What is an ETF?

Markus Muhs - Feb 19, 2019
Surprisingly I still get asked this question a lot. Okay, at one point ETF might have been industry gibberish, like PPN, CDO, or FTLP, but by today I’d think the acronym ETF has reached the same recognition by the average retail investor as GIC.

Anyway, obviously you’re here, so I won’t blame you for not knowing what an Exchange Traded Fund is, or for knowing what one is but wanting to learn more. Truthfully, many who know full well what they are – and use them actively – still don’t fully understand how they work.

An Exchange Traded Fund, as the name suggests, is an investment fund (like a mutual fund) that trades on a stock exchange.

For most people, that’s about all they need to know. We all know what investment funds are; they’re single securities which own a bunch of other underlying securities, such as stocks, bonds, etc. There are some significant differences though between various investment funds; notably how they accumulate money and parlay it into various investments. Let’s start by looking at some of the investment fund models we might be more familiar with:

 

Open Ended Mutual Fund

 

This is the one we all know. You can buy them at the bank or through any of the other nearly 100,000 mutual fund dealers in Canada, as well as from investment advisors. Most of the $1.5 trillion Canadian mutual fund industry is in open ended funds from the various fund companies we’ve all become familiar with (banks, Fidelity, Mackenzie, CI, etc).

Open ended funds trade at daily closing net asset values (NAVs) at the end of each trading day. You can’t buy and sell them actively during a trading day, but you know you’re always getting exact end of day NAV value when buying and selling.

When you “purchase” an open ended fund, you’re literally sending your money to the fund company. When you “sell”, the fund company sends it back to you. The fund company sees in-flows and out-flows day to day and has to manage these while at the same time managing the investment portfolio.

Investor fund flows can be a challenge, not only because it often forces fund managers to sell securities when they don’t want to (to satisfy out-flows, which tend to happen when security prices are at their worst, ie: December 2018), but a popular outperforming fund can also attract too much in flow of capital, putting the fund manager in the position of having to invest money when security prices are high (or else dilute the fund with a large cash holding).

Investor fund flows, along with the proactive decisions by an active fund manager may also create tax consequences. Remember, you’re pooling your money with everyone else, and if everyone else bails you may still end up with a tax bill for capital gains, even though you didn’t actually sell the investment. A lot of mutual fund investors saw their active mutual funds go down in 2018 (or stay mostly flat, in the case of most U.S. equity funds) but may still receive a T3 or T5 with significant capital gains for two reasons: a) gains earlier in the year, when stocks were higher and active managers decided to sell some positions, b) forced selling by the fund manager as fund out-flows skyrocketed in December.

 

Closed Ended Mutual Fund

 

These funds are more rare, but worth mentioning to help understand how all these types of funds work. Closed ended funds are initiated by way of a type of “initial public offering” (IPO) at which point the fund company raises a certain amount of money. After IPO, there are no more in-flows or out-flows, which is good for both the fund manager and the investor (tax-wise).

After their initial funding, closed end funds sell on an exchange at a price simply determined by the supply and demand of the fund. Tendency is for closed end funds to trade at somewhat less than their net asset value as there are a whole bunch of people owning the fund, who might want to sell for various reasons, while the fund company ceased all its marketing of the fund after IPO and very few out there are actively seeking to buy said closed end fund.

 

Exchange Traded Fund

 

The reason I went through explaining both open end and closed end funds above, is because ETFs technically are a little of both worlds. In a way really, they’re the best of both worlds.

Like a closed end fund, ETFs trade on an exchange. They aren’t “closed” to new investment though, so an ETF sees fund in-flows and out-flows sort of like an open ended fund.

How the money gets from your investment account to the fund manager differs quite a bit though with ETFs. When you buy a Vanguard ETF, for example, you’re not sending your money to Vanguard for them to invest. You’re buying those shares on the open market from other investors, just as with a closed end fund. What’s different though is that Vanguard is constantly creating or deleting shares on the open market in an effort to keep the ETF’s market value as close to NAV as possible. When demand for the fund goes up, they create more units and sell them, effectively seeing an in-flow to the fund’s assets under management (and vice versa).

When creating/deleting shares, the fund company is buying or selling a basket of the ETF’s underlying securities; this is where things get tricky and possibly costly for a fund company. Looking at the ETF landscape you’ll notice that ETF Management Expense Ratios (MERs) can vary greatly, from just a few basis points (hundredths of a percent) above zero, to 1% or more.

