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

Episode Summary

Executive Summary: Episode 413 is a deep dive into how ETFs actually work behind the scenes, focusing on Canadian market structure, liquidity, creation/redemption mechanics, block trading, NAV pricing, and tax efficiency. Morley Kahn explains the roles of issuers, custodians, market makers/APs, and advisors, while highlighting why ETFs often provide better liquidity and execution than investors realize.

Main Topics: ETF ecosystem and market participants (Priority: 5/5): The conversation maps out the full ETF value chain: issuers/asset managers create products, portfolio managers run them, custodians move funds and provide position data, market makers and authorized participants quote and facilitate trading, and advisors/dealers distribute products. Creation/redemption and primary vs secondary liquidity (Priority: 5/5): Kahn explains the mechanics of ETF unit creation and redemption, distinguishing exchange-based secondary trading from primary creations/redemptions, including in-kind versus cash exchanges and how these processes stabilize ETF pricing. ETF pricing, spreads, and block trading (Priority: 5/5): The guests discuss how ETFs are priced for large trades, what determines bid-ask spreads, why block trades often require hedging with underlying securities, and why ETF liquidity is largely driven by the liquidity of the underlying assets. NAV, dislocations, and market stress (Priority: 4/5): They cover how market makers arbitrage ETF prices back toward NAV, why apparent discounts can arise in stressed markets, and how ETFs can sometimes provide better liquidity than the underlying cash market during crises like March 2020. Canadian vs U.S. ETF market structure (Priority: 5/5): The episode contrasts Canada and the U.S. on retail participation, active versus passive product mix, derivative-based products, trading volume, and tax treatment, showing Canada as smaller, more retail-driven, and more active-fund-heavy. Tax efficiency and CRM3 disclosure (Priority: 4/5): Kahn explains Canadian ETF tax advantages and the capital gains refund mechanism, then argues that CRM3 total cost reporting will likely push investors toward lower-cost ETF options. Product innovation and investor behavior (Priority: 3/5): The discussion touches on how ETF market makers influence product development, including leveraged, covered call, buffer, and even private credit ETFs, and how investor sophistication is broadening over time.

Key Arguments: ETF liquidity is not determined mainly by the visible quote on the exchange; it is driven by the liquidity of the underlying securities and the market-maker ecosystem. Secondary-market trading often absorbs most investor flow, reducing the need for primary creations/redemptions and helping limit tax consequences inside the fund. Creation/redemption works as a pressure valve: when demand diverges from supply, authorized participants can create or redeem units using underlying securities or cash. Wide bid-ask spreads are usually a symptom of underlying market conditions, time of day, volatility, currency/foreign market issues, or cash-adjustment factors—not an easy profit source for market makers. During market stress, ETF prices can reveal more accurate tradable values than the underlying cash market, especially when the cash market is frozen or stale. Canadian ETFs are more retail-driven and more active-fund-oriented than U.S. ETFs, while U.S. ETFs have deeper trading volume and more derivative/structured product usage. CRM3 total-cost reporting should favor lower-cost ETFs because investors will see all-in fees more clearly and compare them against higher-cost mutual funds and alternatives. ETF market making is an expensive, competitive business requiring technology, balance sheet capacity, and experience; profitable execution comes from scale, relationships, and many small wins rather than large arbitrage gains.

Data Points: Canadian ETF market size: $850 billion - Kahn cites the approximate size of the Canadian ETF market. Canadian ETF tickers: Almost 1,900 - Number of ETF tickers in Canada mentioned in the discussion. U.S. ETF market size: $14.7 trillion - Kahn contrasts the much larger U.S. ETF market. U.S. ETF tickers: Around 5,000 - Number of ETF tickers in the U.S. market. Canadian ETF retail share: 65% to 70% - Estimated retail trading share in Canada. U.S. ETF retail share: 65% to 70% - Estimated retail share in the U.S., though RIAs are included in this figure. Canadian active ETF share: 25% to 30% - Share of Canadian market in actively managed products. U.S. active ETF share: Under 10% - Share of U.S. ETF market in active products. ETF trading volume vs primary flows in U.S.: 20 to 30 times - Kahn says U.S. ETF secondary trading volume can be 20-30x primary net inflows/outflows. ETF trading volume vs primary flows in Canada: 6 to 10 times - Canadian ETF secondary trading volume relative to primary flows. Cash adjustment factor (CAF): 5 to 25 basis points - Typical CAF range embedded in pricing for less liquid or foreign markets. Capital cost disclosure implementation: By 2027 - Expected rollout timing for CRM3 total cost reporting. ETF inflows last year: About $125 billion - Kahn references prior-year Canadian ETF inflows. ETF inflows pace this year: Around $85 billion to $88 billion by end of May, on pace for about $200 billion - He suggests strong ETF inflows may be partly driven by cost transparency and advisor migration. Private synthetic benchmark financing cost: SOFR/CDOR +45 to +100 bps - He cites elevated costs for synthetic index exposure and swaps ahead of major IPO/funding demand. Institutional ownership threshold: Up to 10% of an ETF - Some institutional clients want holdings large enough to represent up to 10% of the ETF.

Pivotal Quotes: "“The liquidity, when all is said and done, is driven by the underlying components of the ETF, not that visible ETF quote that you see on the stock exchange board.”" — Morley Kahn: Explaining that ETF liquidity comes from the underlying basket and market-making ecosystem, not just exchange screen depth. "“You don't learn from your winning trades, Cameron. You only learn from your losing trades.”" — Morley Kahn: Discussing the art and experience required to price block trades and manage ETF market-making risk. "“I think that an ETF that fails is not a negative for the market... innovation should not be deemed in a negative light.”" — Morley Kahn: On ETF closures and product experimentation as a healthy part of market innovation.

Implications: For investors, ETF execution is more sophisticated than it appears: timing, underlying liquidity, and market conditions matter. For the industry, Canadian ETFs are likely to keep growing as disclosure improves and advisors shift toward lower-cost, tax-aware products.