How Canadian ETFs Actually Work | #413 (Morley Conn)

31:22With the net asset value trade, that's an agreement where we will exchange. We will trade with the client at the closing price based on the net asset value of that fund. it's all of the component parts in their percentages in that etf we will meet at a price that is the closing price net asset value fair value so if they're a buyer or seller we will execute at the closing price it's just a very very different it's almost more like your traditional mutual fund type trade but there are definitely some investors out there in the marketplace that are more comfortable doing net asset value trades and make that a standard fair for their transactions.

32:10So this is like if we needed to buy whatever a million dollars or 10 million dollars of some ETF and at risk trade, is that just like going to the market and buying it? Yeah, exactly. Okay. And then a nav trade is like is a closing price. It would be the closing market price. And is that like we're calling you up and saying, hey, we want to do a nav trade? That's right. Very standard fare. Interesting. Okay. And it's your risk and it's also our risk as the dealer on the other side of the trade, it will be our risk on a risk trade. So what involvement do market makers have with new ETF products?

32:43Since we're in constant conversation and contact with the asset managers, the ETF issuers, and as well we are speaking to all swaths of investor from investment advisor to institutions we're hearing what investors want and need and are looking for that might not be out there in the marketplace right now like some of this etf slop that you guys love so much kidding aside so a number of products actually have developed and grown that originated from conversations with market makers. And then ETF issuers took them up on some of these ideas and did bring products to market. I must confess that there's definitely been some of the leverage products have been in that category, guys.

33:32That has definitely been the case. And as well, some of the covered call products have also come out of some of those sorts of conversations. Inevitably, though, it's what we are hearing what investors would like to see. One of the cool things about ETFs is that you can take covered calls as one example, a relatively complex strategy to implement on your own, and you can put it in a product and it becomes super easy. As much as I don't think people should be investing in covered call products, if you were so inclined to do so, having it in an ETF is pretty incredible. It really is. We talked about at-risk trades and NAB trades.

34:07We talked about block trading and ETF pricing and all that kind of stuff. When you think about retail investors, what do you think they need to be aware of and thinking about when they're going to their discount broker account and trading ETF units? Oh my goodness. Investors need to definitely take into consideration when the markets are on holiday. And it sounds so simple, guys, but when the US market is on holiday, you should not be trading Canadian market ETFs who underlie the US market. It makes sense, but investors still do it. The same applies to Europe. The same applies to Remembrance Day when the Canadian bond market is closed.

34:47Just stay away. Those are better days. You want the best and most efficient price discovery in whatever security you're trading. So don't do it on days when markets are in holiday mode because you're going to get a holiday mode price. I also would stay away from the first 20 to 30 minutes of the market opening. and I would also stay away from the 20 to 30 minute close. These are messier periods of time. In particular, that opening is when market makers are still trying to figure out where these ETFs are with all their various underlying securities and pricing can be all over the place. You could maybe get a deal, but you more often than not will not.

35:39And so you are better off to let the dust settle. Market opens 930. Look at the market 10 o 'clock afterwards. So those are definitely factors that people should take into consideration. Can a retail investor place a nav trade if they wanted to? Investment advisor certainly could. It would be a little bit more challenging for a DIY, do-it-yourself investor, direct investor. replace that trade. Don't know if it's impossible, but technically right now, I think it would be a bit of a challenge. We certainly do them for investment advisors. One of our biggest clients is our investment advisor network guys.

36:22So we speak to them, provide them with a lot of trading advice and guidance on best execution practices and see them as a very important partner to what we're trying to achieve. Which is great. It makes a lot of sense. When you talk about not trading when a market is closed, which of course intuitively makes a lot of sense, is the bigger risk there that you're going to get a wide spread or just that you're going to get noisy pricing of the underlying? Noisy pricing, for sure. Most definitely. On holiday days, you do see less players in the marketplace. There is definitely a liquidity factor as well to take into consideration.

