ETF Mid-Year Market Review & Outlook

ETFs experience record flows, provide liquidity when investors need it

In Canada, by June 30 net flows into exchange traded funds (ETFs) had reached a staggering $22.4 billion, a record for the first six months of the year1. Investors used ETFs to navigate market turmoil and volatility, to rotate into and out of exposures, to find liquidity, and to manage portfolios efficiently. The benefits and advantages of ETFs were evident over the last six months as investors dealt with the Covid-19 virus shock and then the massive fiscal and monetary stimulus to reinflate markets, as the market rotated from bull to bear and back to a bull market, in such a short period.

ETFs proved their value once again to investors, as markets appear to shift more rapidly, both with the depth and the speed of the correction and the subsequent rebound. Using the S&P 500 as an illustration, markets had dropped by one-third on March 23 (2237 index level) from late February highs (3386 index level) and recovered 40% by June 30 (3100 index level)2. With investors caught by surprise both times, and with equity markets now more expensive than they were pre-Covid, investors used ETFs to efficiently transform portfolios with an easy-to-use, single ticket solution.

In terms of asset classes, the risk-on sentiment which influenced the market rebound in the spring drove investors into equity ETFs. Equity flows were over $15 billion in the first half of the year and fixed income flows were over $5 billion3. The Canadian ETF industry began the year at $205 billion and now sits at $217 billion, driven mostly by net inflows as the market recovery continues3.

Canada listed ETF Flows by Calendar Year

Canada listed ETF Flows by Calendar Year

Source: BMO Global Asset Management. Data as of June 30, 2020.

ETF Fixed Income Liquidity During the Market Sell-off

In March, we witnessed a historic sell-off that saw global equity markets drop by 25% during the month, as investors scrambled to make sense of a growing pandemic and ensuing economic shutdown.4 As equity markets were down so drastically into the first quarter end, investors needed to raise capital from fixed income investments to rebalance their asset allocation mix and the ETF market was one of the first places they looked to raise cash, simply because the ETFs continued to trade while many of the underlying bonds did not. As the vast majority of investors were trying to sell, the market became one-directional with limited buyers. Even capital markets participants, which in a normal market environment provide a second layer of liquidity for ETF markets were limited in their ability to buy bonds as their balance sheets were near capacity.

What we witnessed over these few weeks was a wide price dislocation between fixed income ETFs’ market prices and their Net Asset Value (NAV). As the bond market went “no bid”, ETF NAVs remained stable, yet the ETF market prices dropped significantly. Since mutual funds (which trade on NAVs) and direct bond holdings had minimal price movement, some investors questioned if this pointed to a weakness in the structure of the ETF or a problem with the market price. However, the opposite was true. The underlying bonds in the ETF had limited trading, so the quotes that were used to price the NAV were not moving even as the bottom fell out of the market. The stale pricing of the NAV was not reflecting the changing market environment. The ETF’s market price was actually a more accurate representation of the marketplace and the value of the underlying bonds. This also demonstrates the liquidity premium that was attached to the bonds when liquidity dried up. Since then, we’ve seen a return to a tighter NAV vs market price reflecting the announcement of the Bank of Canada’s (BoC’s) asset purchase programs. This highlights how well an ETF works; during an extremely stressed market, fixed income ETFs continued to trade and provided liquidity for those who needed it. We can’t overstate enough the importance of liquidity when it is needed and ETFs, while subject to market volatility, provided liquidity during the March correction.

BMO Short Corporate Bond Index ETF (ZCS) Market Price vs NAV

BMO Short Corporate Bond Index ETF (ZCS) Market Price vs NAV

Source: BMO Global Asset Management, July 10, 2020.

Fixed Income

Fixed income is a huge opportunity for ETFs because it provides an over-the-counter (OTC) asset class greater transparency, tradability on the exchange, and tighter spreads. These features and benefits were most apparent during March as fixed income ETFs were available and continued trading when the underlying bonds were not.

