Investors have pulled billions from Canadian mutual funds in the high interest rate era

A trader in busy office looks at data on computer screens.

Sales of both Canadian ETFs and mutual funds have slowed in the higher interest rate era, but only ETF sales have remained net positive.(Alex Segre/Getty Editorial) (Alex Segre via Getty Images)

After pulling billions of dollars out of Canadian mutual funds, February 2024 was the first time in a year that investors put more money in than they took out.

The month that ends with Canada’s RRSP contribution deadline had net-positive sales of around $3.2 billion, according to data released last week by the Investment Funds Institute of Canada (IFIC). That followed 11 months of net redemptions totalling tens of billions — the same pattern as the previous year, beginning when the Bank of Canada began ratcheting interest rates higher in March 2022.

“Last year, with rates for short-term products nearing or even reaching six per cent, many investors shifted toward more conservative investments,” Ian Bragg, IFIC’s vice-president of research and statistics, told Yahoo Finance Canada. “Finally, there was a high degree of market volatility, which also would have affected investors’ willingness to invest in stock and bond funds.”

Some of the mutual fund net outflows have been substantial. Investors pulled a net $10.4 billion out of mutual funds in June 2022, $9 billion in Sept. 2022 and $12.5 billion in October 2023, IFIC data show.

Interest rates account for part of the trend out of mutual funds, but experts say other factors are likely also at play, in particular the rise of exchange-traded funds (ETFs).

“It reflects a general trend that you see also in the U.S., that there is a shift from mutual funds to ETFs,” said Fabio Moneta, a professor in finance at the University of Ottawa.

Sales of Canadian ETFs have also slowed in this interest rate cycle, but have remained net positive. Net sales of ETFs in 2023 were $37.6 billion, up slightly from 2022 but down from a peak of $58.3 billion in 2021, according to IFIC’s 2023 investment funds report. Mutual funds, in contrast, saw net redemptions of $57.1 billion in 2023 and $43.7 billion in 2022.

Moneta said that the move from mutual funds to ETFs can be understood as one “from products which are more expensive … to a cheaper product.”

Canadian mutual funds are “notorious for charging very high fees,” said Saurin Patel, an associate professor of finance at the Ivey School of Business at the University of Western Ontario. He noted those fees can be especially hard to justify if a fund fails to deliver returns higher than an index fund.

“Most mutual funds charge very high fees and underperform” versus index funds, Patel said. “Which is kind of generally the case, that evidence is fairly consistent across the world. So what hurts Canada even more is that you have even higher fees and underperformance.”

Fund performance comes into particular focus when interest rates are higher, Patel noted. A mutual fund has fees and an element of investment risk, he said, whereas a guaranteed investment comes with neither.

“I know a lot of people who would say, I’m getting five per cent, six per cent on a GIC — why bother with a mutual fund?”

There’s a demographic factor at play, too. Data show that younger people tend to invest more in ETFs, Moneta said. Susan Christoffersen, dean of the Rotman School of Management, noted that baby boomers are also moving RRSPs into registered retirement investment funds (RRIFs), where they might choose, say, a lower-risk GIC option over a mutual fund.

What the future holds

In spite of the pattern of net redemptions, market gains meant net Canadian mutual fund assets rose seven per cent in 2023, and crossed $2 trillion in February 2024.

Net assets have effectively doubled in the past ten years through both sales and market gains. (IFIC’s Bragg pointed out that the key driver of mutual fund growth is “the rise and fall of the value of underlying assets” ahead of new sales.)

But the growth curve for ETFs is far more dramatic: a 21.9 per cent gain in 2023 and a sixfold increase in the last ten years. Net assets in ETFs reached $403 billion in February.

The total number of mutual funds in Canada contracted slightly last year to 3,384. An average of 28 new funds have been added per year over the last decade. In contrast, companies added 70 new ETFs in 2023, bringing the total to 1,126 — more than triple the number in 2014.

The experts say the changes playing out will likely mean more choice for investors, but not the demise of mutual funds. Whereas robot advisor platforms like Wealthsimple favour ETFs, the financial advisory divisions within Canada’s major banks “rely heavily on the mutual fund distribution model,” Patel said.

Morgan Stanley’s U.S. ETF funds recently hit $1 billion in assets, for example, driven in part by conversion of mutual funds to ETFs.

The decline in mutual funds is playing out in many cases at the same institutions seeing ETF growth. Companies are adding new ETFs or converting mutual funds into ETFs, said Patel, “so the money still remains in the family, but in a different vehicle.”

IFIC’s Bragg, citing “strong and growing investor interest in ETFs” noted that “several fund companies offer the same investment strategies in both mutual funds and ETFs and leave it to the investor to decide in what form, or in what structure, they want to access that strategy.”

But if inflation continues to stabilize and interest rates fall, Bragg said, “we expect to see a return to more consistent positive mutual fund sales.”

Christoffersen outlined two potential positive outcomes for investors: first, the proliferation of lower-cost alternatives will put downward pressure on mutual fund fees, “just in terms of the competitiveness within the marketplace.” More importantly, investors will see an even wider range of options for their money.

“These ETFs really have evolved in terms of the types of exposure,” she said. “They’ve created crypto ETFs, They’ve created ETFs that give you exposure to different types of markets. So I do think that they will continue to evolve to try to meet new demand for access to different markets.”

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