36:58There's just less prices out there. There's less participants. I think that it's not as much the spread as just a really bad fill. And there's been some famous ones in the past that have occurred and they've been in sizable trade. So there's been some lessons learned about that type of trade. It's not just also retail investors that need to be careful of that. There's been institutions that have borne the brunt of that as well. So here's the best execution practice question for you. When does it make sense to place a block trade order for an ETF? I'm going to give just a lame answer, but it completely depends on what you are looking to achieve.

37:40What is the goal? What are you looking to achieve with that trade, Cameron? Is it the immediacy because you think that the market's going to rally that particular day? Is it a risk reduction trade that is occurring? and you need to get off that exposure as quickly as possible? Is it the need to transact before a central bank decision occurs at either 10 o 'clock at Bank of Canada or into the afternoon with the Fed? It completely depends on what the drivers are of the portfolio manager's decision-making process and its traders for that matter. You know what as well? There's a lot of quantitative trade that occurs, a systematic trade that'll go through the market.

38:26So it can be driven by levels as well, technical levels, breakouts. There's a lot of that type of activity that occurs in the ETF market. So technical levels, systematic, a lot of drivers for where blocks will trade. How did the ETF blocks actually get priced? With great difficulty. I'm kidding. It goes back to where do I think I can hedge my exposure? And for most decently sized trades, it's not going to be too far off of where the current market quote is. But if it's a larger trade in some sort of sector ETF, for example, or a more esoteric bond ETF, the market makers really need to think, where am I going to get the offset?

39:20What is it going to cost me? And it's really an art and a science. The market making of ETFs is an art and science. There are tools that market makers will use that will give them indications to what the depth looks like of a given basket of stocks and how far down you think or how high up you think you're going to have to go if you were a certain percentage of the market volume. Those don't help you in non-exchange traded products though, guys. And so those will help. It goes back to experience. Pricing, a lot of block trades. and knowing where you think you're going to be able to hedge that risk.

40:03Another factor is market tone on the day. Is it a positive day? Do you think it's going to be difficult to get your hedges in? Or is it a negative day? And it's going to be difficult to find buyers of the underlying securities. That sort of tone, it's only sitting on a desk and seeing and experiencing it for a prolonged period of time, you'll really get a sense of how to price and how to trade it. We've been talking about block trades, but can you maybe just for listeners' sake, describe what a block trade actually is and how that's different from other types of trades? The term block trade is pretty wide anyways, because it depends on the underlying market.

40:45I have a screen set up that any trade, in theory, a million dollars or more is considered kind of of a block trade. But a million dollar trade, a million dollars worth of trade in something like a very liquid trade underlying the TSX 60 or 300 or the S &P 500 for that matter, that's nothing. Like block trades would be in the hundreds of millions, like sizable trade that would be very challenging to trade would be hundreds of millions of dollars worth of trade. But in theory, a trade in excess of a million dollars could be considered a block. But as mentioned, trades of that size in very active ETFs are not a big deal.

41:31It's only more sizable, but it's going to depend. There's going to be some types of ETFs where$10 million is going to be a very significant move, moving 10 million worth of those securities. Whereas in more active, big indices, as mentioned, it's going to be a lot larger. But we use the gauge of a million dollars, but it really does vary from ticker to ticker. It really does just speak to the ETF structure though, right? Where it's like, if people wanted to trade those underlying, you're basically talking about how hard it is to do it well and get good prices on the securities. But when someone's trading an ETF unit, they're just buying the unit.

42:13And you guys basically are doing all the hard work behind the scenes. Yes, there's a lot of work that goes behind the scenes. Each of the banks for our ETF market making operations, we have teams of developers that support our models. So we get, is mentioned from the custodians. We will get the inventory, the portfolio basket view of various ETFs in the morning. And then we will input those, update our models that our developers work on to price all of these different ETFs. So there's a lot that goes into it. There is a huge infrastructure. It's a very challenging business because the margins are tight, very competitive pricing, and yet there's a big capital outlay in both tech and people that's required.

