I recently had the chance to speak to Jonathan Needham, Vice President & Director, Lead of ETF Distribution at TD (TSX:TD) (TSX:TD) Asset Management. I talked to him about the surging popularity of ETFs in Canada, a range of Canadian ETFs to gain key long-term secular trends, and whether USD or CAD denominated ETFs are best for Canadian investors.
What's driving the popularity of ETFs in Canada?
Ketki Saxena: Hi Jonathan, thanks for being here today. Shall we dive in?
Jonathan Needham: Great to be here, Ketki. Let's do it.
Ketki Saxena: So Jonathan, one of the things that I want to touch on first is the growing popularity of ETF Assets in Canada. Recent data from IFIC shows that ETF assets increased 5% this year to September whereas mutual funds just saw a 1.5% increase. That's a huge difference. What do you think is driving the adoption of ETFs versus mutual funds in Canada?
Jonathan Needham: I think it’s a number of things. If you look at cash flow, the amount of money that is coming to ETFs this year is equal to the amount of money that's gone out of mutual funds this year and it's in the 30 billion dollar range.
In terms of the reasons why ETFs are becoming more popular not just in Canada, but globally. I think first of all, flexibility. It's really easy for an investor to pivot even on the margin quickly and effectively. The second is transparency. You know exactly what you own and why you own it, the basket is published on a daily basis. Another reason is that you get instant diversification with a single ticket. A diversified, balanced portfolio one ticker, away you go.
And then of course costs and accessibility. ETFs are on all platforms. You’ve got a massive choice in terms of exposure. And of course, it doesn't hurt that an ETF vehicle is lower cost overall than a traditional mutual fund. And so the less we charge as an asset management firm, the more the end investor gets to keep the compounding effect in returns.
I think the final thing is really just a transition and investor behavior, and that's on the institutional side. We've seen massive adoption of ETFs on the advisory side as they continue to go fee based. The direct investing client has grown in double digits for multiple years particularly during Covid.
Investors who are more educated today and are doing more research have gravitated towards ETFs because of their flexibility, their costs and diversification and all those things.
Ketki Saxena: So those are a lot of the fundamental benefits of ETFs, which are definitely attractive to investors. What do you think are some of the macro drivers that have driven growth in ETFs recently?
Jonathan Needham: I certainly think there's multiple macro drivers. You're seeing the younger generation, the smaller accounts tend to embrace and utilize ETFs, and so the next generation of wealth and when that wealth transfers, they only know ETS.
And wow we're seeing in Canada about 30 cents of every dollar going into active ETFs, so you're actually seeing asset managers launch their active strategies in an ETF vehicle, and particularly south of the Border massive franchises in the multi billions moving from funds to ETFs for all those reasons of flexibility.
USD or CAD Denominated ETFs for Canadian Investors?
Ketki Saxena: With these drivers pushing the proliferation of ETFs, there’s pretty much an ETF out there for any theme you want exposure too. And adding to this range of options, many of these ETFs - such as those in the TDAM suite of products - come in both USD and CAD versions. What are the advantages of a CAD vs USD ETF for Canadian investors?
Jonathan Needham: Yeah, great question. Certainly have to talk about that. We used to say there's an app for that. Now I can say there's an ETF for that. So any type of exposure you want, you can get it through the ETF vehicle.
When it comes to currency, whether to use the USD version tends to be more like an investor preference.
So for example, a lot of Canadians. have places in Florida or Arizona and so they consume and they spend in USD. Those clients are going to continue to own US dollar Investments. If you're spending in USD, you want a certain amount of portfolio in USD. That's one of the reasons why Canadian manufacturers make sure they have US dollar exposure and US dollar options.
There's also a lot of tax benefits. I won't get into that today, but for a Canadian investor that has a US dollar Canadian domicile ETF. It's a mutual fund trust. And even if it owns the S&P 500 it's not considered a foreign security. It's considered a Canadian product. And therefore there's some tax benefits for certain individuals.
Now when it comes to hedging and not hedging, here's the great thing. The overall consensus is the Canadian dollar will likely strengthen somewhat particularly if oil continues to stay strong. But the reality is I don't have a crystal ball.
