Buyside Breakdown Part 2: Exchange Traded Funds

Part 2: Exchange Traded Funds (ETFs)

As a buyside segment, ETFs can have a significant impact on their company constituents. Companies that are part of an recognized index and subsequently tracked by a passive ETF may benefit from increased liquidity and market capitalization. With significant growth in the number of active ETFs, there is hope for other companies to capture the interest of ETF asset managers¹.

In Canada, the split between active and passive funds is approximately 50/50², in a world where passive ETFs typically dominate the landscape. In the US, roughly 6% of ETFs are actively managed. However US active ETFs accounted for 25% of the new money from investors in the first 9 months of 2023³. In Europe, active ETFs have increased by 92% between 2016-2022⁴. ETFs are generally more appealing to investors during volatile markets. This may further encourage the growth of active ETFs with the recent socio-economic turmoil in our markets⁵. Both the growth and appeal of ETFs may result in an opportunity for increased investor relations engagement with active ETF asset managers.

Source: TMX

Why ETFs Matter

Buying Power

National Bank Financial reports that while ETFs still lag in terms of inflows of capital compared to mutual funds, in volatile markets, ETFs appeal to investors over mutual funds because of their intra-day liquidity, their lower costs, and greater transparency⁵.

The growth of ETFs cannot be ignored. As at December 31 2023, on Toronto Stock Exchange alone, there were 1000 ETFs listed, representing $585B in value traded. With a growing amount of capital funneling into ETFs, we may expect to see even greater product specialization.

Trading Impact

ETFs may have impacts on equity trading. The constituents of a passive index-tracked ETF may expect increased trading activity during the onboarding and offboarding from an index, as well as during the index's "rebalancing" periods⁷. For example, the S&P/TSX Composite Index* is rebalanced quarterly - effective after the close following the third Friday in March, June, September, and December⁸. It is therefore important for listed companies held by ETFs to understand the index methodology and rebalancing schedule to anticipate any increased trading activity and the implications to the companies' stock price.

Additionally, it is possible with passive equity ETFs that market makers need to hedge the index's underlying stocks⁵. Hedging in liquid stocks has minimal impact on the pricing of the underlying stocks. Even for niche ETFs holding more illiquid securities, the impact on underlying securities is still considered muted⁵.

Active ETF constituents will have similar predictability in terms of trading activity although portfolio managers have the ability to shift holdings based on market conditions. Active management may include the rotation of sectors to shield investors from periods of volatility⁹. However big swings in holdings are rare because they must stay within the confines of their investment strategy.

Influence

One way ETFs have influence over companies is in terms of fund construction. An ETF provider can choose to create a passive or active equity ETF which ultimately influences whether the fund has any control over the equity asset constituents. Further, fund providers may create ETFs that use screening techniques, or construct a fund around a theme (thematic funds) to appeal to a wider range of investors. Themes and construction techniques can further influence the constituents or influence the individual weightings of the constituents within a fund.

A second area of influence is shareholder proxy voting. ETF providers act as fiduciaries of clients' assets through their stewardship teams engaging with companies and voting on proxies. The voting power for constituents of index-tracking ETFs has been concentrated among large ETF asset owners¹⁰. Typically, ETF fund managers cast votes on shareholder proposals on behalf of their clients, who are the actual owners of the ETF shares. In the US, it is estimated that BlackRock, State Street and Vanguard control between 15 percent to 20 percent of most large US public companies because of their number of funds¹¹. However, in the last two years, there has been some change. Blackrock was the first to allow ETF shareholders proxy voting on held funds. This change enabled eligible institutional clients as well as retail investors to vote on some of their ETFs¹²; generally referred to as pass-through voting¹³.

How to Identify ETF Holdings

ETFs are transparent in their holdings:

1. Passive ETFs are a replication of the referring index. Generally index providers publish their constituents. However, the percentage weighting of each constituent company may not be publicly available.
2. Active ETFs in Canada only have to report top 25 holdings quarterly to the public¹⁴. In the US, ETFs must report holdings daily if they have non-US holdings¹⁵.
3. The ownership module on TSX InfoSuite^Ⓡ can be used by issuers to determine the North American ETFs and mutual funds holding their stock or a peer.

