A tutorial on exchange-traded funds

Opinion

Hey there, time traveller!
This article was published 05/03/2010 (5679 days ago), so information in it may no longer be current.

In the last few weeks I have written about active versus passive investing, and the use of ETFs (exchange-traded funds) as an investment vehicle.

However, I broke my cardinal rule of writing: Start at the beginning and don’t assume people are experts on the subject.

So, this column will attempt to explain how ETFs work, how they differ from mutual funds, and then talk about some of the choices of underlying investments that are blurring the line between the two.

Recent press on ETFs has been overwhelming. You can hardly pick up a newspaper without seeing something on ETFs. What’s behind the hype?

The biggest practical differences are lower fees and passive management style, but the underlying structure is also different.

Conventional mutual funds are mostly open-ended unit trusts (though some are corporations), which means at the end of each trading day they issue units to buyers in exchange for cash, and provide cash to sellers — those people who want to redeem their units. The fund guarantees to do this at the NAVPS (net asset value per share), which has always been one of the benefits of open-ended funds. While the underlying assets of the fund are subject to price changes based on supply and demand, the units of the fund itself are not.

On the other hand, closed-end funds trade throughout the trading day, but their price is based on supply and demand, like any other stock, only loosely based on the NAVPS.

ETFs are a hybrid of the two. They trade throughout the trading day, so you can buy and sell them when you want.

However, they have a “market maker” (a bank or other large institution) that promises to buy and sell units at virtually the NAVPS, eliminating the supply and demand risk.

You pay a commission when you buy or sell, but the ongoing management fee is as low as 0.30 per cent per year.

Up until this year, a main difference between funds and ETFs has been the management strategy, between active and passive. Lately, that line has been blurring.

Virtually all mutual funds are actively managed — a manager is paid a fee to select individual investments to buy and sell, based on the stated mandate of the fund.

The thesis is that a full-time professional, backed by analysts and researchers, can perform better than simply following a group of stocks picked based on some static (but objective) criteria, such as size.

Research has not proven that this thesis is correct. See last week’s article for more.

The largest provider of ETFs in Canada — iShares — announced last month that total ETF assets in Canada had grown 30 per cent in 2009, to over $30 billion. This still only represents 4.6 per cent of total mutual fund assets in Canada.

IShares has 80 per cent of the ETF market in Canada. They, and Claymore, a main competitor, offer mostly passive, index-linked investments. For example, XIU is an ETF that tracks the performance of the 60 largest stocks on the Toronto Stock Exchange, while XRE tracks the index of real estate investment trusts. Other ETFs track bonds, small cap stocks, energy stocks, socially responsible companies, and almost anything you can imagine. More and more specialized indices are being made available, almost weekly.

Now, conventional active management is also available through the ETF structure. The performance of Horizons AlphaPro ETFs are linked to the performance of portfolios managed by several well-known investment managers with excellent track records. Information is available at www.hapetfs.com. (Ignore the fact that two of their trading symbols are HAW and HAH.)

A difference is higher fees than passive ETFs — like 0.70 per cent, plus performance fee of 20 per cent of profit above a high-water mark.

Last week, I mentioned the Invesco PowerShares, which use an ETF structure to access modified indices, but have other features and fees closer to conventional funds, with a trailing commission paid to an adviser.

Lots of choices. Let me know what you would like to hear more about. (And enjoy that spring weather.)

David Christianson is a fee-for-service financial planner and portfolio manager, providing comprehensive financial advice and management services. You can email him at dchristianson@wellwest.ca or visit his blog at www.davidchristianson.com.