During an extremely stressed market, fixed income ETFs continued to trade and provide liquidity for investors.

The BoC’s response to the fixed income market crisis in March, soon after the U.S. Federal Reserve’s announcement on March 23, has been highly effective. On top of short term paper asset purchase programs, they expanded into Government of Canada, Provincial and Corporate bonds. For Provincial bonds, the program size is up to $50 billion, with BMO Global Asset Management (BMO GAM) as the asset manager.5 For corporate bonds, the program size is up to $10 billion, with TD Asset Management as the asset manager.5 These announcements were positively received in the marketplace, resulting in tighter spreads and improved liquidity, leading to limited bond purchasing to date.

Within the BMO ETF product shelf, we saw flows move from aggregate exposures to segmented ETFs as investors looked to capitalize on specific dislocations across credit and term and rotated into more defensive fixed income to offset heightened equity risk. We saw notable flows into federal bonds, especially in the first quarter as investors retreated to safer asset classes. The BMO Long Federal Bond Index ETF (ticker: ZFL) gathered $146 million over the six-month period while the BMO Government Bond Index ETF (ticker: ZGB) took in $123 million in net flows.3

We saw an increasing amount of large volume trades indicating that institutions and asset managers were ready to reposition portfolios with ETFs.

As an example of the precise ETF exposures now available, early this year BMO launched The BMO BBB Corporate Bond Index ETF (ticker: ZBBB) which allows investors to pinpoint a segment of the investment grade Canadian corporate bond universe to add a yield pick-up without going as far as high yield bonds. As the risk appetite of the market returned in April, fixed income investors looking out on the risk spectrum found value in the BBB space. In Canada, BBB bonds are issued by many blue-chip companies such as Canadian Tire, BMO, and Rogers.

The safe-haven “cash vehicle” trade which was popular throughout 2019 remained relevant. Investors looked to cash-like ETFs as a safety play and to park assets during the market stress. For short term ETFs with a floating NAV, they benefited from the decrease in yields, with the 91-day T-bill yield moving to 20 basis points on June 30 from 166 basis points on December 31.2 BMO Ultra Short-Term Bond ETF (ticker: ZST) saw flows of $63 million so far this year, while High Interest Savings Account (HISA) ETFs which are designed to give investors a savings account like product within an ETF continued to attract significant flows as well. A concern moving forward is now the lack of yield on these idle assets, and how long the cash will remain on the sidelines. Investors who have moved to cash are looking to time their market exposure return, but they have already missed out on the
three month recovery through the second quarter of 2020.

With yields so low, investors are more focused than ever on returns after fees, where the low-cost benefits of ETFs leave more return to the holder. With the expectation that yields will remain compressed for several years, investors are challenged to find return opportunities in fixed income, so the precise segmentation in fixed income ETFs allows for targeted exposures and efficient rotation strategies.

Equities: Broad Beta and Sector Rotation

Equities have been a distinct winner this year, attracting flows of over $15 billion by June 30.3 The most obvious trend was into broad market exposures as investors traded into equities at attractive valuations during the sell-off hoping to capture growth during the recovery. This trade played out as the market reacted to a record amount of stimulus announced by central banks across the globe, ushering in one of the swiftest and most aggressive bull markets of the century.

The most notable market was in the U.S. where a “V-shaped” market recovery has played out so far. By the end of June, the broad U.S. market had almost recovered all of March’s losses. S&P 500 Index ETFs were the overall winner in terms of flows, gathering $3.4 billion.3 The BMO S&P 500 Index ETF (ticker: ZSP) captured over a quarter of the flows within this space.3

Investors traded into equity ETFs during the selloff hoping to capture growth during the recovery.

The NASDAQ 100 Index recovered and has since set new highs as investors look to “new economy” companies that can capitalize on the transformations in the way we work and live. NASDAQ tracking ETFs in Canada attracted $560 million in net flows over the last six months.3 Investors looked to increase exposure to this Index which has been lifted by mega-caps Amazon, Microsoft, Apple, and Alphabet which make up a combined 40% of the index and were the top contributors to its performance. These companies have been benefitting the most from the new trends emerging from a more distanced world. Information Technology (IT) as a sector has been performing very well. However, it is interesting to note that only two of the top four names in the NASDAQ are in the IT sector, as Amazon is in Consumer Discretionary, and Alphabet is in Communication Services.