How to Engage and Access ETFs

There isn't a reason to target passive ETFs, but companies may want to consider looking at how to gain access to active ETF managers. With greater money flowing from active mutual funds to active ETFs, some value might be achieved by looking at actively managed Canadian equity ETFs.

Active ETFs provide more insight and transparency regarding their objectives than active mutual funds. This means companies could theoretically tailor their pitch to ETF portfolio managers. It is therefore important to build relationships with active ETF managers and consider highlighting liquidity or market capitalization within your investor decks.

Footnotes

1. The Impact of ETF Index Inclusion on Stock Prices, Social Science Research Network, John Duffy, Daniel Friedman, Jean Paul Rabanal, Olga Rud, May 24, 2022,
   https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4061686.

2. Active ETF activity grows, Investment Executive, Melissa Shin, October 11, 2022,
   https://www.investmentexecutive.com/newspaper_/etf-guide-2022/active-etf-activity-grows/#:~:text=More%20active%20ETFs%20have%20launched,lower%20than%20for%20passive%20ETFs.

3. Capital Group bets big on fully transparent active ETFs, Pensions&Investments, Ari I. Weinberg, November 6, 2023,
   https://www.pionline.com/exchange-traded-funds/capital-group-bets-big-fully-transparent-active-etfs.

4. Why ETFs are set to dominate fund assets, Wealth Professional, Jean Dondo, May 8, 2023,
   https://www.wealthprofessional.ca/investments/etfs/why-etfs-are-set-to-dominate-fund-assets/375732.

5. Canadian ETF Flows, National Bank of Canada, Daniel Straus, January 5, 2023,
   https://nbf.bluematrix.com/sellside/EmailDocViewer?encrypt=72d5702c-0270-4406-9463-e44e70dec4c8&mime=pdf&co=nbf&id.

6. The Renaissance of ETFs, Oliver Wyman, Kamil Kaczmarski, Sean Farrar, Philipp Zelter,
   https://www.oliverwyman.com/our-expertise/insights/2023/may/exchange-traded-funds-are-fueling-market-opportunities.html.

7. When the boat rocks: trading during an index rebalancing — Quant Simplified, Medium, Finsinyur, December 27, 2023,
   https://caden-finsinyur.medium.com/when-the-boat-rocks-trading-during-an-index-rebalancing-quant-simplified-3f00f53aa4f0.

8. Index Inclusion, TMX Group, April 14, 2022,
   https://www.tsx.com/company-services/learning-academy?id=578&lang=en.

9. Passive ETF: What It Means, How It Works, Investopedia, Daniel Liberto, January 26, 2024,
   https://www.investopedia.com/terms/p/passive-etf.asp.

10. ETFs' Growing Proxy Power, ETF.com, Jessica Ferringer, January 19, 2022,
    https://www.etf.com/sections/features-and-news/etfs-growing-proxy-power.

11. From the Financial Times. August 28, 2023. Vanguard's backing for green and social proposals falls to 2%. Madison Darbyshire, Brooke Masters. © The Financial Times Limited 2013. All Rights Reserved.
    https://www.ft.com/content/4313afe4-1fee-447d-b05b-0c8c38cfbff1.

12. Empowering investors through BlackRock Voting Choice, BlackRock,
    https://www.blackrock.com/corporate/about-us/investment-stewardship/blackrock-voting-choice#:~:text=BlackRock%20has%20seen%20growing%20interest,more%20accessible%20for%20eligible%20clients.

13. Pass-Through Voting, Broadridge Financial Solutions, Danielle Gurrieri,
    https://www.broadridge.com/ca/article/wealth-management/pass-through-voting.

14. ETFs in the spotlight: The CSA review exchange-traded funds, Borden Ladner Gervais LLP, Kathryn M. Fuller, Melissa Ghislanzoni, Lynn McGrade, Whitney Wakeling, Griffin Murphy, October 05, 2023,
    https://www.blg.com/en/insights/2023/10/etfs-in-the-spotlight-the-csa-review-exchange-traded-funds.

15. Active Semi-Transparent ETFs: What's Under the Hood?, Charles Schwab, Emily Doak, April 5, 2023,
    https://www.schwab.com/learn/story/active-semi-transparent-etfs-whats-under-hood.

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