EXCHANGE TRADED FUND
An exchange-traded fund (ETF) is an investment fund traded on a stock exchange. An ETF holds assets such as stocks, commodities, or bonds. Normally, trades close to its NAV or net asset value. The trade takes place during the course of a trading day. Most ETFs track an index, such a stock index, bond index or a commodity index. Investors find ETFs attractive as investments. This is because of their low costs.
There are two key aspects to how an ETF works.
• The Primary Market What’s unique about ETFs is the creation/redemption process that takes place in the primary market. To create new units for sale in the secondary market, a designated broker delivers a basket of securities, which is determined by the ETF sponsor. In return, ETF units of equal value are delivered to the designated broker. The designated broker then sells the units to the public on the exchange to meet investor demand.
• The Secondary Market In the secondary market buyers and sellers transact on the stock exchange – units are bought from/sold to another investor without any involvement/knowledge of the ETF sponsor. These transactions are processed throughout the trading day at negotiated at market prices.
Investors tend to choose ETFs over mutual funds due to these reasons-
• Cost-effectiveness / diversification
When you invest in an ETF you are purchasing a portfolio that consists of a number stocks or other investments. You acquire a diverse investment. This helps you reduce the risks of turbulence in the market that you would normally find by investing in a single stock. ETFs are available in a broad range of asset classes and sectors in stocks, bonds, and commodities thereby enhancing further diversification. Also, the cost of an ETF is much lower than purchasing each stock individually.
ETFs are transparent. Their holdings are published every day. It is easy to monitor and track the weighting, current market price each day as it is traded on an exchange. It is also possible to see what investments an ETF holds as this is published each day. This enables an investor to evaluate if the EFT meets their investment objectives.
• Ease of Trade
Trading of ETFs can be done easily through an exchange. This may be done through and investment company or through on line banking. Trading takes place throughout the day at a current market price. The trade involves a commission for each trade.
• Low cost to possess
Since ETFs simply track an index and does not involve a lot of research the cost to purchase an ETF is less than that of a mutual fund.
There are three types of ETFs-
• Index ETFs
This is the most common type of ETF. This type tracks the performance of an index and could involve stocks or a bond market index. The ETF could track the entire NASDAQ or S&P/TSX exchange. Or an ETF may just track a particular sector the stock exchange. The performance of the ETF depends on the performance of the particular index that it follows. Exchange-traded funds that invest in bonds are known as bond ETFs. They thrive during economic recessions because investors pull their money out of the stock market and into bonds. Commodity ETFs trade just like shares, are simple and efficient and provide exposure to an ever-increasing range of commodities and commodity indices, including energy, metals and agriculture.
• Actively managed ETFs
The actively managed ETFs approved to date are fully transparent, publishing their current securities portfolios on their web sites daily. A portfolio manager is involved and makes decisions and the objective of this type of an ETF is to out perform the index. This type of an ETF has higher fees.
• Leveraged ETFs
Leveraged exchange-traded funds are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs. The risk exposure is high in this type of an ETF. The reason being that the ETF uses borrowing to increase the return. The borrowing aspect creates the leverage.
Stable low interest rates have heightened interest in the strategy of leveraged investing. Cautious and prudent leveraging can accelerate asset growth, but it can also involve high risk. Rising interest rates and market downturns would certainly increase investment losses. Rising interest rates are normally followed by a dip in the stock exchanges. The interest paid on leveraged accounts to earn interest and dividends could be deducted from taxable income. However, there are strict limitations and it would be prudent to consult your tax advisor.
Like any other investment an ETF is exposed to risks. There is no guarantee that an ETF would be in the money for an investor. The risk also depends on the type of ETF. ETFs have similar risks to the underlying investments. An ETF that follows a fixed income index has risks similar to a bond. An index ETF may not achieve the same return as the index or sector it tracks. This is because the weightings of investments in the ETF are not exactly the same as those in the index. Another factor is that fees and expenses could lower the return. ETFs that invest in commodities tend to be higher risk because they are concentrated in one sector and the prices of commodities easily fluctuate. There are several factors that could contribute to theses fluctuations some could be also political. Leveraged ETFs are very sensitive to market volatility. They typically aim to double or even triple the daily return of a market index.
Cost, fees, distributions
Trading in an ETF involves commissions, fees and operating costs. A commission is incurred for each trade. The commission is paid to the investment firm. Commissions depend on the plan chosen by the customer. All exchange-traded funds incur expenses related to the management of the fund. The most common expression of the fees associated with an ETF is the Management Expense Ratio (MER). ETFs that are not actively traded cost less as the fund manager does not have to engage in research. ETFS also incur operating costs such as fees associated with complying with national regulations and the fees payable to members of the board of governors of the ETFs. ETFs declare distributions. An ETF invested in bonds will pay an interest distribution; an ETF invested in a stock index will be a dividend. A capital gain would result if an ETF were sold at a higher price than its purchase price.
ETFs invested through an RRSP or a RRIF account will not attract tax. However, tax would have to be paid if the RRSP or RRIF is withdrawn. The tax will be on the distributions as well as on any capital gain. The treatment is different if an ETF is purchased through a TFSA account. There will be no tax on the distribution or capital gain whilst the ETF is in the plan or withdrawn from the plan. ETFs pay dividends less often than mutual funds.
Normally, ETFs are a good choice for an investor because they provide liquidity, are flexible, and are cost – effective. Investors wishing to add an ETF to a portfolio would need to evaluate their own situation, investment style, knowledge level and time frame to conclude if an ETF meets their investment strategy.