So I always tell the end client: the good news is the ETF gives you that option hedged on heads USD or CAD with no additional cost.
Whereas if I were to try to do it on my own within my portfolio, there's going to be a pretty significant cost of putting on a hedge even with multi millions of dollars. I'm looking at spot price plus some basis points and in some cases a full percent. Instead you can get an ETF. We don't pass on those additional costs to the investors.So that's phenomenal.
But I tell the average investor if you are not sure like me whether I'll be right or wrong on the dollar split the trade. So in this type of scenario, having half in hedged is the safe bet, and a lot of retail investors do that. In the advisory side they tend to follow their firm's outlook.
I would say I'm seeing now that clients are starting to put on a currency hedge, both when they're looking at US Equity exposure, but also international exposure.
ETFs for Exposure to Long-Term Secular Trends
Ketki Saxena: I want to talk a little bit about themes in the market Jonathan, and touch on recent research from BlackRock (NYSE:BLK) (NYSE:BLK). BlackRock talks about certain themes that investors are trying to increase their exposure to for example AI or Tech Innovation.
BlackRock recommends ETFs as a vehicle to get this exposure because many people, when they're looking at AI for example, they just focus on the Magnificent Seven, but that actually gives them limited exposure to AI innovation. What’s an ETF you’d recommend for exposure to AI, and tech innovation ?
Jonathan Needham: Yeah, there's a few within the TD suite of products. The obvious one is TD Global Technology Leaders (TSX:TEC). And yes, that will have the Magnificent Seven right in the top Holdings.
The reality is those megacaps are going to be the leaders in AI we're already seeing that and they're the ones that are massive chests of dollars to spend on research and development. So I would actually argue that the best exposure actually is probably a market cap weighted ETF with those megacap holdings.
If you're a little nervous about having too much exposure to the mega caps because you already own it, the S&P 500 or an ETF that gets the exposure, then you're going to want to diversify away from the Magnificent Seven, because you already own them.
Then, something like the TD Global Technology Innovators Index ETF (TSX:TECI). You're going to get some more I'll say the future Apples or Googles of the world. You’ll get some networks like Palo Alto, and some software companies that are cost based and software microchip Tech.
And then actually the final product that I really like. It's a suite, our enhanced dividend ETF Suite. So TD Active Global Enhanced Dividend (TSX:TGED) for Global, TD Active U.S. Enhanced Dividend ETF (TSX:TUED) for US equity exposure.
It's actively managed by Ben Gossick and it really is meant to take advantage of what we see as long term secular trends like AI. So if you're looking to get exposure from an expert, who essentially is looking for companies that 1) not only are going to be there for long term secular trends 2) also have strong balance sheets 3) future cash flow that's underestimated and 4) can manage the risk by doing an options overlay strategy.
Our enhanced dividend strategies would certainly give you that exposure and again. Microsoft (NASDAQ:MSFT) (NASDAQ:MSFT) Apple (NASDAQ:AAPL) (NASDAQ:AAPL) Amazon (NASDAQ:AMZN) (NASDAQ:AMZN) Nvidia (NASDAQ:NVDA) are all in the top five within TGED. Those are the companies you want to own first and… foremost . If we do technically go into a tougher economic environment, they're going to continue to survive and thrive.
Ketki Saxena: That makes a lot of sense for the people who are looking for the next Microsoft but don’t necessarily want to get into the active management. After you’ve got your exposure to The Magnificent Seven, of course. I also wanted to touch on another theme: healthcare innovation, which was mentioned as a key trend in 2024 by the same research from BlackRock. What are your thoughts on having exposure to the sector?
Jonathan Needham: Now a couple of things about the healthcare space first off as a sector.
It's the second best performing sector over multi decades.
Looking ahead, not only do you have long-term secular trends like demographics and massive Innovation and strong balance sheets and planned investment in R&D, Healthcare today is actually very attractive from a valuation perspective.The stocks are also pretty cheap particularly relative to the broad market and relative to tech in particular.
