They are readily traded, carry low management fees and offer special tax loss benefits.
Over the last decade there has been explosive growth in exchange traded funds, or ETFs. According to Bloomberg, as of June 2014 there were over 7,100 ETFs listed globally, with a market value of $2.8 trillion.
What is an exchange traded fund? It is an open-ended fund that is listed and traded on a stock exchange. The fund typically holds a basket of securities, which can be either stocks, bonds or such other assets as commodities, which include precious metals or oil. The fund may hold a representative basket of securities or it may use derivatives to mimic such a basket. The ETF can be bought and sold during regular trading hours, like any other security. The investor pays a commission to buy or sell the ETF.
No managers needed
Exchange traded funds were successfully launched in 1990 in Canada with the introduction of Toronto Index Participation Shares (TIPS), which were designed to track the TSE 35. Initially, most ETFs were designed to follow the performance of an index. They offered a very inexpensive way to access passive investing. Actively managed mutual funds bear a much higher level of expenses and include commissions and trailers, portfolio managers and research teams, and regulatory administration. ETFs have very low cost.
Whether the mutual fund’s extra expense of active management provides value in terms of higher returns can be a matter of argument. This depends on the fund. It is up to the investor or their financial advisor to determine this.
Besides having lower expenses, ETFs provide several other benefits to investors. First, basic ETFs are very simple to understand. Secondly ETFs can be bought and sold anytime during trading hours. An investor can also specify a target price to buy or sell an ETF. Mutual funds, on the other hand, only settle at the end of the trading day so you do not know what your cost will be until then. This can be very hazardous in volatile market conditions.
The ETF’s portfolio composition can be viewed on a daily basis, providing greater transparency than a mutual fund. A tax consideration is the fact that ETFs tend to have lower portfolio turnover and therefore fewer realized capital gains and losses than mutual funds. (Have you ever been surprised by a large capital gain on a mutual fund T3, even when the fund itself may have had a losing year?)
Investors use ETFs for various reasons. Of course, being much less expensive than a mutual fund, they lower portfolio overhead. They offer instant diversification to various markets or sectors. They provide a strong core holding for a portfolio. For example, a Canadian equity ETF can provide equity exposure while the investor tries to buy various individual securities, drawing funds out of the ETF as trades are filled.
Offer tax benefit
ETFs are useful for tax loss selling. You can sell a portfolio security, place the proceeds into a suitable ETF in the same sector and then repurchase the security after 30 days. You thus avoid having the loss denied under CCRA rules which prohibit buying the same security within 30 days.
Fixed income ETFs are much less expensive than bond funds and permit better management of duration through selecting ETFs by maturity – that is, short term, mid-term and long term.
So ETFs can be a valuable tool in building your portfolio at any stage of life.
Dianne J. Szelag is an investment advisor and financial planner with BMO Nesbitt Burns.