Investors also looked to Emerging Markets, seeking exposure through the broad index. The BMO MSCI Emerging Markets Index ETF (ticker: ZEM) saw over $500 million in flows over the last six months.3 Emerging Markets have become a compelling region for investors looking for growth and exposure to a global economic recovery. The index carries over 40% weight in China. China was one of the first economies to recover from the coronavirus crisis and its market came back strongly in Q2 2020, driven by a growing technology sector in the country.

Some secular trades have also played out as investors rotated into specific sector exposures to take advantage of tactical market opportunities. Notably in the Financial sector, where bank ETFs saw $541 million in flows so far this year. The BMO Equal Weight Banks Index ETF (ticker: ZEB) took in $246 million in the last six months.3 The banks were hit hard in March, and loan loss provisions soared, preventing the sector from a quick recovery. However, Canadian banks remain extremely well capitalized and continue to offer a stable dividend, so many investors recognized the opportunity to get exposure to this historically resilient sector at a discount. ETFs allow investors to invest in the six largest banks in Canada, instead of picking a single bank exposure,and ZEB goes a step further by equal weighting the portfolio.

Currency was not immune to the market volatility through March and April, especially looking to the U.S. market as a Canadian investor. Currency experienced extraordinary levels of volatility, which significantly impacted performance numbers. The Canadian Dollar (CAD) hit a low of $0.68 and a high of $0.77 relative to the U.S. dollar (USD) in the first half of the year.2 The loonie has been under pressure, affected by both low interest rates and the falling price of oil. In addition, USD strengthened during the sell-off as investors turned to it as an equity market safe-haven. Generally, many Canadians look to hedge as CAD falls below $.70 and seek USD exposure when it moves towards the mid- $0.70’s. BMO ETFs offers a range of currency options in its ETFs. This gives
investors more options to manage currency when looking to add U.S. and international equities to portfolios.

Gold was a huge winner to start the year, in terms of asset gathering and performance. Investors looked for a safehaven asset class amid doubts surrounding the economy,worsening economic data, inflation expectations and second wave fears. The BMO Equal Weight Global Gold Index ETF (ticker: ZGD) returned 25% In the last 6 months6 and is BMO ETFs’ top performer during this time. The sector is benefitting from the increasing price of gold which ended the quarter at over $1800 per ounce.2 Gold equity companies are among one of the few sectors posting positive, strong earnings as the increasing price of gold means greater profits over fixed mining costs. While gold miners initially fell with the market sell-off, they were quick to recover and benefit from the rising price of gold, fueled by market fears and possible longterm inflation driven by the stimulus packages.

Factor Rotation Plays Out

Factor exposures are gaining traction with investors. As shifting economic factors changed the markets from January to June, the rotation in factor exposures played out. Late in 2019, low volatility was the most popular factor exposure as investors positioned their portfolios more defensively becoming weary with late-cycle fears. During the sell-off in March, low volatility did offer downside protection as designed. However, since March, low volatility equities have not bounced back to the extent of the broad market, due to avoiding the higher beta stocks which have really outperformed during the spring.

The quality factor has outperformed, as the stressed market environment has highlighted the resilience of high-quality companies with low debt, stable cash flows, and high return on equity. Quality companies have been a strong outperformer of the broad market, and all other factor exposures over the past year. The BMO MSCI High Quality Index ETF (ticker: ZUQ) has returned 6.2% while the BMO S&P 500 Index ETF (ticker: ZSP) has returned 1.2%6 in the last 6 months. High quality companies are defined as market leaders that have durable business models, strong balance sheets, and sustainable competitive advantages. We continue to have high conviction in the Quality Factor as it offers both defensive down-side protection against a correction, and offensive positioning for market recovery.

