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Exchange Traded Fund (ETF)
Exchange Traded Fund (ETF)

Exchange Traded Fund (ETF)

The Exchange-Traded Fund (ETF) industry has been innovating seemingly nonstop since its creation in the 1990s. Starting with just a handful of ETFs, there are now over 13,000 globally, providing access to an ever-widening range of asset classes, sectors, and geographies. Before buying an ETF, investors should research offerings so that they align with their particular goals and risk tolerance.

What is an Exchange Traded Fund (ETF)?

An Exchange Traded Fund (ETF) is an open-ended fund that is listed and traded on a stock exchange and can be bought or sold directly during trading hours, much like a stock. An ETF is a basket of securities consisting of stocks, bonds, or other assets such as commodities. The asset mix of an ETF generally aims to track the performance of an index or asset class. Different types of ETFs are available in the marketplace and can be broadly classified into equity, bond, and commodity ETFs.

What are the Benefits of ETFs?

ETFs combine the diversification of mutual funds with lower investment minimum and real-time pricing. ETFs are popular because of their low fees, tax efficiency, liquidity and transparency. The ETF industry has grown substantially, with trillions of dollars under management.

  • Lower Cost: ETFs typically charge lower mangement fees and expenses
    • Lower costs mean that more of your money is working for you over the long-term
    • By purchasing an ETF, an investor avoids the commission costs that would normally be paid for purchasing each underlying security in a diversified portfolio, while only paying one commission fee for the purchase of an ETF
  • Diversification: ETFs aim to incorporate all, or a representative sample of the securities that make up an index, regardless of the number of securities involved
    • This offers investors lower portfolio variability and can reduce the impact that volatile markets can have, especially when compared to holding individual securities
  • Flexibility & Liquidity: Unlike other investments, ETFs enable investors to buy and sell at any point while the markets are open
    • In addition, the liquidity of the underlying securities represents the true liquidity of an ETF due to the creation and redemption process
    • ETFs allow investors to access securities that are broadly linked to a particular region, market, sector, commodity or factor without the need to trade each individual security
  • Tax Efficiency: ETF units are primarily bought and sold between different investors
    • This means that there are typically fewer realizations of capital gains and losses with ETFs than with other investment products
    • ETFs that track the performance of a specific benchmark tend to have lower overall portfolio turnover
    • Fewer transactions within the ETF again means fewer realizations of capital gains and losses that may flow through to ETF holders
  • Transparency: An investor can view the current trading price of an ETF at any time during the course of a regular trading day can also verify the composition of an ETF’s actual portfolio on a regular basis
    • This provides ongoing transparency, which can be particularly helpful during volatile markets

What are the Types of ETFs?

  • Active: With an active ETF, portfolio managers use their discretion to select holdings and aim to deliver risk- adjusted returns that beat a benchmark
    • Because of the additional cost of research, analysis and trading, active ETFs tend to have the highest fees
  • Alternative: offer exposure to the alternatives asset class and invest in strategies such as real estate, hedge funds and private equity
  • Bond: offer exposure to a wide selection of fixed income instruments
  • Commodity: track the price of a commodity, such as oil, gold or wheat
  • Foreign Market: follow non-U.S. markets, such as the United Kingdom’s FTSE 100 Index or Japan’s Nikkei Index
  • Index: An index ETF is designed to track an entire index, such as the S&P TSX or the S&P 500
    • It is generally the lowest cost option as it seeks to simply match a specific index rather than beat it.
  • Passive: track the market rather than actively attempting to outperform the market and typically have a lower cost
  • Quantitative: Securities are selected based on a systematic approach that relies on exploiting historical patterns in data
    • These strategies are actively managed and their rules are continually reviewed to ensure their efficacy
    • When needed, rules can be modified to seek improved risk-adjusted returns.
  • Sector & Industry: invest in a particular industry, such as technology, healthcare or financials
  • Strategic Beta: The securities in these ETFs are chosen based on factors that have historically produced better returns under specific market conditions using a rules-based implementation
  • Style: are devoted to an investment style or market capitalization focus, such as large-cap value or small-cap growth
  • Stock: track a certain stock market index, such as the S&P 500 or NASDAQ

Creation & Redemption Process (Primary Market)

ETFs differ from stocks in an important way: the supply of ETF shares can be adjusted up or down as needed. If there is demand for an ETF, a designated broker can create new shares at any time. A designated broker can be a market maker or financial institution. It is the designated broker’s role to acquire the securities that the ETF wants to hold. In exchange, the ETF manufacturer provides the designated broker with a block of equally valued ETF shares, called a creation unit. The process can work in reverse. The designated broker can remove ETF shares from the market by purchasing enough of those shares to form a creation unit and delivering the shares back to the ETF manufacturer.

Benefits of the Creation/Redemption Process

  • ETF shares can be created/redeemed based on supply and demand
  • Keeps ETFs trading close to their NAV
  • Reduces trading costs since ETF manufacturers do not take in or remit cash to investors
  • Reduces portfolio turnover through in-kind redemptions, resulting in fewer realized capital gains

Buying & Selling on the Exchange (Secondary Market)

The secondary market occurs when investors buy and sell ETF units from each other on the exchange through financial professionals or with a brokerage account. Shares can be bought and sold at the current market price whenever the exchange is open.

ETF Trading Best Practices

Once you determine the right ETF for your portfolio, you can purchase ETF units through a full service or online broker in the same way you would purchase stocks. Here are several factors to consider when buying and selling ETFs:

  • Avoid Trading Around Market Open & Close: Use caution when trading during the first and last 15 minutes of the day, when prices are most volatile and bid-ask spreads tend to be wider
    • In early trading after market open some of an ETF’s underlying holdings may not have started trading, and the ETF may not be priced accurately
    • Near the end of the trading day it may be difficult to buy or sell, as designated brokers begin to balance their books and may be reluctant to take on large positions
  • Order Type: Consider placing limit orders, which specify the price at which you will buy or sell
    • In contrast, a market order will attempt to complete your trade as soon as possible at the current price
    • Pay attention to bid-ask spreads indicative of the liquidity and the cost to trade the underlying assets
    • Using limit orders ensures your order is executed within a desired price range
  • Geographic Time Zone: Trades in international ETFs should be executed when that market is open, to minimize tracking errors and premium/discount aberrations
    • If underlying assets aren’t trading, intra-day ETF prices must be estimated
  • Liquidity:An ETF’s average daily volume is not the only indicator of its liquidity
    • Unlike stocks, where liquidity is based on trading volume, the underlying holdings of an ETF reveal its true liquidity
    • Investors should pay attention to the bid-ask spread and liquidity of the underlying securities to understand the overall liquidity
  • Large Orders: Consider trading through a broker when placing large trades
    • Brokers may have inventory or a greater ability to provide a superior trading result

Conclusion

ETFs come with risks and may not be suitable for all investors. It’s important to carefully consider the objectives, risks, and expenses of an ETF before investing.

  • Stay Focused: Don’t let down markets make you lose sight of your long-term goals.
  • Stay Invested: Missing the best days of a rising market can drastically reduce your long-term returns.
  • Stay Diversified: A diverse portfolio can protect you from downturns and give you access to markets and investments that are on the rise.