Typically, those ETFs which track a cap-weighted index (an index where the biggest companies represent the biggest portion of the index’s value) have the lowest MERs. This is because it’s relatively easy to create/delete units when those companies which you need to trade the most shares of are also the biggest and most liquid around. Other ETFs that are equal-weighted, factor-weighted, or have some sort of underlying management strategy, tend to have higher MERs because it’s not quite as easy to trade their underlying securities on the fly.

The biggest benefit to the way the ETF manages fund flows is that you – the existing investor in the fund – are not affected in any way whatsoever by other investor’s fund flows. You own your shares, representing an underlying basket of securities, and other investors are buying either new baskets of securities that the fund company created or buying them off other investors. Thus, ETFs tend to be – all else being equal – more tax efficient than mutual funds. You pay taxes on interest and dividends that the ETF generates, pay capital gains mostly upon the sale of the ETF, and otherwise see only very minor capital gains generated at the end of the year from deliberate rebalancing within the fund (less on cap-weighted index funds, which only would trade underlying securities if there are changes to the index, a bit more on factor-based or active ETFs).

 

 

ETFs Today

 

Back in the day I dealt entirely with mutual funds, and for some clients the mutual fund concept was something new. I think many envisioned a mutual fund to be simply a basket of stocks that’s fairly static and determined by the classification of the fund (ie: a basket of Canadian stocks, a basket of U.S. stocks, a basket of tech stocks, etc). This is actually more precisely what ETFs tend to be, whereas with a mutual fund (the vast majority of which are actively managed) you’re not so much buying a basket of stocks as you are sending your money to a fund manager, effectively hiring them for their expertise.

Many see the differentiation between ETFs and mutual funds as simply:

  • Mutual funds are actively managed and very expensive (over 2% MERs).
  • ETFs are index based and very cheap (under 0.10% MERs).

 

This is an oversimplification brought about because of where most assets are weighted in each fund type. It’s true that most mutual fund assets in Canada are weighted heavily toward actively managed funds, and of these, most are sold through advisors and have embedded within their MERs trailing commissions of around 1% (bringing total MERs up to 2% or higher).

Of the more than $120 billion in ETF assets in Canada, the lion’s share are in index funds with iShares, BMO, and Vanguard. A much smaller proportion are in active or factor-based mandates which have MERs not much different than active mutual funds.

Because it’s relatively easy for companies to either pop up and start offering ETFs, or for multinational players like iShares and Vanguard to start offering their product on Canadian exchanges, there’s quite a bit more competition on price, which has yielded relatively lower MERs. Currently, the lowest-costing index mutual funds in Canada have MERs more than 3x those of their ETF equivalent (in the U.S. meanwhile, index mutual funds are actually available at lower MERs than their ETF equivalents).

I should add that while U.S. based mutual funds are unavailable to us in Canada, U.S. listed ETFs are available. This adds a universe of more than 2000 U.S. listed ETFs to the 800 available on the TSX.

 

Conclusion: What it means to you

 

Many consider ETFs – specifically low-cost index ETFs – to be the “democratization of investing”. I am a huge proponent of this, as I believe that successful investing isn’t about picking stocks or trying to choose the right fund manager. Being a successful investor means 1) having good investor discipline, 2) having the proper asset allocation. ETFs allow you to easily do 2, and 1 is what every good advisor’s biggest value add is to the client.

For financial planners like me, it also allows us to focus on the above while the client pays for what really matters: the financial plan.

I see some detractors to index ETFs in the investing community herald the merits of active fund management or stock picking, while at the same time using the long term track record of the S&P500 – with dividends reinvested – as rationale for long term buy and hold investing. Well… if the S&P500 has such a great 60+ year track record, why not invest in the investment that closely matches the S&P500 and have as much of those dividends reinvest as possible?

While index ETFs are great for certain core components of an investor’s portfolio, I’m not so biased into believing that there is no room for active or factor-based strategies. All should be taken into consideration when building a portfolio, and whether an investment mandate comes in ETF or mutual fund structure should be secondary to the underlying investment.

I’m always happy to answer any questions left unanswered and help you learn how ETFs can fit into your investment portfolio. Don’t hesitate to e-mail me.

 

Markus Muhs / CFP, CIM

 

 

Further reading:

WisdomTree: ETFs vs Mutual Funds

Vanguard: ETF Education Center