Pat Dunwoody
Executive Director, Canadian ETF Association
Exchange-traded funds (ETFs) are investment funds that let you buy a diversified basket of individual stocks or bonds in one purchase on a stock exchange. ETFs have a number of benefits for investors.
ETFs are an efficient, low-cost investment vehicle. The typical Canadian ETF management expense ratio falls between 0.25 percent and 0.75 percent, which is substantially lower than other investment funds.
ETFs provide trading flexibility. Limit orders allow you to set the price at which you’re willing to trade an ETF. Limit orders also provide investors with greater control over their execution price.
You can benefit from mid-day political and economic announcements. Macroeconomic news can introduce greater market fluctuations, affect the price of securities, and potentially widen bid/ask spreads for ETFs. Being able to trade with a known price throughout the day instead of having to wait for the end-of-day net asset value can be beneficial.
ETFs provide liquidity. They don’t have a fixed number of units outstanding, just like open-ended mutual funds. This enables new units to be created as needed to support demand. With ETFs, there are two levels of liquidity: primary and secondary. The ETF’s trading volume on the exchanges — what is visible — is secondary liquidity. Primary liquidity is the most important level of liquidity as it’s based on the liquidity of the underlying stocks in the ETF’s portfolio.
ETFs offer a range of investment strategies. Index ETFs provide investors with passive exposure to the performance of market indices, with their holdings reflecting the constituents of its benchmarked index.
Factor-based ETFs use a rule-based system for selecting investments to be included in the fund portfolio. They’re built on traditional ETFs and then tailor the components of the fund’s holdings based on predetermined metrics.
Actively managed ETFs’ holdings can change day to day, based on the discretion of their portfolio manager.
Commodity ETFs make it easier for investors to access specific commodities by holding derivative contracts to reflect the price of the underlying commodity, like gold or oil.
Fixed-income products are typically illiquid and hard to trade, but ETFs have made it possible for investors seeking investment security and income to access bonds and other debt instruments.
Leveraged/inverse ETFs use leverage and short-selling, and offer investors the ability to gain 2x, -1x, and -2x exposure to popular market indices and strategies. These should be considered trading vehicles, and not buy-and-hold investments.
ETFs are tax-efficient. The efficiency of ETFs generally refers to the taxable activity that occurs within the ETF compared to a traditional mutual fund. Buys and sells typically happen between investors on the exchange — no taxable activity occurs within the ETF itself. In contrast to this, investors buying or selling a traditional mutual fund do this directly with the fund, which may result in the fund having to either buy or sell underlying investments each day that investors transact. This can result in more taxable activity in a traditional mutual fund than an ETF.
The second aspect of tax efficiency is the creation/redemption mechanism, which allows for the increase or decrease of ETF shares based on demand without impacting other investors of the fund. This is an important contrast to a mutual fund, where any buying or selling in the fund impacts all investors.
