ETFs now account for about 18 per cent of Canada’s fund market.Natali_Mis/iStockPhoto / Getty Images
A recent consultation paper on the exchange-traded fund market in Canada likely offers more insight into how the sausage gets made than most advisors and their clients want to know.
Yet, among the big-picture takeaways from the Canadian Securities Administrators’ (CSA) consultation paper is that this fast-growing segment of Canada’s investment landscape serves investors well, despite concerns about liquidity in times of market stress – particularly for small ETFs.
“Overall, the report should not be seen as a warning sign,” says Prerna Mathews, vice-president of ETF product strategy at Mackenzie Investments in Toronto.
That said, there’s room for improvement, adds Ms. Mathews, who is also vice-chair of the Canadian ETF Association’s board.
The CSA consultation paper, released in late June alongside an Ontario Securities Commission (OSC) study examining ETF liquidity and arbitrage mechanisms, pushes for improvements.
More investors are using ETFs, which reached $518-billion in assets under management (AUM) in Canada at the end of 2024, up from $382-billion in 2023 and $90-billion in 2015, the OSC report notes.
As of June 30, ETF assets totalled $589.6-billion, according to National Bank Financial.
ETFs now account for about 18 per cent of Canada’s investment fund market, which is still dominated by mutual funds, says Tiffany Zhang, director of ETFs and financial products research at National Bank Financial in Toronto.
“[ETFs’] growing popularity is the reason we’re seeing more of these studies,” she says, noting it’s incumbent on regulators to examine and address potential sore spots.
Another driver is aligning regulation more closely to the International Organization of Securities Commissions’ best practices for ETFs, Ms. Mathews says.
These reports put the spotlight on ETF market makers, particularly authorized participants (APs) that facilitate liquidity and price discovery.
“Among the notable concerns are instances in which a fund has just one AP,” says Andres Rincon, managing director and head of ETF sales and strategy at TD Securities Inc. in Toronto.
In Canada, APs are usually investment dealers and banks that sign agreements with ETF issuers for the right to create and redeem their fund units. APs help manage supply and demand for ETF units, which, unlike shares of publicly traded companies, can be continually created or destroyed (redeemed) to meet demand.
APs engage in arbitrage trading to manage the premium discount that can occur when the ETF price deviates from net asset value (NAV) as a result of supply imbalances.
That happens frequently intraday – albeit briefly – because available fund units may not meet demand, and vice versa. In instances of low supply, pricing is at a premium to NAV. When units exceed demand, unit prices may be discounted.
APs are incentivized to help keep prices and NAV tight because they can profit from mispricing through arbitrage.
The OSC study found the mechanism works well. From 2019 to the end of 2023, it found median price deviation from NAV ranged from 7 basis points in 2019 to a high of 14 in 2020. The next highest median divergence was in 2022 at 11 basis points. Both years with higher divergence are notable because significant geopolitical events occurred, causing extreme volatility: COVID-19 and Russia’s invasion of Ukraine.
How many APs are enough?
Of most concern are small ETF providers with one AP – although these account for about 8 per cent of total funds and roughly 1 per cent of all AUM.
Ms. Zhang says the OSC study found “no relationship” between the number of APs and an ETF’s bid-ask spread, noting 42 per cent of ETFs had nine or more APs. “But regulators believe having multiple APs is beneficial,” she adds.
In Canada, most APs are market makers, and regulators worry that ETFs relying on just one could decrease pricing transparency and increase premium discounts to NAV. And investors would be largely unaware, Ms. Zhang says.
What’s more, the OSC study found evidence that a higher number of APs leads to smaller premium discounts, “but it wasn’t clear if a minimum number of APs would promote sufficient arbitrage,” she says.
Still, the CSA consultation proposed a minimum AP rule, seeking industry feedback. It also noted a potential negative impact.
“It mentioned that could be a hurdle for smaller issuers, potentially hindering the introduction of innovative funds,” she says.
Ms. Zhang further notes that the number of APs and ETF size are likely less of a factor in spreads, NAV deviation and liquidity than what ETFs hold.
“ETF liquidity is determined by the liquidity of the underlying assets,” she says.
For many ETF providers, the concerns are moot. Most use multiple APs, who are often market makers, as a best practice, says Paul MacDonald, chief investment officer at Harvest Portfolios Group Inc. in Oakville, Ont.
“The key takeaway for us is there is likely to be increased oversight … and that’s not a bad thing,” he says, noting Harvest’s ETFs have multiple APs.
“You want to make sure if spreads open up that there are robust mechanisms to respond.”
Yet, mandating minimum APs may not have the intended result, given a second AP does not have to be a market maker, Mr. Rincon says. “If it’s not the responsibility of the second AP to quote and support the ETF in the market, it’s almost like having no additional AP at all.”
Still, he notes that having one AP has risks, including technology failure, leading to an AP’s platform going offline.
“Then you have no quote, unless … there is natural secondary market trade activity.”
The industry will likely voice similar concerns when the consultation wraps in October, he says.
What likely has more traction is the proposal to increase disclosure on spreads and premium discounts for funds.
Takeaways for advisors
Although these issues may seem of little concern to advisors and clients, the findings underscore the need for “good trading hygiene,” Ms. Zhang says.
That includes employing limit orders and avoiding trading at market open and close when liquidity is low. As well, it means avoiding trading ETFs listed in Canada that have international exposure when those markets are closed, notably during U.S. holidays, when higher premium discounts often arise.
“Whatever ETF you’re trading, big or small, you want to use best trading practices,” she says.
These may result in just a few cents per share of savings. Yet, Mr. MacDonald adds, “A penny saved is a penny earned in my book, and we want to make sure we’re really tight on spreads for our investors.”