The value trade has been long out-of-favour, but we have seen value start to emerge at the end of Q2 2020, perhaps signaling the factor may rebound. In Canada, value companies are dominated by the Financials and Energy sectors, both which have yet to recover as quickly and ardently as other sectors have. Investors can also seek exposure to value with dividend ETFs which are biased to value and these have also struggled through the year as companies become under pressure to cut or suspend dividends as they become more cash-strapped in
 his environment.

BMO ETF Factor Performance

BMO ETF Factor Performance

Source: Morningstar Direct. Data as of June 30, 2020.
Past performance does not guarantee future results

We expect the record trading volumes of the first half of 2020 to be an indicator, not an anomaly, of future ETF acceptance.

ESG

BMO launched a suite of Environmental, Social and Governance (ESG) ETFs in January, bringing a range of ESG options to investors. As the market collapsed, investors looked to quality companies with prudent management teams and strong governance as companies that could best weather the market correction. Governance, the “G” component in ESG has been put under the spotlight recently. Investors are becoming more aware of the impact on which strong corporate governance has on a company’s resilience under stress. Therefore, we expect that ESG will continue to provide performance opportunities for investors in the future. Politicians in the U.S. have recently challenged this notion, stating ESG should not be considered in an institutional investing context. But as we continue to gather more data and the performance continues to trend above the broad market, the ESG benefits are delivering results and helping investors invest to align with their values. BMO was the first in Canada to offer a one-ticket ESG ETF solution with its Balanced ESG ETF (ticker: ZESG), which provides an all-in-one solution to address ESG investing across asset classes and markets.3

Looking Ahead

With 36 providers now participating in the ETF marketplace, and an accelerating number of ETFs coming to market, investors are benefitting from more precise exposures and innovative strategies to pair with the recognized broad market ETFs.3 This allows for more advanced portfolio construction, with disciplined, low cost core exposures and satellite ETFs to address market opportunities. With markets shifting faster, and more dramatically than many investors expect, ETFs have proven to be efficient portfolio tools, both by flows and by trading liquidity.

We continue to see ETFs, as a percentage of exchange dollar trade volume, double during periods of market stress. The market crash in 2008 demonstrated the importance of ETFs in portfolios, based on liquidity and increased dollar trade volume. We expect 2020 to be a greater proof point, now that more investors use ETFs as they have evolved into a mainstream investment option. We see a healthy ecosystem, where large institutional investors and direct investors alike use ETFs to build portfolios. We expect the record trading volumes of the first half of 2020 to be an indicator, not an anomaly, of future ETF acceptance.

Disclosures

1 National Bank, June 30, 2020 

2 Bloomberg, June 30 2020 

3 BMO Global Asset Management, June 30 2020 

4 MSCI World GR Index dropped 25% from February 28, 2020–March 23 2020. Source Morningstar Direct. 

5 https://www.bankofcanada.ca/markets/market-operations-liquidity-provision/marketoperations-programs-and-facilities/

6 Morningstar Direct, June 30, 2020

Forward-Looking Statement:
Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance.They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

The BMO ETFs or securities referred to herein are not sponsored, endorsed or promoted by MSCI Inc. (“MSCI”), and MSCI bears no liability with respect to any such BMO ETFs or securities or any index on which such BMO ETFs or securities are based. The prospectus of the BMO ETFs contains a more detailed description of the limited relationship MSCI has with BMO Asset Management Inc. and any related BMO ETFs.

This communication is intended for informational purposes only and is does not constitute a solicitation of an offer to buy, or an offer to sell securities, and nor should it be construed as, investment and/or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus before investing. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

®BMO ETFs are managed and administered by BMO Asset Management Inc., an investment fund manager and portfolio manager and separate legal entity from Bank of Montreal.

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp.,BMO Asset Management Limited and BMO’s specialized investment management firms.

®/™Registered trade-marks/trade-mark of Bank of Montreal, used under licence.

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