund companies – including some of the largest global players, such as Fidelity, Invesco Ltd. and JPMorgan Chase & Co. – have applied to copy the dual class structure. And due to economy of scale, many of these U.S. ETFs will be able to charge much lower management fees than what is offered in Canada.
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Canadians are not legally able to buy U.S mutual funds. Now, as ETF share classes can be bought on any public exchange, Canadian fund companies fear there is a significant risk that investors will sell their Canadian holdings and buy much cheaper versions of the new U.S. funds, according to Eli Yufest, executive director of the Canadian ETF Association, or CETFA.
In Canada, there are 45 providers who manage $650-billion in assets across about 1,400 funds. And while Canadian ETFs have continued to grow every year, the number of Canadians buying U.S. ETFs has also increased significantly.
Currently, more than 30 per cent of Canadian-held ETF assets are invested in U.S. products.
“Instead of those dollars supporting the Canadian economy, they are leaving our borders and fuelling the U.S. ETF industry and tax system,” Mr. Yufest said during an interview with The Globe and Mail.
“Right now, the Canadian ETF industry is at a critical junction.”
There are already more than 4,000 ETFs in the U.S., and all of them – except for the 47 Vanguard ETFs that have corresponding mutual funds – are stand-alone products, according to a report by RBC Capital Markets.
RBC estimates at least 1,200 ETFs are set to to be greenlit as ETF share classes by the Securities and Exchange Commission in the coming months.
“Should this exemption get approved, it is not hard to imagine a world where the sheer number of U.S.-listed ETFs grows significantly and potentially even doubles, within a short time horizon,” said Valerie Grimba, director of institutional ETFs sales and strategy from RBC Capital Markets.
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To stem the loss of investment dollars, Mr. Yufest is asking the federal government to reverse a major tax policy introduced in the 2019 budget that prevented certain mutual fund trusts and ETFs from deferring capital-gain taxes.
Over the past decade, ETFs have grown in popularity because they offer investors the ability to passively track major stock indexes for a fraction of the cost of mutual funds. However, distributions from these investments are generally taxable, which can reduce an investor’s potential after-tax return.
Prior to the budget changes announced in 2019, distributions of income and capital gains could be allocated differently, making some ETFs much more tax advantageous for investors.
Known as the “allocation to redeemers” methodology, the change in the Income Tax Act was a major blow to Canada’s asset management industry – particularly ETF providers – who said the capital gain taxes were only being deferred, and not a form of tax avoidance as indicated by the government. Nonetheless, the companies were required to shut down or alter the funds.
Now, if the U.S. ETF share classes are approved, U.S. fund managers will have access to the tax deferral advantage that is no longer available in Canada – providing investors with better tax efficiency around capital gains when they sell.
While the tax efficiency of ETFs is not the same in Canada, Canadian investors have had access to mutual funds as an ETF share class since 2013. In Canada, investor interest and specific “ETF series” launches have picked up in recent years. Last year, a third of all new ETF launches were an ETF series.
Ms. Grimba said the Canadian ETF industry could benefit if the government revisited the removal of the “allocation to redeemer” rule, and allow Canadian ETFs to be at par with U.S. ETFs from a tax perspective.
“This is a primary driver of why the ETF as a share class is going to take off in the U.S.,” she added.
The ETF industry is also lobbying the government to consider several other new tax measures to help keep Canadian dollars from heading south.
One proposal is to introduce a “maple investment” tax-advantaged savings account, which would provide a bigger tax benefit for investors who hold Canadian stocks, ETFs or mutual funds.
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“We are not advocating for prohibition on Canadians buying U.S. ETFs, that’s not what we are suggesting. We don’t want to reduce choice,” Mr. Yufest said. “As the government is championing the ‘Buy Canada’ movement, why don’t we create an account where we are given a higher exemption when we invest in our own country?”
Other proposals include urging the government to lower sales taxes, such as GST and HST, on ETF management fees to be more competitive against U.S. funds, and to work with provincial stakeholders to ensure all ETF products marketed in Canada are subject to the same set of investor protection rules and sales practices.
Daniel Straus, managing director of ETFs for National Bank Financial, says he is not sure whether the new ETFs will tempt Canadian investors by themselves, as many of them will be actively managed – likely making them more expensive than plain vanilla index funds.
As well, he says, the “sheer number” of products in the marketplace could lead to investor confusion, especially if they double or triple in the near future.
Editor’s note: A previous version of this article said that Valerie Grimba, director of institutional ETFs sales and strategy from RBC Capital Markets, is calling on the Canadian government to revisit the removal of the “allocation to redeemer” rule. Ms. Grimba observed that the Canadian ETF industry could benefit if the Canadian government revisited the rule.