What is an Exchange Traded Fund (ETF)?
Exchange Traded Funds or ETFs operate very much like mutual funds except that instead of taking in capital and issuing redemptions on a daily basis they are closed end which means they trade like a stock and are bought and sold on a normal stock exchange. ETFs can be actively or passively managed. They come in all types and at all risk levels. For our purposes, we are going to focus on passively managed indexed ETFs as a means of tracking the performance of a market, style or industry index.
How to Use ETFs?
Our discussion on ETFs will center on using them to create a passively managed segment of your portfolio. The purpose of the indexed ETF is that it tracks a particular index. For example, if you wanted to allocate 10% of a $100,000 portfolio to the TSX Composite index, then you could purchase $10,000 worth of units in an ETF like the S&P/TSX Capped Composite Index Fund which bears the trading symbol XIC. A quick look through iShares.com and you will quickly see that you have access to a wide range of indexed ETFs for virtually every industry in the Canadian market, U.S. based and global equities, as well as style funds, such as the Dividend Aristocrats Index. The same products are also available from other ETF providers such as www.vanguardcanada.ca as well as all of the major banks.
Passive Mutual Funds (Index Funds) versus ETFs
Although most mutual funds are actively managed, there is a certain class, indexed mutual funds, which provides the same type of passive stock market exposure as indexed ETFs. The difference between the two types of instruments is the structure. Indexed mutual funds are open end funds and receive contributions and redemptions on a daily basis. The fund itself manages these transactions and issues new fund units or redeems existing units for cash based on the daily calculated net asset value (NAV).
ETFs are closed end funds and maintain a consistent number of units which trade on an exchange like a regular stock. The ETF itself does not deal with contributions or redemptions on a daily basis. Just like with a stock, when you want to acquire units you buy them on an exchange and when you want to redeem you sell them on the exchange…the ETF itself doesn’t have anything to do with these transactions.
There is no clear answer for which is better – indexed funds or indexed ETFs. The open ended structure of the indexed mutual fund does require the fund to maintain a higher ongoing cash balance to ensure they can honour daily redemptions. This can create a “cash drag” as not all capital is fully invested and earning a return. ETFs don’t have to deal with daily redemptions and therefore don’t need to carry as much cash. Another interesting characteristic of ETFs is the ‘in kind’ redemption feature which provides tax deferral for unit holders. When an index fund sells stock to fulfill redemption requests, the capital gain tax liability is spread amongst the unit holders, regardless of whether or not they are redeeming. Investors in ETFs can realize return by either selling their units on the open market or by exercising the ‘in kind’ redemption, whereby they would receive a basket of securities proportional to their fractional interest of the securities owned by the ETF. For the “in kind” redemption, no tax liability is incurred unless sales from the basket of securities are made.
Understanding Discounts and Premiums
Another thing worth knowing is that because ETFs trade on an exchange, the price is determined by supply and demand and at times, ETF units can trade at a premium or a discount to their net asset value. Normally, this isn’t too much of a concern as discounts and premiums tend to be very marginal. However, it is worth noting whether you are paying a discount or a premium on the ETF when you purchase it. In general, indexed ETFs should trade at a very modest discount to their NAV.
Indexed Exchange Trade Funds (ETFs) can be highly efficient vehicles through which investors are able to purchase diversified exposure to an entire market index, sector, or geographic region. Benefits include a competitive fee structure, simplicity of trading, tax advantages over indexed mutual funds, and unique features such as in kind redemption. However, ETFs come in all types and risk levels and it is important that investors much understand the type of investment they are purchasing. We advocate the appropriate use of non-leveraged ETFs that are indexed to diversified indices, but warn investors against more exotic ETFs such as those that use leverage or are tied to the performance of commodities or other risky assets.
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