The U.S. autocallable ETF market has grown to more than US$5-billion in assets since the first products launched last year.ismagilov/iStockPhoto / Getty Images
Autocallable exchange-traded funds are one of the hottest new product innovations in the United States. Now that they’ve arrived in Canada, advisors may be asking if these ETFs make sense for client portfolios.
Casey Yang, director of ETF sales and strategy at TD Securities Inc. in Toronto, says autocallable ETFs are among the fastest-growing ETF segments in the U.S. because they meet a specific investor need: high income with some downside protection.
The U.S. autocallable ETF market has grown to more than US$5-billion in assets under management since the first products launched last year.
“Growth is being driven by demand for income alternatives to traditional fixed income and covered-call ETFs,” Ms. Yang says.
How autocallable ETFs work
A TD Securities Inc. report published in September describes the autocallable ETF as a “market-linked investment that provides regular coupon payments and aims to return principal at maturity, or earlier if the note is called, provided the underlying reference index […] remains above predetermined downside thresholds.”
The report adds: “A useful way to think about it is as a bond-like investment [in which] both the income stream and principal protection are linked to equity market performance rather than traditional interest rates.”
Autocallable ETFs offer the potential for higher monthly income than traditional fixed-income securities, but that potential comes with some equity market risk.
Coupon payments typically continue as long as the reference index remains above a pre-set downside barrier.
Principal is generally returned in full at maturity, the TD Securities report says, unless the index finishes below that barrier, “at which point investors may experience a loss of capital.”
The ETF wrapper is attractive, Ms. Yang says, because it provides daily liquidity and easier access for investors.
To that end, Canadian issuers are now bringing structured-income strategies into the domestic ETF market. Purpose Investments Inc. led the way with the launch in August of Purpose Structured Equity Yield Fund (PSY-T), which offers a structured income strategy based on broad market indexes.
BMO Global Asset Management followed in September with the launch of BMO Strategic Autocallable Income US Large Cap ETF (ZACU-T), Canada’s first dedicated autocallable ETF, which applies the structure to a portfolio of U.S. large-cap stocks rather than a broad index.
Sara Petrcich, head of ETFs and alternatives at BMO GAM, says autocallable notes have become increasingly popular but can be difficult for investors to access.
Ms. Petrcich, who took over BMO GAM’s ETFs business in 2023, when it was combined with the synthetic asset management business, says BMO GAM created the ETF to make this investment strategy more accessible.
Ms. Petrcich says one of the key advantages of the new BMO GAM autocallable ETF is that returns aren’t dependent solely on strong stock market growth.
Investors may continue to earn income even if the underlying stocks are flat or experience moderate declines, provided certain thresholds aren’t breached.
The strategy also offers diversification by investing across a range of leading U.S. companies and sectors, reducing reliance on the performance of any single stock.
Ms. Yang says what differentiates BMO GAM’s new ETF from existing autocallable funds is its positioning between the two major camps in the U.S. market.
Specifically, on one end are diversified autocallable ETFs based on broad market indexes while on the other are concentrated single-stock autocallable ETFs that can generate substantially higher distributions, but with much greater risk.
Many U.S. autocallable ETFs based on broad indexes generate yields ranging from roughly 8 per cent to 18 per cent, she says, while some single-stock autocallable ETFs generate even higher distributions.
The BMO GAM ETF “attempts to strike a middle ground by combining diversification across multiple stocks with the higher income potential associated with individual-stock volatility,” Ms. Yang says.
Who are these ETFs for?
Ms. Yang says autocallable ETFs are best suited for income-oriented investors who are comfortable sacrificing part of their upside potential in exchange for higher cash flow and some downside protection.
“They may appeal to retirees, yield-focused investors and those looking for alternatives to covered-call strategies,” she says. “These products are generally better viewed as strategic income holdings rather than short-term trading vehicles.”
As for the risks and downside, Ms. Yang notes the protection is conditional: if the underlying reference stock or index falls below the protection barrier, investors can be exposed to significant losses.
Another risk is capped upside. If markets rise sharply, the autocall feature may trigger an early redemption, meaning investors may not capture the same gains that a traditional equity investment would.
There’s also the complexity to consider, Ms. Yang says.
“These products are more sophisticated than traditional equity, bond or covered-call ETFs, so investors need to understand how coupon barriers, autocall triggers and protection barriers interact,” she says.
Given the strong adoption of autocallable ETFs in the U.S., she says it wouldn’t be surprising to see meaningful interest from yield-focused Canadian investors.