Canadian Mutual Fund Industry: A Changing Landscape

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DerailedCapitalism.com Page 1 Canadian Mutual Fund Industry A Changing Landscape The Canadian mutual fund Industry has experienced significant setbacks since the credit crisis in 2007. The growing lack of credibility with global capital markets has caused general public scepticism and market risk aversion. The total landscape of the mutual fund industry has structurally changed as investors re-evaluate their retirement savings plan and seek alternative sources of capital preservation. Mutual funds, once a secure wealth management industry has suffered drastically over the past 3 years. The average Canadian retail investorsfaith in the mutual fund industry has somewhat eroded. In 2009, confidence in mutual funds polled 75% declining from 86% in 2006. Figure 1: Total Canadian Mutual Fund Assets ($Billions) Source: https://www.ific.ca History of Canadian Mutual Fund Industry: The first major sign of growth and popularity of mutual funds in Canada took place during the 1960’s when total industry assets surpassed $1 billion nominal value. The industry experienced steady annual growth through the 1960s to the 1990s. The largest influx into mutual funds came during the 1990s when double-digit interest rates that had lured Canadian savers into GICs tumbled and investors sought higher return investment vehicles. 0 100 200 300 400 500 600 700 800 2009 2004 1999 1994 1989 1984 Total Mutual Fund Assets TOTAL ASSETS ($Billions)

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Canadian Mutual Fund IndustryA Changing LandscapeThe Canadian mutual fund Industry has experienced significant setbacks since the credit crisis in 2007. The growing lack of credibility with global capital markets has caused general public scepticism and market risk aversion. The total landscape of the mutual fund industry has structurally changed as investors re-evaluate their retirement savings plan and seek alternative sources of capital preservation. Mutual funds, once a secure wealth manag

Transcript of Canadian Mutual Fund Industry: A Changing Landscape

Page 1: Canadian Mutual Fund Industry: A Changing Landscape

DerailedCapitalism.com Page 1

Canadian Mutual Fund Industry A Changing Landscape

The Canadian mutual fund Industry has experienced significant setbacks since the credit crisis in 2007. The growing lack of credibility with global capital markets has caused general public scepticism and market risk aversion. The total landscape of the mutual fund industry has structurally changed as investors re-evaluate their retirement savings plan and seek alternative sources of capital preservation. Mutual funds, once a secure wealth management industry has suffered drastically over the past 3 years. The average Canadian retail investors’ faith in the mutual fund industry has somewhat eroded. In 2009, confidence in mutual funds polled 75% declining from 86% in 2006.

Figure 1: Total Canadian Mutual Fund Assets ($Billions)

Source: https://www.ific.ca

History of Canadian Mutual Fund Industry: The first major sign of growth and popularity of mutual funds in Canada took place during the 1960’s when total industry assets surpassed $1 billion nominal value. The industry experienced steady annual growth through the 1960s to the 1990s. The largest influx into mutual funds came during the 1990s when double-digit interest rates that had lured Canadian savers into GICs tumbled and investors sought higher return investment vehicles.

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Interest rates and mutual fund sales had a direct correlation in the 1990s. In May 1990, the Bank of

Canada rate, on which financial institutions base their interest rates, stood at one of its highest levels

ever; 14.05%. The Bank rate steadily declined and by the end of December 1993 the rate was at 4.11%.

Mutual fund sales surged 140% from the end of 1992 to the end of 1993 and strong markets sent assets

up to almost $114.6 billion.

Mutual funds continued to climb through the 1990s and became the fastest-growing segment of the

Canadian financial services sector, with assets under management (AUM) increasing from $25 billion in

December 1990 to $426 billion by December 2001, an increase of 1,700%. These assets were managed

in about 1,800 different mutual funds held in more than 50 million unit holder accounts.i

Credit Crisis The credit crisis that originated in January of 2007 did not affect the mutual fund industry size until 2008. The industry suffered a total asset decrease of approximately 27% compared to a CAGR of 7.2% over the previous 6 years. The industry total asset size tracks equity market returns as displayed below in Figure 2: Canadian Mutual Fund Total Assets vs. TSX Index Value.

Figure 2: Canadian Mutual Fund Total Assets vs. TSX Index Value

Source: https://www.ific.ca The mutual fund industry was severely impacted in September of 2008 when there was the equivalent of a bank run in the United States on money market mutual funds. These funds which frequently invest in commercial paper issued by corporations to fund their operations and payrolls, experienced massive

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withdrawals of $144.5 billion during one week, versus $7.1 billion the week prior. This interrupted the ability of corporations to rollover their short-term debt. Based on North American capital market interconnection, the Canadian money market experienced similar effects as investor liquidated assets for capital safe havens. These dramatic effects caused the TED Spread, an indicator of credit risk in the general economy, to spike in September 2008 as shown below in Figure 3: TED Spread 2008. The money market issue flowed to all aspects of the capital markets causing the TSX equity market to decline by 14.6% in index value during September 2008 alone, compared to a 39% drop for the entire year.

Figure 3: TED Spread 2008

Harmonized Sales Tax (HST) The Ontario and British Columbia governments first announced their intention to move towards a harmonized sales tax in March and July 2009, respectively. This regressive tax, as defined as a tax imposed in such a manner that the tax rate decreases as the amount subject to tax increases, will negatively affect the mutual fund industry. Although the full impacts are not quantifiable to date since the implementation in both provinces was only in July 2010. The Investment Funds Institute of Canada (IFIC) has projected that investment fund holders will pay 160% more under HST. This translates into less annual returns for investors which compounded over years ultimately reduces overall retirement savings. While the IFIC expresses concern with the implementation of HST, they do not mention that Canada has one of the highest mutual fund management fees in the world. To put things in perspective, the average Canadian mutual fund costs investors about 2.5% per year in expenses while HST will merely add 20 basis points to the fees. While we are not going to focus on the ridiculous MER, HST has many associated negative macroeconomic effects.