43:08So if an ETF gets closed down, what happens to the assets inside the ETF? It does happen from time to time, and there's a few ways that it can happen. One, closing of an ETF does happen when an issuer just deems that a product, quite frankly, has been unsuccessful and they just want to close it down. The size of the Canadian ETF markets,$850 billion right now. We've got about almost 1 ,900 tickers. The US market is$14.7 trillion with the T. they've got around 5 000 tickers wow we have too many tickers in canada yes we do so what issuers will do is they will close and cancel out products that don't get critical mass and it's unfortunately not done enough issuers will leave products outstanding but to close them out to your question, to close them out, it's a pretty straightforward process.

44:20It's literally a few weeks time. It'll be press released. And the issuer, if there's any liabilities outstanding, those will need to be repaid, any lending if there's leverage involved. And then the net assets will all be returned to the ETF investors. I can tell you that we are seeing some issuers cancel and close out products with a little bit more regularity these days, which is actually, I think, really positive. I think that an ETF that fails is not a negative for the market, for the business, for the issuer. I think it just proves and shows that we're going to innovate. And innovation should not be deemed in a negative light.

45:07It should be seen as positive because that's how we get new products. We meet new needs of investors. And I think it shouldn't be deemed in the negative light that it has in the past. I show that as well, Cameron, that another reason why a ETF might get closed down is if the actual, the issuer was to go into receivership. There was one that occurred in the market in Canada in the last few years. And when the ETF issuer unfortunately went into bankruptcy, it ended up taking eight to nine months before. Well, first off, the ETFs all halted, and it took eight to nine months before the ETF investors got back their funds, and they did not get back their full funds.

45:56Obviously, in most situations, normal situations where it's not driven by a bankruptcy, you're going to get your full funds. But in that situation, it was very unusual. It rarely happens. ETF investors certainly did not get 100 pennies on the dollar. I know the story you're talking about. That was a crazy one. What percentage of ETF flows are retail versus institutional? In Canada, it's about 65 % retail trade. 65 to 70 % is easily retail trade. Retail drives the trade. You do have those large trades that happen from time to time, but retail is all over this market. This is actually kind of interesting, guys, in the sense that in the US, it's somewhere around the same, somewhere between 65, 70%.

46:51But in that retail number, the RIAs are included. Now, I don't know about you, but some of these RIAs, the registered investment advisors, are monsters. They're as big as institutions, and they're about 35 % of the market. So if you take the IRAs out and include them, it's more like almost, I don't know, are they institutions or are they not institutions? They run billions of dollars. I would argue that in the US, it's probably about two thirds institutional if you include the RIAs as institutions. So it is definitely a different market down there than it is up here. And what types of institutions are using ETFs?

47:36Everyone. It runs the gamut from multi-asset, balanced fund type asset managers, and all the banks have them. They are actually some of the largest users of ETFs in the marketplace. Hedge funds use them. A lot of actually, believe it or not, guys, active single security investors will use ETFs as well. I'll get into that a little bit soon. Hedge funds use them. Pension funds certainly use them. I would say every walk and type of institutional investor is using ETFs in some sort of way in the marketplace, for sure. How does the activity in the ETF market between retail and institutional differ, like in the way that they're trading them?

48:27The retail will use ETFs as the component part to their portfolio strategy. It is the core. So once someone adopts ETFs, and I can't say this across the board, but I would say it's a general rule that we see. Once they start using ETFs as their core strategy, it becomes slowly over time, it becomes the full strategy and they'll use it for almost everything. And then not everyone does that, but it certainly is more used in that way. Whereas I would say institutions, there's a lot more tools that they have at their disposal. They'll use total return swaps. They will use futures. They're going to use all sorts of other different structures to invest.