You need to own it and most Canadian investors don't own much Healthcare as there's few Healthcare stocks in Canada for the most part. So you need to go Global particularly. They need to go to the US.
In terms of ETFs to take advantage of these trends, there’s really two I like. First, there’s TD Global Healthcare Leaders Index ETF (TSX:TDOC). That's really the best way to get exposure to healthcare and the growing trends within health care. And TDOC does that in a single ticket solution.
The second thing that I would say, the reason why TDOC is a great solution is that. The other advantage of TDOC is that you're actually limiting your exposure to the mega cap pharma companies and you're getting more exposure to some of the more large and mid-cap companies that are going to be the next leaders and have less risk of patents expiring, and so on.
And so TDOC is my solution for taking advantage of the trends in healthcare and obviously those came to fruition as we saw during Covid. I don't think we’re likely to see a slowdown in investing in that space.
Ketki Saxena: Particularly if we get any more waves of Covid.. So Jonathan I want to ask, apart from what BlackRock thinks are going to be the key themes into next year, what do you see as the trending themes next year?
Jonathan Needham: So short-term future - I hate to say this but boring will be exciting.I think bonds are going to be exciting this year going into next year. They're very attractive yields again, you’re no longer being punished for being a lender or saver for the first time in years. There's capital gain potential as many of the bonds within these ETFs are for sale or trading at a discount.
And then rates are likely to drop next year. We're starting to see inflation come down. You're starting to see the pain being felt by these higher rates and the economy starting to suffer. And so we predict in the second half of next year rates drop by 50 to 100 basis points.
And so if that happens and you own TD Canadian Aggregate Bond (TSX:TDB), which is the aggregate bond market, you've got a potential seven and a half percent upside, because of a simple rule of thumb in terms of duration relative to rate cuts.
And then if you're trying to manage tail risk and you're willing to go out a little bit longer on the curve something like a TD Q Canadian Low Volatility ETF (TSX:TCLV) which has a 15 year duration, there you've got an opportunity for 20 plus percent returns.
So bonds are going to play a place in the portfolio not only from mitigating risk and offsetting Equity volatility, but they're actually going to provide attractive returns next year.
In the equity space I would actually argue traditional boring will be good, and that's quality.
Quality Companies once were - strong balance sheets, with consistent cash flow that are paying out that cash flow in the form of dividends. So mandates like TUED and TGED, which I previously mentioned, are at least 70% of the companies are paying a dividend.
And then TD Q Canadian Dividend ETF (TSX:TQCD) and TD Q Global Dividend ETF (TSX:TQGD), which are essentially trying to harness that quality factor and companies that are paying consistent and growing dividends over time.
So bonds and quality balance sheet companies. And then the final one - which is sort of like a favourite child. TD Q U.S. Small-Mid-Cap Equity ETF (TSX:TQSM). First, phenomenal returns relative to its Benchmark. Second, investors are underweight small and mid-cap equities and relative to the broad market that is heavy Tech in the US today and concentrated in The Magnificent Seven.
TQSM gives you a lot of diversification and valuations that are about a 35% discount relative to historical Norms.I would argue you're not going to be able to do it on your own by picking stocks in that space.
Any Final Words of Wisdom or Advice?
Ketki Saxena: Thank you so much Jonathan. Those were all the main questions that I had for you, but I wanted to ask if you had any words of wisdom or guidance to share with about ETFs?
Jonathan Needham: Yeah, certainly. I think first and foremost, they should know that not all ETFs are created equal, right? So look under the hood. You want to make sure you're with a trusted provider.
And you want to know what your own. The good news is, the baskets are published daily.
Depending on the type of exposure you're looking to avoid, make sure you're looking at the structure of the ETF. Is it physically backed by the securities themselves or not? Is it by a trusted brand? Unfortunately, we've seen one particular company in Canada this year closing shop, right? No liquidity.
So you want to make sure you want to know what you're owning and be with a trusted provider and then obviously do your research and if you have more complex life situations consult the financial advisor.
Ketki Saxena: Thank you, Jonathan, for your insights today. Thanks so much for joining us.
Jonathan Needham: Thanks Ketki, greatly appreciate it.