Investment Facts: What are Exchange Traded Funds (ETF’S)?
Investor Education Series Part 3
The world’s first exchange traded fund (ETF) was created within Canada in 1990, transforming the investment landscape and offering benefits of pooled investing and trading flexibility. Since inception, the Canadian ETF market has grown to approximately $90 billion as of 2015. In Canada, there are hundreds of ETF options available with a value of $87 billion. Globally, there are thousands of ETF’s with a value of three trillion U.S. dollars. (Values as of October 2015.) As a result, this can make choosing an ETF quite challenging. Below we explain what an ETF is, the various types and the benefits of placing them in your investment portfolio.
What are ETF’s?
ETF’s provide exposure to pools of securities similar to mutual funds. Like stocks, ETF’s are bought and sold throughout the day at different prices when stock exchanges are open and have a ticker symbol.
What are the major types of ETF’s?
There are 4 major types of ETF’s.
At Sharp Asset Management Inc. we focus on passively managed ETF’s that track a stock market index. Passively managed ETF’s are built to closely follow an index benchmark. It is important to understand that not all index ETF’s follow stock market indices. There are fixed income ETF’s that track bond indices and ETF’s that track a specific commodity such as oil and gold to name a few.
In some of our portfolios we use:
XIU – tracks TSX 60 Index—this is the largest ETF in Canada.
XSP- tracks the S&P 500 Index with a Canadian dollar currency hedge.
XIN- tracks the MSCI EAFE Index with a Canadian dollar currency hedge.
SPY- tracks the S&P 500 Index without a currency hedge—this is the largest ETF in the world.
Understanding what index the ETF is tracking is important as it determines the sector weightings within the investment. For example, iShares S&P TSX 60 track the TSX 60 index. The sector weightings as of June 30th 2016 are listed in the graph.
It is important to consider the sector weightings as two indices may hold the same investments but in different proportions. This can provide very different returns and impact the comparability between ETF’s.
What are the benefits of ETF’s within a portfolio
ETF’s enable an investor to gain exposure to an entire asset class (broad diversification) with a single security and a single transaction cost, thus avoiding the risks of owning individual securities and multiple transaction costs.
ETF’s are traded on stock exchanges during trading hours providing intra-day liquidity. What exactly is meant by intra-day liquidity? If you need to sell your ETF position this trade can be executed fairly quickly and you know your exact proceeds. On the other hand, mutual funds must wait until the end of the day in order to determine the net asset value and that’s when your redemption is complete. During periods of severe market volatility, there have been some liquidity issues with ETF’s.
There has been a major surge in ETFs because of their lower management expense ratios (MER) or annual operating costs as a percentage of average net assets. For example, the MER for the Ishares S&P TSX 60 is .18% whereas fees for index mutual funds are almost double. Compared to an actively managed mutual fund that can have an MER of over 2%, ETF’s are a bargain.
ETFs are highly transparent as their holdings are disclosed on a daily basis. Thus, an investor can determine the exact makeup of their portfolios at any given time.
Taxation of ETF’s
ETFs are favoured among tax-aware investors because ETFs are among the most tax-efficient securities due to their low internal portfolio turnover and their unique method of creating and redeeming shares “in-kind”.
Are all ETF structures the same?
Not all ETFs are structured the same. In the current market place, there are two types of ETF structures and the difference relates to the ownership of the underlying securities.
A physically-replicated ETF is one that holds all the securities in the index. We only purchase ETF’s that have this structure. Using the iShares TSX 60 XIU as an example, if you purchase the TSX 60 XIU, the fund actually owns all of the stocks in the TSX 60, in proportions equivalent to the index.
On the other hand, a derivative-replicating ETF holds a derivative through a counter party who will deliver the benchmark return to the ETF. In most cases, derivative-replicating funds have a higher risk profile then physically-replicating ETF’s due to their exposure to the swap counter party. However, these types of ETF’s are a good way of gaining exposure to markets that cannot be accessed through physically-replicating funds (i.e. commodities).