49:16So the ETF is just one component that they will use to invest in markets. There are institutions that will look at the cost between putting on total return swaps versus futures versus having on ETFs, putting ETFs as their exposure. They will look at the cost for these various tools, and they will decide which one they want to allocate to. A really anecdotal, interesting point, guys, in the last little while, last few weeks ahead of all of these big AI related and SpaceX IPOs, the cost of synthetic index type exposure has gone sky high through the roof. Why? Because there's a lot of funding, pre-funding that's being asked for by institutions, by all sorts of different financial service companies in the marketplace.

50:16There's a lot of borrowing that's being done right now to get various index exposures and to get exposure to some of these new IPOs. And so the cost of them like benchmark money market spreads of 45 like CEDOR or in the US, SOFR plus 45 to 50 up to like 100 basis points over. The total return swaps, just so that I'm not throwing jargon here, these total return swaps are how investors, large institutional investors will get equity index exposure without putting out cash. What they'll do is they will buy a swap and they will get a return on an index. And in return, they will pay for that by paying some spread above a funding rate.

51:09So that's just one tool that they will use in lieu of ETFs. So lots of different tools at their disposal. So you touched on this, but how are the Canadian and US ETF markets different? It's really interesting. We talked about before how retail is so prevalent in the Canadian space. The Canadian market is somewhere, actively managed products are somewhere between 25 % and 30 % of the Canadian market. Whereas in the US market, they're only about 8 % to not even 10%. And that's that$14.7 trillion market. That's where all the activity has been in the last little while or an inordinate amount of the activity in the US market.

51:56But traditionally, the U.S. market, because of Fidalsa as well, it's institutional bent, investors in the U.S. market were really looking traditionally for beta exposure. They were looking for market, pure market index exposure. Whereas in Canada, because we have so many more retail investors, they're looking as well for actively managed alternatives. And even though these are actively managed funds, they are still more attractively priced than traditional mutual funds of a comparable ilk. And so that is one very big difference between the US and Canada. I already alluded to it already, but the amount of trade in the US market is just insane.

52:50It is such a capitalist cowboy market. There are so many different strategies being utilized. The liquidity is truly amazing. Whereas the Canadian market is still developing from that standpoint. As well, another difference is because there's such a big RIA component to the US ETF market, that sophisticated group of investors looks to the etf market to buy a lot of derivative based etf products yes ben these are buffer type products believe it or not they are actually buying there is a lot more interest in derivative based products in the u.s market than there is right now in the canadian market i would say that from a simplicity standpoint because Because the Canadian market is as retail focused as it is, I think that the education involved with some of these derivative strategies is keeping investors from those products to date.

53:57But let's not oversell the retail investor. They are keeping up to speed and they are getting involved in more products over time that do have sophistication. So I just think it's a matter of time before we do start to see more derivative-based strategies grow in the Canadian market. And perhaps that means that, yes, we are going to have more ETF slop. It's just a matter of what investors are looking for over time as their tastes change and they become more sophisticated in some of what they're looking to achieve. We've got the slop regardless. We've got tons of structured products in Canada. So it's either going to be structured products directly from the bank or it's going to be a buffer ETF.

54:41But the products exist either way. It's just different ways to access them. There is different wrappers. The ETF one just seems to be coming more popular over time. Yeah. How does the tax efficiency of ETFs in Canada differ from that of the US? ETFs in the US are more advantageous for investors down there. Yes. There is a bigger difference between utilizing ETFs and ETFs are more attractive vis-a-vis mutual funds in the US from a tax standpoint. In Canada, ETFs, because of some of the secondary trade that we mentioned before, they do have some tax advantages that aren't available to mutual funds, but they're not quite as attractive in comparison to mutual funds as US ETFs are.

55:35In the US market, ETF holders do not have to be concerned with absorbing the capital gains of other holders of their funds. That capital gain, pinpointed, will be isolated to that investor. Whereas, yes, up here in Canada, if you own an ETF and you aren't transacting, there is still the possibility, even though we have the capital gains refund, there is the possibility that you will still be impacted from a tax standpoint if transactions do occur in the fund and you aren't involved in them. That is a big difference between the two jurisdictions. What are some of the most common misconceptions about ETS that you see?

