This past spring, a number of Canadian iShares ETFs celebrated their 10th birthday. The country’s largest ETF provider now has 10 funds with a history that goes back to at least 2001, and according to the research firm Fundata, six of them were first quartile performers for the decade ending June 30, 2011. (This means they outperformed at least 75% of their peers.) A pair of others were second quartile, with only two lagging the category average:

iShares ETF 10-year quartile
DEX Short Term Bond Index Fund 1
DEX Universe Bond Index Fund 1
S&P 500 Index Fund 1
S&P/TSX 60 Index Fund 1
S&P/TSX Capped Composite Index Fund 1
S&P/TSX Capped Financials Index Fund 1
S&P/TSX Capped Energy Index Fund 2
S&P/TSX Capped Information Tech Index Fund 2
S&P/TSX Completion Index Fund 3
S&P/TSX Global Gold Index Fund 4

Fundata also reports that 11 of the 16 iShares ETFs with a five-year track record were first quartile performers, too. That’s an impressive result for a family of funds that simply try to capture the returns of an asset class with no attempt to beat the market.

An ETF history lesson

Even before iShares, Canada was a pioneer in the ETF space: in 1990, the first successful exchange-traded index trackers appeared in Toronto. They were called Toronto Index Participation Shares (TIPS), and they tracked what was then called the TSE 35. In 1999, this product was purchased by Barclay’s Global Investors and later rebranded as the iUnits S&P/TSE 60. Today it’s called the iShares S&P/TSX 60 Index Fund (XIU), and it’s far and away the largest ETF in Canada, with about $10 billion in assets.

The ETF that is now the iShares DEX Universe Bond Index Fund (XBB) was also a trailblazer: it was one of the first fixed-income ETFs in the world when it was launched in November 2000. But it wasn’t an index fund: it simply held a single 10-year Government of Canada bond. (It used the ticker symbol XGX, with the G indicating “government” and the X a nod to the Roman numeral 10.) The predecessor of the iShares DEX Short Term Bond Index Fund (XSB), launched the same day, held one five-year bond. By December 2004, these ETFs had evolved into the index-tracking products they are today. They now hold hundreds of bonds each, and boast more than $3.5 billion in assets.

Another change in the iShares lineup came in 2005, when the federal government eliminated the foreign-content rules for RRSPs. Before that time, investors could hold only 10% to 30% of their RRSPs in non-Canadian assets. However, because XSP and XIN are domiciled in Canada, they offered a way to get U.S. and international exposure without qualifying as foreign content. After those restrictions were lifted, and investors could buy cheaper US-listed ETFs that tracked the same indexes, iShares added currency hedging to XSP and XIN to differentiate them.

The middle of the last decade was an interesting period for ETFs in Canada. iShares’ only competitor was TD Asset Management, whose four Canadian equity ETFs couldn’t compete on price. With incredibly bad timing, TD got out of the ETF business in late 2005. Just a couple of months later, Claymore launched its flagship Canadian Fundamental Index ETF (CRQ) and the popularity of ETFs began to snowball.

The future for ETFs

I recently spoke with Oliver McMahon, director of product management at iShares Canada, about the evolution of ETFs in this country, and where the industry may be heading.

“My prediction is, because most of the large and recognizable indexes are already covered by ETFs, a lot of the products you’re going to see in the future will not track an index,” McMahon says. “The holdings are still going to be fully transparent, and they’re going to be passive investments: the portfolio manager is not trying to derive alpha. But rather than paying a provider to produce an index, the methodology may just be determined in-house.”

One example already in the iShares lineup is its Diversified Monthly Income Fund (XTR), which used to be the iShares S&P/TSX Income Trust Index Fund. When income trusts all but disappeared last year after the government changed the tax rules, this fund had to evolve. It now holds nine income-oriented ETFs with a breakdown of 50% equities and 50% fixed income, rebalanced quarterly. With such a simple mandate, it doesn’t make a lot of sense to pay an index provider.

Along the same lines, one has to ask why a fund like the BMO S&P/TSX Equal Weight Banks Index ETF (ZEB) needs to license an index. The ETF simply holds equal amounts the Big Six Canadian banks—presumably any fund manager with the ability to divide by six would be able to figure out the holdings. Yet part of the fund’s MER goes to S&P for performing this mathematical feat.

It will be interesting to watch the marketplace evolve in the coming years. I think there’s plenty of room for ETFs that don’t track a third-party index, though I hope it isn’t a slippery slope. Will the portfolio managers of these index-free funds be bound by strict rules, or given the leeway to use their own judgment? If it’s the latter, at what point does a supposedly passive fund become actively managed?

There is a lesson in iShares’ 10-year track record. All of those first quartile performers are plain-vanilla index funds, which means the old model works. It remains to be seen whether innovations can improve on it.