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The HST has altered CPI data through creating the perception of inflation. While Core CPI m/m for July was -0.1% compared to 0.1% expected, CPI m/m read 0.5% compared to 0.0% expected. This indicates that HST managed to raise the price of goods for consumers even while the economy was deflating. Since the government is focused on decreasing its budget deficit, it is doing so at the expenses of the consumer. Additional tax on necessity goods diminish purchasing power and in turn adversely affect consumer savings; mutual fund inflow.

Proliferation of Exchange-Traded Funds Over the last few years, exchange-traded funds (ETFs) have exploded in popularity, flooding the market at every angle with funds that track everything from equity sectors to commodities and are levered 1x to 3x the underlying. Besides posing severe systematic risks to the financial system, ETFs offer retail investors the ability to track a certain underlying without purchasing the whole basket or having to invest in a mutual fund. Critics of ETFs believe that they are short-term speculative instruments that provide insufficient diversification. While proponents believe the offering of investment flexibility and long-term lower management expense ratios (MER), make ETFs superior to a mutual fund investment. Mutual funds actively manage their portfolio, while ETFs are passive investment vehicles. The proliferations of ETFs have had certain advantages for individual investors, we are skeptical about the systematic effects on the financial system into the future. While not available for the TSX, the S&P 500 implied correlation index, ICJ and JCJ, indicate that index implied correlation is currently 77.62 from 53.41 at the beginning of 2009. This metric proves that stocks are trading more and more as one asset class. Aside from removing mutual funds ability to seek alpha, the threat of market globalization has unknown ramifications that the financial system is likely not prepared for.

Figure 4: ICJ Index (Implied Correlation 2009)

Source: Bloomberg

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Figure 4: JCJ Index (Implied Correlation 2001)

Source: Bloomberg

Sediment Post Flash Crash On May 6, 2010, the Dow Jones Industrial Average experienced the second largest point swing, 1,010.14 points, and the biggest one-day point decline, 998.5 points, on an intraday basis in overall market history. While the cause of this dramatic effect remains unknown, this event has further caused skepticism about the credibility and security of capital markets. This historical event combined with poor macroeconomic fundamentals ignited rapid mutual fund outflow specifically the domestic equity market from long-term funds. Since the beginning of May, Canadian Domestic Equity Outflows of Long-Term Funds has equaled $5.92 Billion compared to a $5.82 Billion YTD. These figures directly show that the flash crash ultimately has alerted mutual funds investors that their capital may not be secure and have caused them to liquidate holdings. We note that there is disconnect between the recent market rally and equity flow correlation as shown in Figure 5: TSX Performance vs. Canadian Domestic Equity Flows to LT Funds. While on a short-term chart the correlation is difficult to determine, referring back to Figure 2: Total Assets vs. TSX Domestic Equity Flows to LT Funds has proven to be a good indicator of market movements. We have been skeptical of the recent market melt up as macroeconomic market fundamentals have disconnected from market prices. Fundamental data continually weakens as economies have started to slow with 9 of the 14 Canadian macroeconomic indicators for August missing to the downside. Since monetary stimulus has worn off we expect continued equity market weakness as the TSX Index reverts back to the correlation of Mutual Fund Domestic Equity Flows. Through the month of July, even as mutual fund redemptions were the largest amount for the year at $2,617.5 Million, the TSX rose 4.6%. This has raised many unanswered questioned and unfortunately we do not have the ability of market foresight. Although based on historical movements with domestic equity flows and the index returns, the TSX index market returns going forward do not seem to shed any positive light.

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Figure 5: TSX Performance vs. Canadian Domestic Equity Flows to LT Funds

Source: https://www.ific.ca

Conclusion

For years, the Canadian mutual fund industry has experienced tremendous growth while providing

investors with a means of capital preservation. The landscape has structurally changed since the

beginning of the credit crisis in January 2007. Investors are now cognizant that the industry does have

systematic risks and is not sheltered from economic downturns. The outlook for Canadian savers is

deteriorating with the implementation of HST combined with nominal equity market returns. The debt

burdened Canadian government is indirectly causing moral hazard on the public sectors’ retirement

plans while creating obstacles for those wishing to save. Canadian mutual fund investors have decreased

their risk appetite and now seek investment vehicles that will merely return their capital. Additionally,

the credit crisis has created capital market awareness as individual investors now attempt to manage

their own retirement funds via ETFs. While these instruments prove advantageous from a costing

standpoint, they pose severe systematic risk that can only be hypothesised about due to significant

market correlation. The mutual fund industry is constantly changing; the fundamental driver between

equity market returns and domestic equity mutual fund flows should remain intact. We recommend

entering tactical long-term short positions on the TSX until domestic equity flows turn positive.

(Please note, we are entitled to change our opinion at any point in time without any notice. All trades

are the sole decision of the individual and please seek financial advisor assistance before making any

investment decisions) – email us at: [email protected]

i The Investment Funds Institute of Canada: https://www.ific.ca

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TSX Performance vs Domestic Equity Flows to LT Funds

Equity Funds ($Million) Return