56:22One of the biggest ones is, and this is institutions as well that will do this, is that they'll look at the assets under management. and if they're not, for example, a billion, they won't have interest in investing. Whereas that's not reflective at all. It's the underlying securities, getting back to that, the underlying securities are the true arbiter of the liquidity of that ETF at any point in time. And so even institutions will err on that. But one factor as well, Cameron, for institutions is many want to own an ETF that they'll want to own up to 10 % of the ETF. So if they want some sort of critical mass position of 50 to 100 million, they do want to see more AUM.

57:09That is a legitimate factor. But just the fact that an ETF, the size or the amount of trade that's occurring, liquidity at any point in time is no true indicator to how much truly we can trade in that ETF. So a lot of misconceptions occur around that. And then, Cameron, I have to admit to you, one of the biggest misconceptions that I was guilty of, when I originally heard the high yield bond funds, bond ETFs were coming to the marketplace, I said, this will never fly. This was back in like 2000, circus 2006, 2009 sort of era. I thought, okay, you've got a less liquid over-the-counter bond, and you're going to package it into a listed security.

58:01This will never fly. This will not work. We come into the first dust-up, first market-type sell-off or very, very unfavorable market conditions, this won't fly. I could not have been more wrong, guys, because through every disaster scenario, and we've had many disaster scenarios, every time the market has gone through difficult times, we have seen more liquidity come into both high-yield bond funds and as well ETFs in general. It has truly amazed me, and I could not have been more wrong. So even today, when we look at what's going on on the private credit, private equity side, and there's been a few ETFs that have tried to introduce on a lower percentage level, albeit a 15%, which is what the SEC allows them to do.

58:56But they've introduced some private credit to their ETFs. Those ETFs have not been a smashing success. It's been a tough tape for private credit in general with some of the very well-pronounced bankruptcies of private credit companies. And I think that it's going to take time to develop. But just like I thought that there was no way that high yield could ever do this, I don't think we can discount that down the road, private credit will also make its way into ETFs in a more significant way. It's not now. The liquidity isn't there. The innovation and technology to trade those securities is not quite where it needs to be.

59:41But I'm not going to say definitively that it's a done deal, that it's not going to happen in the future because I was so wrong in the past when it came to opining how well these ETFs would do. How do you think CRM3 total cost reporting, which in Canada is a new disclosure regime where financial advisors have to show all of the fees, including fund fees in dollar terms to their clients each year, how do you think that'll affect the ETF market? The total cost reporting that comes out of the client relationship model phase three, that the Canadian Securities Administrator, they're a collective of all of the Securities Commissions, the Provincial Securities Commissions, and they put together rules and consultation that then eventually becomes finding law by the Securities Commissions.

1:00:39Just to give some background here, so the Canadian Securities administrator, along with Ciro, has implemented this total cost reporting as part of the client relationship model. And it's to increase disclosure around cost linked to ETF to all ETFs issued in the market. And interestingly enough, this total cost reporting is going to go into place by 2027. So issuers and the market is working on it right now. It's going to be very favorable to ETFs. And we've already actually seen some of that occur. Why? Because now mutual funds, alt funds, and ETFs are going to have to provide additional disclosure, full disclosure on all their costs.

1:01:31If you are using leverage, you need to reflect that cost. If you're using swap facilities, you need to give all of your other sundry costs that your fund is enduring, including performance-related fees. So those funds that are underperforming and are high costs are at risk of seeing investors through IAs in particular sell down those positions and move more into lower cost alternatives. In particular, of course, lower cost alternatives is what the ETF market is all about. And so this is definitely a tailwind for the ETF industry. the huge spike we've seen in ETF activity and flows this year inflows into the market.

1:02:22Last year, guys, we saw about$125 billion in inflows into the ETF market. And we're on pace now at the end of May, around$88,$85 billion. We're on pace to get to like 200 billion. And I think some of that flow is driven by some IAs moving out of high cost products and into lower cost products, hence the ETF market. I've had conversations with IAs where this is definitely occurring. They're very sensitive to it. So it is truly a reality. Final question for you, Marley, and this has been fun. How do you define success in your life? Oh my goodness. This is your classic question? The classic. Yes, classic question.

1:03:08As I think I mentioned, guys, I've been in this business 30 years. I've loved it. The investment business is so challenging. It's so interesting. I've had the great opportunity to work with just such intelligent clients, colleagues, and yes, even competitors. And yet, as good as this business is, we're just always working towards the next goal, next achievement. And that's great. That's capitalism. That's business. But there's never enough. Every year, it's more and more. And so I think we need to gauge success outside of just this business alone. And we need to really work on those sources outside of this business alone.

1:04:01And that's family, that's friends, it's hobbies and interests. You will find true satisfaction and achievement in those and you will find enough. Whereas in this business, as good as it is, there will never be enough. There is more return to be had. There is more ETF adoption to occur. There is more of everything. And so you will never find true satisfaction from this business alone. You need to find it in your personal life, as mentioned, through family, friends, hobbies. It can be religion. It can be many different walks. you will find your success in those parts of your lives. For me, that is where I will find my true success and where I will find enough.

1:04:53And it's also the opportunity to, in those parts of my life, to give and to give more than I get. And that's how I'm going to find my true satisfaction in life. Really nice answer. It's been a great conversation, Marley. We really appreciate you coming on and shedding some light on how the ETF market in Canada works. And for bringing the nice soup. My pleasure, guys. And now let's enjoy some slop together. This is the first prop I think we've had on this show. Thanks for joining us. It was really fun. I really enjoyed it too, guys. Great to meet you. Thank you. Yeah, that was great, Marley. Thanks a lot.

1:05:29Take care. Cheers.

1:05:35Morley Conn:Hey, everyone. It's producer Matt. Thank you so much for tuning in to this week's episode. Before we sign off, here's the disclaimer you've been waiting for. Portfolio management and brokerage services in Canada are offered exclusively by PWL Capital, which is regulated by the Canadian Investment Regulatory Organization and is a member of the Canadian Investor Protection Fund. Investment advisory services in the United States of America are offered exclusively by One Digital Investment Advisors, LLC. One Digital and PWL Capital are affiliated entities, and they mostly get on really well with each other.

1:06:07Morley Conn:However, each company has financial responsibility for only its own products and services. Nothing herein constitutes an offer or solicitation to buy or sell any security. Occasionally, we tell you not to buy crappy investments in the first place, but that's not the same thing as telling you to sell them. This communication is distributed for informational purposes only. The information contained herein has been derived from sources believed to be truthy, but not necessarily accurate. We really do try, but we can't make any guarantees. Even if nothing we say is fundamentally wrong, it might not be the whole story.

1:06:42Morley Conn:Furthermore, nothing herein should be construed as investment, tax, or legal advice. Even though we call the podcast your weekly reality check on sensible investing and financial decision-making, you shouldn't rely on us when making actual decisions, only hypothetical ones. Different types of investments and investment strategies have varying degrees of risk and are not suitable for all investors. You should consult with a professional advisor to see how the information contained herein may apply to your individual circumstances. It might not apply at all. Honestly, you can probably ignore most of it.

1:07:14Morley Conn:All market indices discussed are unmanaged, do not incur management fees, and cannot be invested indirectly. Which is a shame, because it would be awesome if you could. All investing involves risk of loss, including loss of money, loss of sleep, loss of hair, and loss of reputation. Nothing herein should be construed as a guarantee of any specific outcome or profit. Past performance is not indicative of or a guarantee of future results. If it were, it would be much easier to be a Leafs fan. All statements and opinions presented herein are those of the individual hosts and or guests and are current only as of this communication's original publication date.

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